Why does the government need to control interest rates?

Question

Context As far as I understand, economic cycles are mostly dependent on the amount of demand (which is influenced by money supply, which is in turn influenced by the availability of credit). Since credit dwarfs cash as a % of total currency, credit is by far the most important driver of money supply. In general, the government controls interest rates to slow down an overheating economy, or to expand a slowing economy.

Question My question is, why do we need government to control interest rates? Assuming banks are rational and want to make money, wouldn't banks tighten credit rules in the midst of an overheating economy? If banks sense that debts are too high, wouldn't it make sense for them to increase interest, or stop lending to risky customers to avoid customers that default on their debts? I don't see why government is any more qualified at controlling interest rates than banks themselves. You could argue that banks are greedy, but at the same time, they're smart and have a long-term view. If a bank loaned money in an overheating market, they wouldn't be in business for too long.

Thanks!

Answer 1

why do we need government to control interest rates? Assuming banks are rational and want to make money, wouldn't banks tighten credit rules in the midst of an overheating economy?

I assume that by government you mean central bank. Otherwise, I agree with you by saying that governmental intrusion in monetary policy often creates inefficiencies and distortions.

The purpose of any [private] financial entity is to maximize its profits rather than the stability of the domestic currency. Thus, a central bank's primary goal is (or should be) to procure that currency stability, which it pursues by "printing money" and issuing bonds. The conventional term "control [of interest rates]", however, is a overstatement/misnomer from the standpoint that financial entities are not prohibited to transact with each other (or with the public) at lower or higher rates than the ones pursued by the central bank.

That being said, a central bank's pursuit of other goals in addition to --or in lieu of-- currency stability tends to impair its ability to achieve that primary goal (see also last paragraph of this answer). See, for instance, the Federal Reserve's assertions of its dual mandate of maximum employment and price stability. Notwithstanding Ben Bernanke's renown inflationary profile, his repeated calls in the midst of the Great Recession for Congress to enact reforms reflects his awareness that his monetary policy of essentially printing more money was improper, insufficient, and/or ineffective to address the core issues of the labor market. The vulnerability is more severe in those economies where a government exerts greater control on that nation's central bank.

You could argue that banks are greedy, but at the same time, they're smart and have a long-term view. If a bank loaned money in an overheating market, they wouldn't be in business for too long.

Some financial institutions negligently or recklessly incur excessive risk, thereby causing severe repercussions when unexpected market conditions occur. Consider the Barings Bank. This entity was founded in the XVIII century, yet the lack of scrutiny of a strategy performed by one of its hitherto "star traders" caused its collapse in 1995.

My allusion to the Barings Bank diverts from your central inquiry, but it illustrates that an entity's longstanding prevalence in the economy does not disprove the necessity for a [purportedly disinterested] regulator or central bank to scrutinize anomalies that are potentially catastrophic.

Answer 2

There’s two somewhat related points that give a simplified answer to your question.

1. The government (central bank) sets the base interest rate in a free-floating currency.
2. The government will set that interest rate in a manner that meets its policy objectives; the private sector has no incentive to meet those objectives on its own.

I will outline these in turn.

If we are discussing a free-floating currency (e.g., no gold conversion right), the central government is the monopoly supplier of the monetary base. Roughly speaking, all private monetary claims can be viewed as a claim on that government-issued money. As the monopoly supplier, the government can dictate the price of money - i.e., the interest rate.

More specifically, private sector debt arrangements are typically set up with liquidity backstops. For example, commercial paper lines are backed with credit lines at banks. Some banks will go to other banks for backstops. However, those banks need a backstop - the central bank. In a liquidity crisis, the central bank sets the interest rate for emergency lending to banks. The interest rate for such lending becomes the base rate of interest in the economy. This rate is determined solely at the discretion of the central bankers, and thus is under control of an arm of the government.

(Hyman Minsky discussed the liquidity structure of banking systems in detail; my description here is my own phrasing. The book “Stabilizing an Unstable Economy” discusses the evolution of the financial system of the United States in the post-war era.)

Once we accept that the government sets the base rate of interest, how does it set it? That leads us to the whole theory of monetary economics, which I cannot hope to summarise. The standard story is that the central bank sets the interest rate to control inflation.

Why won’t the banks do this? Private sector lenders only care about getting paid back. If the economy is growing rapidly in nominal terms, it means that borrowers’ incomes should be growing - and they can easily meet debt repayments. So there is no reason to fear inflation.

One could argue that bankers are worried about the real return on lending. However, this ignores the nature of banks. Banks are highly levered entities, and so their return on equity (what they care about) is much higher than the level of interest rates - so long as borrowers do not default. Therefore, they have no reason to care about the inflationary consequences of their lending decisions.