Anyone with any level of familiarity with economics
knows the saying that there is “no such thing as a free lunch”. This is the easy way of summing up the
concept of opportunity costs: that when you do something with your time, money,
or other resources, that you forego doing the next best thing that you could
have done with that time, money, or other resource. If I buy a movie ticket, I cannot use those
10 dollars to buy two five-dollar foot-longs from Subway. It’s a pretty straightforward concept. Now if instead of two hours of entertainment
or a sandwich, you wanted to buy money, you could take what we know is called a
“loan”. While it might seem
counterintuitive to buy money with money in the future, loans are created with
interest added onto them to compensate the lender for his initial outlay and to
charge the borrower for taking money that was previously not his. In this arrangement, both parties are better
off because he is able to fund something right away that might not have been
attainable and the lender is able to make money by selling his money. Loans make up a massive industry between
mortgages on the personal level, commercial paper on the corporate level, and
interbank loans between commercial and investment banks and the central
bank. These loans make up transactions
worth trillions of dollars every year and the interest rate is the driver that
allows all of them to happen. The interest rate is what a borrower has to pay
to be able to use the money they take now, as opposed to their own money later.
At all
levels, from individuals to the largest banks, the interest rate also
encourages people to save or spend their money.
For example, if you could get 5% on money saved in a bank account
(besides living in a land of unicorns), you’d be much more likely to save it
than if the interest rate was only .05%.
This is because you get more value from the former situation than the
latter. Plus, your “next best thing”
might be more valuable to you than .05% and less valuable than 5% interest,
prompting your ever-rational self to spend money in the case of the .05% and
save it in the case of the 5%.
The
Federal Reserve understands this incentive structure and influences the
interest rate that banks use as a benchmark for the rest of their interest
rates in such a way that they deem best for the economy. They need to be careful though, because the
interest rate has such massive and far-reaching consequences. These days, since the United States is in an
economic slump, the Reserve has been trying to stimulate the economy by trying
to get people to spend. As we know, the
way to encourage spending is to lower the interest rate and so that’s what they
have been doing. Unfortunately for the Fed, the nation as a whole is spending
less and saving more anyways because it is scared of what’s coming in the
future. What’s worse for them is that
the nation seems to have reached something my professor would call a “zero
lower bound” where the interest rate can’t be lowered much more. So the Reserve has gotten creative in its
economy-manipulating tactics and is introducing money into the economy in
unprecedented amounts. That’s a whole
other can of worms to let out and untangle in a different post.
The
economy runs on expectations and right now the Fed, one could argue out of
necessity, has dedicated itself to keeping interest rates low for years. Fed watchers much have a really boring job
these days because I can summarize their past few and certainly next few press
releases in one sentence, “We will keep interest rates low until 2014 and
continue with our program to buy Treasuries.”
2014 will roll around and they’re singing a different tune, or at least
replacing “2014” with “2016”, that is.
The glimmer
of hope in this low-interest-rate situation is for those in need of loans,
whether it be a home mortgage, student loan, business loan, etc. Buying money is cheaper than ever and the
Reserve’s hope is that people will start to again have the confidence to invest
in new projects that will bring our economy out of the soup it’s been in for
the past few years.
