Hit the bank first

The central bank, and its overnight interest rate, belongs to us. We should use it

by Kevin Potvin <kpotvin@republic-news.org>

The only economic tool any government in a developed country like Canada still controls is the central bank’s overnight interest rate. It is unlikely our governments will ever get back any of the old tools we used to have. So is it possible for a people to use only their control of their central bank’s overnight interest rate to redirect their economy toward a lower-consumption, smaller ecological footprint model?

First it’s necessary to review what governments actually do with the overnight interest rate. Market speculators who bet on the rising and falling relative values of different currencies from different countries have recently bid the Euro down from US$1.36 to US$1.22 since January this year, marking a fairly rapid 10% drop. They have done so, think analysts quoted in the major business papers, because they believe the European Central Bank will soon lower it’s overnight interest rate.

The overnight interest rate is what private European banks must pay in interest for the Euros they have created during any one day. Private banks create money anytime they extend a loan to a household or a business, and destroy money anytime a person or business repays a part of their loan or makes a deposit. If they finish the day with a positive balance, they must pay interest for it to the central bank. The rate of interest is the only means a government has to restrain the otherwise uncontrolled creation of money by private banks.

Central banks—or the governments who direct them—will usually raise the overnight interest rate if they fear inflation is growing too high. They will lower interest rates, conversely, if they fear business activity is slowing down too much. The European governments have lately noticed that business activity is slowing down, and speculators are guessing the governors of the European Central Bank will therefore lower the overnight interest rate on the Euro.

By lowering those interest rates, private banks that lend to businesses will lower their interest rates to businesses and consumers in turn. When they do, businesses who are working on borrowed money—which is pretty much all businesses big and small—may decide to go ahead with expansion plans or to increase their business activity to take advantage of these cheaper rates of interest, and consumers are expected to go out and buy more things on their credit cards. Usually, this all adds up to businesses hiring more workers.

But when there are less unemployed workers as a result of all the new hiring, the wages companies must pay to retain the workers they have and to attract more will float upward. As wages go up, inflation increases. So central banks must be careful not to lower interest rates so much that high inflation results.

Central banks and the governments that direct them like to keep inflation around two percent. Any higher, and the value of each unit of a country’s currency will decline relative to the value of a unit of another country’s currency. If the value of a country’s currency declines, it will become more expensive to import goods from other countries, including, for example, key industrial commodities like oil. When it becomes more expensive to manufacture goods because of heightened energy, commodities and labour costs, shareholders in those companies will earn less return on their investments.

If shareholders start making less return on their investments, they will sell their shares in those companies. When more people are selling shares than are buying them, the price of the share will go down. If too many companies’ share prices decline and investment in those companies therefore dries up, the economy of the country will slow down, and people will lose jobs, governments will collect less tax revenues, companies will move out, and elected officials will lose their office.

If, on the other hand, a central bank raises overnight interest rates , private banks will pass on the more expensive money to companies who will then shut down expansion plans and lay off workers, increasing unemployment, and lessening tax revenues. If they raise them too high, they endanger the longevity of elected officials. The key activity of all central banks throughout the developed part of the world’s economy is to twig the overnight interest rate up or down a miniscule amount at precise moments so as to always seek out the perfect balancing position between too high and too low an interest rate. It must be low enough to encourage business to expand, and high enough to prevent too much growth that leads to a shortage of labour and therefore loss of profits.

To avoid always being out of balance and always trying to catch up to the direction of the economy, central banks will try to anticipate what their national economies are soon to do, in terms of increasing business activity and hiring more workers, or shutting down and laying off workers. So to set their interest rates beforehand at the right place, central banks study how their big national companies are doing in terms of selling their goods, attracting investors, and making money.

If big companies are having trouble selling their goods, like GM in America currently is with its cars, the central bank might lower rates a bit to ensure other companies pick up the slack and hire the workers GM might be letting go. (GM announced last week it will be laying off 25,000 workers mostly because it has failed to keep modern with its car designs, analysts say, and its share of the car market in America has recently declined as a result from 28 percent to 23 per cent).

