Under free market banking, interest rates (aka the price of money) are set by Supply & Demand. Central banks like to think they are not subject to S&D, which is why they make bad decisions about interest rates.
The interest rate would be set by how many people want to borrow money (buy) and how many people want to lend (sell). The convergence point would be the price of money aka interest rate.
Because it is not realistic. In every nation that has ever existed, the supplier of money has always been a monopolist. And this is precisely because the supplier has requested taxes to be paid in that currency that they supply. If you have multiple suppliers of money, then you literally destroy the entire basis of the state. The whole thing comes crashing down.
> era of free banking in the US, banks issued their own currency
The free banking era illustrates the problem. Rates are endogenous to the money supply. That circularity promotes a hyper-volatile credit cycle. There is no natural counter-balance we’ve discovered to that tendency. (Apart from ruinous boom-and-bust cycles.)
> They still issued USD, which was the only legal currency.
As I recall, they issued the paper version of stablecoins: they were denominated in units of US dollars, but they weren’t government money, and they traded at floating values, typically (aside from many other factors influencing value) declining in value with distance from the issuing bank.
The discount on the notes was inevitably related to the probability that the issuing bank would honor the notes and redeem them with gold.
When the Fed lost all credibility with exchanging their banknotes for gold, we had the Great Depression. FDR then defaulted on the gold bonds, basically stealing from the good citizens who had trusted the government.
I mean exactly that. They issued banknotes (that's why paper money is sometimes called banknotes). The banknotes were denoted in dollars, like bank checks today.
The money supply is endogenous, that is, the people demanding money via loans are the ones that create their own money. The supply of money is effectively infinite and only limited by regulations, the banks risk assessment of the borrower and the profitability of the business Vs the interest rate.
So there is no market for the interest rate of money that can be created.
If you have a fixed money supply then the interest rate isn't set by supply and demand of funds either but by liquidity preference. As the interest rate falls below liquidity preference people will simply hold cash or keep their money in checking accounts. The interest available for borrowing does not fall all the way to zero. It gets stuck at some positive value. This money is "saved" in the sense of deferred spending but it is not "saved" in the sense that it is not lent out and only available in the future once the loan is repaid, no, it is available today to spend.
The difference between classical and Keynesian economics is effectively that in the former you only have saving and consumption but in Keynesian economics you also have a third state "cash" (including bank account deposits) that is a hybrid of the two. It is neither consumption nor classical saving and this is what's the setting of the interest rate in the open market.
Dieter Suhr effectively argues that this liquidity premium is the effect of money being a social network. Just like Facebook extracting profits from your data, people with cash/deposits benefit from the network effects of money and can sell these network effects for money keeping the interest rate high and if they can't sell them they will try to benefit from them directly (e.g. speculation) as that is more profitable than lending money. Businesses and consumers are the ones creating the network effect so they should be compensated and not the idle who do nothing with their money.
The poster is alluding to the fact that an authority such as the Feds have the inclination to change this convergence point (for whatever reason). Therefore, this breaks the assumption that the money market is free.
I interpret that statement as, interest rates are set by demand for money relative to its supply. Doesn't particularly matter exactly what the supply mechanism is, just the level of demand relative to what's available.
There is no such thing as free market banking. Prior to 1913, the money supply was fixed to gold. Therefore, the supply was limited based on the amount of gold reserves held by the bank. This is an artificial constraint on supply, not a free market system.
Oh, it's every bit a free market system. The banks all issue their own currencies. All the government did was equate the dollar to so many oz of gold. The government did not fix the supply of gold. Only the exchange rate.
The supply of gold varied, by quite a bit. See the various gold rushes and the resulting inflation/deflation.
I definitely have no idea what "free market banking" is. Though, I think your statement is contradictory. Central banks control their money supply, and thus they are in direct control of the S in S&D. So I am not sure what it means to say that they don't think interest rates are subject to S&D.
I am quite certain they have an accurate high level understanding of the relationship between their supply, interest rates and inflation.
I would also like to point out that there are different types of interest rates. I am not sure what rates you suggest would be set by S&D.
>I definitely have no idea what "free market banking" is. Though, I think your statement is contradictory. Central banks control their money supply, and thus they are in direct control of the S in S&D.
Free market banking is banking in which any bank can issue money. The "supply" they were referring to is supply in the economic sense of supply and demand, i.e. the equilibrium market price of money/debt that would arise from the supply and demand of market participants.
If one farm had a legal monopoly on selling apples, them yes technically they are "supplying" them, but the price is not what the natural price of apples would be in a competitive market absent any legislatively granted monopolies.
In the modern system S&D is controlled by commercial banks and regulated by the central bank via the central bank rate.
Any bank could go rogue and lend money below central bank/base rate, but because all other banks can "earn" free money at the central bank at base rate this opportunity would instantly be arbitraged away.
Likewise market forces for borrowing are determined by the risk premium on top of base rate, with competition for borrowers arbitraging away opportunities for risk takers (lenders).
Well, being subject to S&D of money is why they have the mandate to keep inflation at 2%, no? You can argue that measuring inflation is a poor way, but you'd have to come up with a better alternative.
Yes, that is true, but it is still part of their mandate. Supply and demand of money gets reflected in inflation and the Fed responds by changing interest rates. Isn't this a free market mechanism?
No. In Friedman's "Monetary History of the United States" he shows how the Fed setting interest rates was rather erratic and much more unstable than the earlier free market mechanism. The Fed would guess at what the S+D point was, since the Fed was not subject to market forces. This meant they were always late and always wrong.
I meant they control the interest rates, which do not control inflation. Inflation comes about from the creation of money, which the central bank does to fund the government deficits.
