Basic: Why would interest rates go up when people save less in a free market economy? (In a

Economics Economics Questions
1

Hello to everyone! It’s my first post here, and I’m glad this forum exists.

I’m familiar to Austrian Economics for some time and have read several “Austrian” books. Today, all of a sudden, the following thought crossed my mind: Why is it, actually, that in a free market economy interest rates would go up when people save less? Until today, it seemed obvious to me: Less savings means less to lend out for the banks (supply of savings goes down, price goes up). But now something bothers me: When people trade with each other, the money simply goes from one bank account to the other. So the amount of available money seems to stay the same for the banks…

I tried to solve this puzzle by thinking: When people save more, prices fall and the value of their money rises. That could be the same as if there were just more money. But that thought doesn’t help, because the amount of money still stays the same, so interest rates are nominally the same as well…

I would be very glad if someone could help me with this. It’s sure some sort of fallacy of mine, but yeah… Thank you in advance.

2

The money on your checking account is not exactly available for the banks to lend out…

3

If on average people start spending more and therefore saving less, and they withdraw money from their bank accounts for this purpose, there are less funds available to the bank to be loaned out, and so interest rates rise. As long as this more spendthrift tendency remains, the higher interest rates will remain. If people revert back to their original frugality, interest rates will fall accordingly as bank deposits increase.

While true that money withdrawn by Jones and spent will ultimately end up in Smith’s bank account, remember that the premise of this hypothetical is that people on average have become more spendthrift; i.e. Smith will also have already reduced his bank deposits, and any income from selling something to Jones will be allocated according to the new more spendthrift consumption-savings ratio. In other words, even though the spent money might flow through the banks briefly in the transaction between buyer and seller, the stock of bank-deposited money relative to the stock of circulating money will be smaller than it was before. And if there’s no change in total money supply, this means an absolute decline in loanable funds and higher interest rates, all else being equal.

4

We had a thread on this not too long ago. Some issues to keep in mind:

The market in loans is not nearly as homogeneous as modern concepts would suggest… the risk profile of one loan to the next is based in a multitude of particular factors that vary from one loan to the next. Thus, there is no such thing as “the” interest rate. An interest rate is only meaningful relative to the loan to which it is attached.

However, like any “confidence” problem, loans can be rated according to the quantifiable attributes of their riskiness (a lot like how insurance works). The risk of loss of principal is one of the key factors determining the price of the loan (interest rate) but certain factors like income, collateral, cosigners, legal security of lenders, and so on all mitigate the risk of lending money and the presence/absence of these factors can be used to categorize loans on the basis of risk.

This is why it’s not as simple as “more funds available to be borrowed equals a lower interest rate.”

However, for a given risk-class, we can ask what happens if there are more loanable funds or less. All things equal, if there are more funds available to be loaned, this implies there is greater competition among holders of capital to identify eligible borrowers in that risk class, which implies a lower interest rate.

And make no mistake, the interest rate is a price, it is just not “the price of money”, it is the price of borrowed funds (loanable funds). David Friedman compares it to rent since the principal is to be returned at the end of the loan. The “price of money” is always 1.0… that is, the price of money is defined in terms of itself and is, thus, identity. Or, a more informative way to think of the price of money is in terms of the things that it can buy. But it’s crucial to remember that this is not a well-defined price because you can never choose a truly representative “basket of good” by which to measure the price of money. This is the ineradicable problem of a “consumer price index.”

The “originary interest rate” is the disposition of individuals to rank future as against present goods. This is a purely psychological ranking and it is the sole determiner of the availability of loanable funds and the demand for borrowed funds for a given rate of profit from lending (investment).

The rate of profit from lending varies over time and is never the same from industry to industry (though the tendency over time is for it to move towards equilibrium across all industries). The rate of profit from lending is also not guaranteed (investment in a venture that eventually goes bankrupt is a catastrophe, not a profit). Nevertheless, as this rate of profit changes overall, it fundamentally alters the relative attractiveness of investment activity versus other uses of wealth.

This is the sense in which the market in loanable funds responds to “the interest rate” - all else equal, a higher interest rate means a larger profit from lending, thus making lending a more attractive venture vis-a-vis other uses of resources (consumption, saving, etc.) But it’s key to remember that because loans are not homogeneous, because there is no “the” interest rate, and so on, that the market can move simultaneously up and down… investment can become less attractive in one area and more attractive in another area and there is no general way to say whether investment-as-a-whole has become more or less in demand.

