It isn’t hard to make the argument that the most important prices of all in a market economy are the prices of loans. Given that it’s saving by households that funds business projects of all kinds and over a broad variety of time horizons, then interest rates—which are, after all, the prices of loans between households and firms—should coordinate the saving plans of households with the investment plans of firms.
The data is clear: Economies grow over time when entrepreneurs discover what we need even before we know it, and financial markets make entrepreneurs’ visions profitable—for both savers and borrowers—when interest rates help families figure out how much to save and for how long. They also help firms decide whether their prospective idea is worth financing at prevailing interest rates, given how long they will need use of the loan amount.
In short, financial markets are how we finance the development of new technologies, improve on existing production techniques and acquire the new tools and machines necessary to use these new ideas—whether simple or profound. And all of these activities can lead to long-term job creation in occupations that may not currently exist.
Despite the critical role loan markets play in long-term economic development by coordinating households’ saving plans with firms’ investment projects, we don’t let interest rates work as well as they should. Why? Because we, as a society, have given the Federal Reserve System the power to manipulate interest rates in ways that serve the Fed’s short-term goals rather than to let rates work like any other price in any other market.
How is it that the Fed isn’t serving our long-term social goals when it seems that is exactly what it should be doing? The answer lies in the Fed’s dual mandate, a charge by the U.S. Congress to the Fed to simultaneously pursue just two short-term goals: maximum employment and price stability.
Of course, these sound like admirable goals. Who wouldn’t want both maximum employment and price stability at the same time? And I think we would all welcome more price stability than we’ve had in the last few years.
Yet the Fed possesses one tool to pursue its mandate: interest rates. In short, if the Fed is more worried about inflation than recession, which has been the case for the last couple of years, it raises interest rates, thereby discouraging borrowing while simultaneously incentivizing saving.
And if the Fed is more concerned about the possibility of layoffs and recession than inflation—as it was for the decade following the Great Recession of 2008-09—then it keeps interest rates low. So, firms and families borrow more than they otherwise would, and families have little incentive to save since it doesn’t pay. And in that same period, the Fed kept its target interest rate so low that it hovered around 0%.
What’s the consequence of using an interest rate policy to ensure maximum employment and price stability in the short run? We all get distracted from the plans we would be making if interest rates were free to play the vital role they should play in a market economy: Helping us to figure out how much to save, how much to borrow and whether to invest in long- or short-term business projects.
I agree that maximum employment and price stability are important. But such outcomes should be the healthy vital signs of a flourishing economy that, over time, leads to ongoing enrichment and opportunities for all. When Congress charges the Fed with its dual mandate, Congress tempts the Fed’s Open Market Committee into playing the economy like a video game, manipulating interest rates to make the scoreboard look good today. And disregarding the long-term possibilities we missed out on as a consequence.
Victor V. Claar is associate professor of economics in the Lutgert College of Business at Florida Gulf Coast University. He chairs the board of the Freedom & Virtue Institute in Fort Myers and serves the James Madison Institute’s George Gibbs Center for Economic Prosperity as its adjunct director.
