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Indian Libertarians

RBI – Destroying the economy through interest rate manipulation

anacap Thursday October 2, 2014

The Reserve Bank of India just made its quarterly monetary policy announcement. The one message that comes out clearly from an Austrian perspective is that the RBI is unflinching in its resolve to do all it can to destroy the Indian economy and heap misery on all Indians not privileged by a closeness to the banking and financial system.

Why such a strong statement

Unlike commonly believed, Central Banks such as the RBI are just legalised counterfeiting agencies granted a monopoly to counterfeit money. The primary role of the Central Bank is to manipulate money supply (which always, strangely, goes up in the long run these days) and interest rates, and provide the last line of defence (from market forces that would bring them crashing down) for an otherwise bankrupt, inflationary banking system.

Central Banks like the RBI carry the ultimate responsibility for two of the biggest economic problems of our times

 

  1. The ever-burning problem of price inflation
  2. The dreaded boom-bust cycle

The economy does not need Central Banks like the RBI

Very simply, an economy can chug along very well without a Central Bank. Money would be one or many of some commodities (say gold, silver). The unit of money would be some standard weight of each money commodity. All prices would be in terms of these monetary units. In fact, that's how it was historically and most, if not all, modern currencies started off as a certain weight of gold or silver of a certain purity. The Pound Sterling, for instance was defined as 1 pound of Sterling Silver. Goods would have prices in each of these monies and there would be an exchange rate between these monies as well.

Production of money would also be an economic activity on the market. Many people falsely believe that this would give extraordinary privileges to those who mine the money commodity and mint the money. The truth is that even these activities are production processes for which the producers have to advance money to purchase the services of factors like land, labour and capital goods. So what the producers gain in these activities is only the surplus of sale proceeds over production costs (called the price spread), like in any other business.

Controlling money supply does not require a Central Bank

A common objection is that these miners and mints can unilaterally pump up money supply (the number of units of money in circulation) and gain extraordinary (often called supernormal) profits. This objection is completely wrongheaded. On a free market, there is a very interesting mechanism that keeps money supply under control and in line with the preferences of consumers.

Increase in supply of money will cause price of goods and factors to rise and purchasing power of money to fall. This combination will lead to a lower price spread in the money manufacturing business. This will lead to a flight of capital from money manufacturing to other lines with higher price spreads (commonly known as arbitrage action). As a result, fewer factors will be applied in money production and money production will fall, reversing the effect of the earlier increase in money supply.

The important point to note is that without a central bank, money supply will be as much as people want to hold. Producers can only produce money in line with the money holding preferences of consumers.

Central Banks are not needed for interest rate determination

Let’s get this straight – Markets can determine interest rates without the need for a Central Bank such as the RBI. Financial intermediaries have existed long before Central Banks were created. Even today, they can and do exist without the need for a Central Bank.

Interest rate is an economic phenomenon that emerges on the time market when people exchange present goods for future goods. When people save, they need to put their saved funds in some productive activity (called investment). Identifying productive activities on behalf of the savers is a service that can be and is provided on the market. We call these entities “loan banks” and the activity financial intermediation. These are entities that accept long-term savings offering an interest and lend it out for a higher interest. The income to the loan bank is the interest rate spread less the bank’s operating costs.

Central Banks are just a cartel of bankrupt banks

Modern banks do not channel savings into investment. Instead, they create money out of thin air and inject it into the productive segment of the economy. This system of banking is called Fractional Reserve Banking (FRB). When banks engage in FRB while the money is a commodity, they become highly unstable. Holders of notes and deposits asking for their commodity units can bring the biggest of banks down in a bank run. This acts as a market limitation on how much money banks can create out of thin air through FRB. When money is not a commodity (as it is today), the banking system can create far more money out of thin air before inflationary pressures force the system to raise rates in an attempt to quench the flames the banks have lit.

Central Banks basically release banks from these market limitations and enable them to inflate money supply almost indefinitely. Central Banks are instituted and/or protected by governments through a monopoly on money production and they in turn protect the banks from bank runs. The entire banking system, in exchange, becomes a source of endless spending money for government. This I-scratch-your-back-and-you-scratch-mine arrangement is how governments, central banks and fundamentally bankrupt modern banks get together to rob everyone else all the time.

Interest rate manipulation hurts the economy

On the free market, there would be an interest rate. At that interest rate, all real savings would have been offered on the time market in exchange for future money (with interest). There is no more potential for lending. How then is an FRB system to deploy the money they create out of thin air? Clearly, they can only achieve this by depressing the interest rate below the free market rate.

In effect, projects rejected as bad ideas on the free market now get funding under FRB. The more the extent of FRB, the worse would be the ideas that get funded. Think pets.com. A bubble is thus created. In this manner, the production system gears itself up to produce a lot of junk that consumers do not want. This bubble goes on for some time till the junk is recognised as junk and a depression sets in. In this manner, interest rate manipulation by the banking system creates the boom-bust cycle that we all suffer.

The massive money creation by the entire banking system also sets prices on a perpetually upward path. Such a situation would not persist on the free-market. The rapid and life-destroying price rise that makes life miserable for all but the super-rich is a consequence of this non-stop money production by the banking system protected by the Central Bank and given legal protection by governments.

What should be done with the RBI

The RBI is a fundamentally pernicious entity. It is unnecessary for an economy to function. It harms the economy in more ways than is obvious. Rather than focus on whether RBI should raise or lower interest rates, we need to focus on energies on getting this economic monstrosity shut down.