Clayton -

5

Under the situation you are talking about banks would either have to artificially create the money, and then lend it, in which case it wouldn’t be dissaving which is happening but rather credit expansion, or the money would have to come from reserves like checking accounts, which would indeed count as dissaving and it would have the affect of raising current spending relative to current investment, shifting the factors of production to a more current use.

6

Eliminate the bank and what you have is a bunch of people trying to fund projects that will pay more than what they need to start, call them entrepreneurs, and another group of people who have wealth and are planning to spend it, call them consumers. The consumers want to consume some of their wealth and they want to save some. The entrepreneurs want to entice the consumers to save their wealth with them and not consumer. The entrepreneurs do this by paying interest on the the money consumers save with them. So if consumers adjust their behavior by consuming more and saving less, then less money is available to the entrepreneurs. So to keep the same amount of savings available the entrepreneurs will have to increase the payouts to consumers by increasing the interest rates.

Even if the amount of money stays the same, consumers adjust their consumption decisions not only to savings versus consumption, but on what products and services they consume to satisfy their preferences. And in a free economy entrepreneurs are always looking to get the wealth of consumers by trading for wealth through interest or by trading goods and servcies. So if the consumer with a constant amount of money can increase their wealth by either having a large set of things to buy or by having cheaper prices for those things.

Now as the consumers see ever expanding values of their money, the money becomes so valuable that it becomes hard to trade so there will be entrepreneurs who jump in to the market in several ways: Cut the amount of gold in the money, Mine new gold, start new forms of money (A person may want 10 ounces of gold for a car or 600 ounces of silver or 6000 ounces of copper, etc, or offer a paper or electronic contract for money.) or get more money by giving users of the metal alternatives. (An entrepreneur could give dentists a ceramic cap instead of a gold one for instance.)

Think for a moment how advantageous it is to have a precious metal with alternate uses for money. Dentists, jewelers, circuit builders, etc all use gold and silver. When the value of these metals as money goes up they use other things, and when the value of gold as money goes down they switch back to the monetary metals. Compare this to the ever decreasing value of paper money.

7

people have to pay more for scarcity.

8

Why is it, actually, that in a free market economy interest rates would go up when people save less?

On the simplest level, interest rates are the price paid for borrowing money. If supply of money available to lend goes down and demand remains the same, there will be more people chasing a smaller pool of funds, meaning the price, the interest rates, would naturally rise.

9

I see. So it’s the money in circulation that is of course not available for the banks… But does this really matter so much? I mean, exchanges don’t take that much time, so the money will quite quickly be on the other person’s account again. So is that really such a big loss to the banks? This short time the money is not available?

10

“I see. So it’s the money in circulation that is of course not available for the banks… But does this really matter so much? I mean, exchanges don’t take that much time, so the money will quite quickly be on the other person’s account again. So is that really such a big loss to the banks? This short time the money is not available?”

That’s meant to be an answer to “Minarchist”.

11

In a free market interest rates on savings would represent the market rate for interest on savings. Ideally from the bank’s perspective the interest rates on savings would be low and the demand high. The consumer preference is obviously high interest. The bank then would have an incentive to raise the interest rates in order to get customers.

12

By way of analogy, suppose there’s a waterslide, where the water collects in a pool at the bottom and gets pumped back up to the top, so that it flows in a loop. The pool is the bank, the rest of the circuit is the path of the money through the economy outside the bank. When the savings rate goes up, the circuit gets longer. Instead of a 100 foot slide, it becomes 120 foot slide, but the total amount of water remains the same. So what happens? The pool loses water, since more water is in the rest of the circuit. Yes, the water that leaves the pool might quickly return to the pool, it could even return more quickly than before, doesn’t matter - the pool still has less water in it at any given time than it did before.

13

@Minarchist: Great analogy, thank you! One last question: What about an economy where everything is like in the US except for the FED leaving the interest rates alone? Would interest rates still go up if people saved less and go down if people saved more? Even though there’s online banking, for example, so the money changes bank accounts extremely quickly and is thus almost always available for the banks?