If the US is successful in encouraging companies to expand and people to buy more by lowering the interest rate at which money is created and borrowed, European companies will suffer a decline in sales themselves. So their central banks will lower their rates to restore their companies’ market shares around the world, all in order to keep their workers in jobs and their investors in profits.

But what happens if both markets, the European and the American, are buying less cars for reasons that have nothing to do with too-high prices or too-tight money supply from too high interest rates? What if both central banks keep lowering interest rates and still people do not buy more, and companies do not expand more, for the simple reason that people in both markets simply do not want any more stuff of any kind, not at any price or at any borrowing cost?

This is exactly the situation today. Governments, in league with businesses, might try to manipulate their people into buying more than they actually need or want, but that strategy seems to be faltering in Europe, Japan, South Korea, and perhaps also in North America.

Businesses might solve the problem by getting governments to consume more themselves, as they have done in America with massively increased military spending. But European people have rejected calls to war and the increase in military spending it would bring cannot be justified in peace time. The depths to which British and US leaders lied to encourage a public acceptance of war in the Middle East (and therefore increased military spending to create enough market demand to keep businesses growing even when consumer demand is stalled), does not bode well for the next time war is called for, whether it is legitimate or not.

The only remaining option is to explore new innovative uses of overnight interest rates at central banks to try to manage a shrinking yet still productive and prosperous economy, without resorting to war and without collapsing the whole economy. It is a tall order. Last century, the economies of the developed countries first were collapsed in the 30s, and then war was initiated to rescue them in the 40s. No other solutions were tried. To avoid those results now, we need to try another solution.

One possible solution today is for the central banks to begin behaving like regular private banks and start attaching different risk premiums to loans made to different kinds of businesses. Today, any private bank making loans to any kind of business will pay the central bank of Canada the very same rate of overnight interest as any other bank making any other kind of loans.

But private banks all the time charge different rates of interest to different customers based on assessments of whether that particular customer has a good track record, what business they are in, what prospects are in their industry, what experience the executives of that business have, and so on. The private banks make all sorts of judgments based on the private bank’s own needs and desires in engaging in the lending marketplace. Ultimately, the board of the bank directs the bank toward what kind of risk and what kind of businesses the bank should be involved with in its lending program. Any private bank favours with better interest rates some kinds of business ventures over other kinds based on what the banks’ shareholders feel about risk and prospects in each of the industries the bank may get involved with.

Perhaps the Bank of Canada can respond to their shareholders—the citizens of Canada—and begin offering different levels of interest rates to different banks making different kinds of loans. If interest rates were lower for a bank that concentrated on supporting companies that sought a zero-growth model, for example, such a bank and the businesses they lent to would be able to compete equally with other banks and businesses concentrated on growing. If it were thus possible to compete with growing companies by trying to sustain a no-growth company, perhaps we would find more successful no-growth companies in our economy.

We could go further. We could offer better overnight interest rates to banks that financed companies working diligently to reduce their own ecological footprint in whatever innovative ways companies might invent to do that. They would get innovative with that kind of thinking if they knew that by doing so, they could get cheaper lending rates from a bank eager to loan to them so that that bank could get lower overnight interest rates from the central bank.

Lower interest rates for the shrinking sector of the economy would promote the growth of that sector over the growth-oriented sector. This may at first seem a dangerous, even counter-productive policy to pursue at the Bank of Canada. But, if crucial commodities like oil are running out and becoming too expensive, and if other factors come to pass that cripple developed economies, they will all be shrinking in any event. Wouldn’t it be prudent to have a means of managing that forced shrinkage rather than to find our economy wracked by it?

For example, rather than pursue a de facto labour policy that encourages companies to hire as few people as possible and work those few a maximum number of overtime hours, wouldn’t it be smarter to instead create a labour policy using interest rate controls that encourage companies to maximize the number of workers and cut each of their hours back as the need for labour declines?

The economy and the environment will increasingly require us to work less and consume less. We can move toward that model simply by applying societal risk assessments to different borrowers of money from our own central bank, and hand them different rates of interest. That central bank, and the overnight interest rate it sets, is ours to do with as we please. So let’s please ourselves.

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