Interest Rates Aren’t the Price of Money

On Saturday, Corie wrote about the “many unsustainable patterns of economic activity” that have been prevalent in the post-Great Recession economy.

In doing so, she quoted Texas Congressman Ron Paul’s most recent commentary on the subject. Says Paul:

Because the interest rate is the price of money, manipulation of interest rates has the same effect in the market for loanable funds as price controls have in markets for goods and services. Since demand for funds has increased, but the supply is not being increased, the only way to match the shortfall is to continue to create new credit. But this process cannot continue indefinitely. At some point the capital projects funded by the new credit are completed. Houses must be sold, mines must begin to produce ore, factories must begin to operate and produce consumer goods. (emphasis mine)

While this analysis is spot-on, it’s important to note one glaring inaccuracy: interest rates are not the price of money.

David Friedman, son of Milton, has explained why on a couple of occasions, and it’s a point that bears repeating. Says David:

The next time someone tells you that the interest rate is the price of money, ask him what he thinks a reasonable interest rate is and offer to buy some money from him—at ten cents on the dollar if the rate he suggests is ten percent. As that example illustrates, the interest rate is not the price of money. The price of money is what you must give up to get it. If apples cost fifty cents each, the price of money is two apples. More generally, the price of money is the inverse of the price level—when prices are high, that means that money is not worth very much.

The interest rate is the rent of money measured in money. Suppose you borrow a hundred dollars at ten percent. If the price of a dollar is two apples, you are borrowing the price of two hundred apples and paying the price of twenty apples a year in interest. If the money supply doubles, prices double, including the price of an apple, you are borrowing the price of a hundred apples and paying the price of ten apples a year in interest. If you prefer, you could do the same real transaction as before by borrowing two hundred dollars and paying twenty dollars a year interest, still at ten percent.

This distinction is an important one, because if interest rates were the price of money, it would imply that “printing more money would lead to lower interest rates.” That’s demonstrably false.

As Prof. Friedman explains:

The reason the description of the interest rate as the price of money is not only wrong but dangerously wrong is that it implies a simple relation between money and the interest rate—in the extreme (but not uncommon) version, the belief that interest rates are set by central banks, with high interest rates the result of a tight monetary policy.

…

The interest rate is a market price—the price paid for the use of capital—and the central bank controls it only in the same sense in which the government can control the price of wheat by choosing to buy or sell some of it. The central bank does not have an unlimited amount of capital from money creation to lend and so has only a limited ability to shift interest rates from what they would otherwise be.

Of course, this doesn’t change the fact that manipulating interest rates through the buying and selling of Treasuries (mostly buying) has resulted in distorted market signals and misallocated capital. But when we want to understand how complex economic policies are likely to impact current and future prosperity, it’s worth getting this distinction right.