By the way: Would online banking exist under a gold standard?

14

Sure. You’d just use information as credits to each bit of gold. There’s still the possibility of issuing more credits than you have gold, so it needs to be tightly controlled and periodically audited so that confidence remains high.

After WWII, the US gave gold to our allies for decades. They never took it out of Fort Knox, we just change who owned it. Thus, exchange requires exchange of title only, not the physical asset necessarily. Which is one of the reasons why fiat money works without a commodity backing, and also one of the reasons why bitcoin functions as money.

15

I think that’s a bit glib. Money substitutes - hell, banking itself - only work if there is some kind of securitization of the assets held. It doesn’t have to be government doing it (in fact, one could argue that the breakdown of the global financial system is naught else but the result of governments securitizing financial instruments) but, somehow, there has to be securitization. Look at Hawala to see a system of distributed securitization.

Clayton -

16

The Hawala system, from the wiki info, looks a lot like what I described in terms of Ft. Knox gold exchanges. It’s all pooled together.

That system also looks a bit like how bitcoin payment obscurers work, or perhaps could work.

The question is where does trust enter the system, and what is the basis of that trust. Under Hawala, it’s reputation of the two money-holders. Under fiat money it’s legal enforcement. Under commodity’s its demand for that commodity which is expected to remain fairly stable (though it’s perfectly possible in theory for a commodity’s value to collapse just like any other price, should demand disappear for any reason). Under bitcoin, it’s the strength of crypto underlying it.

So, take your choice.

17

Without the Fed fixing interest rates, or any other similar government interventions in the credit markets, then rates would be set by supply and demand for loanable funds, as we’ve been discussing. Assuming demand remains the same, then, yes, more savings means lower rates, less savings means higher rates.

I don’t think the speed with which the money moves is a factor here. Returning to the analogy, it doesn’t matter how fast the water moves along the circuit of the waterslide, if the waterslide gets longer, so that more water is in it at any one time (as opposed to being in the pool), then the volume in the pool shrinks. The water can be flowing at 1 mph or the speed of light, doesn’t matter, there’s still less in the pool.

It could, and I assume it probably would. In a free market banking situation, paper money could still exist (and almost certainly would), but it would be redeemable for gold. Electronic money could be similarly redeemable. If you have $100 in your online account, you can go down to the bank and get cash, right? Well, then you could go down to the bank and get gold (or get cash which is redeemable for gold).

18

I don’t think the speed with which the money moves is a factor here.

Actually, I don’t think so either, and of course, also in your analogy, the speed doesn’t matter as soon as the water cycle is closed. Still, if we go away from that analogy, I can’t understand it yet. Because, as already written: Assume, all people save, meaning all people have their money in their bank accounts. That’s the money available for the banks. The banks have all the people’s money available for lending out (I know, in our fractional reserve banking system, the banks create money out of thin air and don’t just take the money from the one and lend it out to the other, but let’s fade that out for now). Now when people become more spendthrift and much money goes from one person’s account to the other, in my understanding, then the amount available for the banks doesn’t change, except for during the exchanges - however, when it comes to online banking and it takes, say, one second for each transaction, then this time in which the banks don’t have the money available almost vanishes and it shouldn’t matter - I know, it sounds strange - whether people save or consume more or less. As I see it, three things influence the supply of loanable funds to the banks: The duration of the transactions, the size of the transactions and the number of the transactions…

This seems so extremely basic that it bugs me, for I thought I understood it and now realize I’ve never really thought it through.

By the way, @ Anenome, Clayton and some others: Don’t think I ignore you, I find it interesting to read what you write, and it seems logical to me. It just interests me the most to understand why the banks have less loanable funds available if people spend more and save less.

19

But there’s money which is entirely outside the banking system (physical paper notes and coins) and the quantity of this money varies. If people are spending more and saving less, money moves out of the banking system altogether (not just from one bank to another) and into circulating cash. Eventually, this cash will make it back to some bank, yes, but in the meantime, it’s out there, not in the bank, meaning the bank has less to loan out.

20

Of course, but that would still mean when all transactions were made through online banking, it practically wouldn’t matter how much people save or spend, at least the interest rates would be unchanged… which I somehow cannot believe.