Why monetary policy doesn’t work

I was recently asked by one of my Substack subscribers to explain why the use of interest rates in an attempt to manage inflation does not work. It is simply not the true function of interest rates.

Primarily, an interest rate is the compensation a creditor requires for credit risk. Credit risak comes in several forms: there is compensation for the loss of possession of the use of a medium of exchange (what some economists term time-preference), there is the risk of non-settlement by a debtor, and there is the risk of loss of purchasing power of the medium of exchange over the period of a loan. It is the sum of these three elements which value credit at a discount today compared with its eventual realisation when possession returns to the creditor, nowadays always expressed as an interest rate.

That is the function of an interest rate. It puts a price on tomorrow’s values today. It is something to be determined between debtor and creditor and is never the business of anyone else, let alone a central bank. But we need to go further and demonstrate that the errors of interest rate management are even greater than insisted by those of us who understand that the preceding description of the role of interest rates is correct. The answer lies in Gibson’s paradox.