Forum Post: Why Interest Rates are Absolutely Critical - Yet people don't understand

"Interest rates are a way for banks to turn more profits by loaning out your money (instead of just charging you a storage fee and keeping your money in its vaults). Before our current system, banks would set interest rates on their own (now the Federal Reserve does it). How did the banks used to set interest rates? First you need to understand that banks like to keep their bank vaults filled with a certain amount of money (reserves). This is because people want to be able to withdrawal their money, and if there isn’t any money at the bank you could force a run on the bank (as everyone becomes worried that by the time they get to the bank all the money will be gone). So interest rates used to work like this - if there are big gains in productivity and everyone’s savings swell at the banks, the banks would in essence have vaults full of money which would allow them to drop their interest rates to entice borrowers to take out more loans and clear out the vaults a little. When the bank vaults money supply became too low the bank would increase interest rates to entice depositors (as they make more money with higher rates) and deter borrowers. This would fill the vaults back up to a comfortable level of money. This allows a balance between savings and loans to occur in an economy as the interest rates would adjust and correct an imbalance if either savings or loans became too great. Today interest rates are controlled by the Fed. How do they lower interest rates? By inflating the money supply, or creating money and loaning it to the banks to “fill up their vaults”. This tips the balance away from savings (as the Fed creates money, or debt, which drives rates down instead of real savings by the people driving rates down). This creates the false impression of a healthy economy (one in which adequate savings have taken place), when in fact it's an economy expanding on credit/debt. This makes investors invest in things that the people haven't been able to put aside adequate savings for to purchase when these investments are completed. This creates a temporary credit boom and stimulates the economy...but it leads to an inevitable bust when the malinvestment and lack of savings from the people comes crashing down....as the people don't have the saved money to purchase the investments which were undertaken because of the low interest rates. There are a number of ways the Fed can lower interest rates, but each one inflates the money supply.

One of the best analogies I've heard about artificially lowering interest rates and how it creates erroneous investments was by a speech from Tom Woods. Say you own a restaurant in a somewhat small town and business is good, but not great. It’s good enough for you to make enough money to pay the bills and keep things going. The Olympics then comes to town and business starts booming. Your customer base quadruples and you’re able to pull in enough revenue to not only pay the bills, but put a bunch of money aside. Now for some strange reason you don’t think the Olympics is ever going to leave, so you start to plan your business around this newly created increase in customers. You decide you have so much money left over that you’re going to open another restaurant and upgrade the current one you’re in. So you invest in expanding the business and now you’re pulling in even more money. But what you did not foresee was that the Olympics was only temporary, the Olympics sent the wrong signal to you for your business. It was an artificial boom that can’t be sustained when the Olympics leaves. So what happens when the Olympics finally leaves? Your business comes crashing down because of the malinvestment due to the artificial stimulus. The Olympics in this example is to this restaurant owner what artificially low interest rates are to investors. This is a simplified version of how it works, but it gets the point across in another way that is perhaps easier for some people to understand.

So now we know that artificially lowering interest rates can only be done through the creation (or inflation) of money. The Fed must fill up the bank vaults to allow them to lower their interest rates, and this is done through money creation. Inflating the money supply is bad because it’s an ingenious way of stealing money from you and you don’t even realize it. You still have your $1,000 in the bank who cares what the money supply is doing? The problem is increasing (or inflating) the money supply causes prices to rise (we’ve seen this with food and energy prices recently provided in the link below), so your $1,000 can’t buy what it used to:

http://hmscoop.com/MoneySupplyvsCommodities.html

It is exactly the same as someone keeping prices the same and physically stealing part of your $1,000 you have in the bank. The amazing thing about it is you don’t know it’s happening – you’re being stolen from without your knowledge. Even more amazing is it’s delayed. So if you add $1 trillion dollars to the economy it will take awhile for prices to begin to rise and you to realize you can’t buy as much. By this time you don’t attribute the rising prices to the creation of new money. It is theft, plain and simple. The genius of inflation can be compared to you stealing money out of someones bank account, but the bank accounts balance doesn't change because of it (and hence the person never suspects fraud).

The real kicker is who benefits the most - the institutions lending out the new money first. Say you’ve counterfeited a million dollars – it’s not in the money supply yet it’s at your house. You are able to buy 4 houses with this fake money for the current price of the houses on the market. You buy the houses and over the course of a few months inflation occurs because you inflated the money supply by a million dollars when you added it to the economy by buying the houses (assume this is a tiny economy). This causes prices to rise (including the prices of the houses you bought which is beneficial for you because you already bought them). So because you were the first person to inject the money into the economy you benefited a little from it as your houses are now worth a little bit more. Any time inflation occurs it’s the people who receive the money first that benefit the most. Who receives the money first in the real world? The institutions that handle the money. Think of this as an incremental transfer of wealth. The further you are from the newly created money the worse off you are. This is because by the time the money has trickled down to you, prices have already begun to rise and you can't buy as much with your money anymore.

Many people are extremely concerned about the increasing separation of wealth in this country (rightfully so) and they should concentrate a lot of their efforts on this criminal process. This process erodes middle and lower class wealth and redistributes it to the upper class. In any instance where the money supply is increasing (artificially lowering interest rates, quantitative easing, fractional reserve banking) the middle and lower class are being stolen from. It's stealing from the poor and giving to the rich in a stealthy fashion which doesn't raise eyebrows because of the complexity of the process. For a video overview of this process here is a short three minute summary of how this works:

http://www.youtube.com/watch?v=hx16a72j__8&feature=player_embedded

It should be noted here that certain indicators that the government uses to judge inflation have been tweaked over the years, and some individuals call into question the validity of these changes. There are a few sources which actively attempt to calculate inflationary indicators (like the CPI) as it was calculated many years ago (1980) with startlingly different conclusions on the current level of inflation:

http://www.shadowstats.com/alternate_data/inflation-charts

This all ties into business cycles as well....you can check out how it works on this site:

www.hmscoop.com