Interest rate fluctuation has a ripple affect on every part of our life. It can be a bit confusing and truthfully it is not always easy to stay focused on explanations of those affects.
Today we'll examine another lesson from Peter and Andrew Schiff's newest book, "How An Economy Grows And Why It Crashes." This uniquely illustrated edition provides the facts using methods that are easy to understand and will keep the reader's interest. If you really pay attention, you can't help but compare the story to today's actual economic situations.
As you remember from previous pages, on this remote island the matter of monetary exchange is fish. We started the story with Abel building a net that allowed him to catch more fish. Then we moved on to Duffy and his ability to build canoes much better than the ordinary islander. His skill and entrepreneurship made canoes cheaper, so more islanders could afford to buy them.
Free enterprise unencumbered by government interference allowed Duffy to build a profitable business that also benefited the general population.
Now as fish wealth began to increase, there was a need to store them in a safe place. "Max Goodbank" had an idea. He would provide a service to secure the fish. But because he was a bit more savvy, he realized that he could increase his profit by loaning some of the fish to islanders looking to build their own business or maybe buy things.
With the extra fish Max earned from these loans, he paid interest to those who deposited their fish in his secure spot. He also paid wages to some islanders for helping to secure the fish. He did all this to create more profit for himself. But just as Duffy before him, Max actually helped many islanders with this free enterprise capitalist idea.
Max had to be very careful. He had to be sure to only loan fish to people he expected to be able to re-pay him. He had to be sure to pay interest to those who left their fish in his care. And he had to attract more people looking to either deposit or borrow.
Max balanced the wishes of borrowers and savers. For those very secure borrowers, those most likely to re-pay the loans, he offered a lower interest rate. For those borrowers he determined to be a little shaky, he charged a higher rate to cover the possible risk involved with such loans.
It was this loan schedule that provided the baseline for interest paid to fish depositors. Those who agreed to leave their fish with Max for a longer period received a higher interest rate payment. Those who didn't want their fish tied up as long received a lower interest rate.
But the market also dictated interest rate levels. During higher productive fishing seasons, Max's bank was filled with fish. In these times he would lower the interest rate to borrowers. There was more fish to cover losses. These good times also encouraged some courageous people to seek loans to manufacture new products that could by purchased by the islanders.
The down side was that with a lower interest rate being paid to borrowers, less was also going to depositors which made saving fish less desirable.
As fish being saved dipped down, Max had to charge higher rates for loans because he had less fish available to back up the loans. And he was much more likely to turn down shaky loans as they were not good for him nor for his fish depositors.
These higher rates allowed Max to pay his depositors higher interest again, so saving came back into the bank. The natural order of the market stabilized itself over time.
And the relative safety of Max's bank made daring entrepreneurs more willing to delay their own personal consumption in favor of investing in capital projects that helped everyone on the island.
So what do we take from this story? Left alone, the markets will always stabilize themselves. There will be up times and down times. Some will get burned in the down times. But these down times also produce the seeds of ideas that always lead to great inventions that better our world. And it is usually a person willing to take a personal risk to launch this new idea.
The Schiff brothers have presented a chapter that perfectly illustrates the situation we face right now. Federal reserve intervention in market flow has disrupted a natural process. Along the way bubbles have been over-inflated.
This is a highly political situation. Elected officials will always seek lower interest rates. Which will always punish savers. A nation that doesn't save and invest is in economic jeopardy. Artificially lowered rates encourage bad decisions. Such as taking out mortgages that turned personal homes in ATM machines.
The federal reserve system relies on a couple dozen people to make world effected decisions. And they are never held accountable for mistakes. They were totally blindsided by the incorrectly labeled sub prime meltdown. It was far more than just sub prime loans. It was a wave of poor judgement based on rose colored economic data.
Those of us in the mortgage business willing to look down the road could see this bubble bursting years ahead of it actually happening. We could see savings patterns going down.
The Schiff brothers correctly put it this way. " There is a consistent bias toward holding rates too low... Remember, low rates encourage borrowing and discourage saving. Not surprisingly, the United States has been transformed from a nation of savers to a nation of borrowers."
We'll draw some more from this empowering book in future pages. I will repeat what I wrote in that first review page. This book should be in every economics class in American high schools. Most economists don't understand economics. They just follow the pied piper of the federal reserve and ignore history.
Teach your children well!