In a recent interview in my home country, Nigeria, I argued against a decision to lower interest rates. I was then asked whether rates should have remained unchanged or been raised instead. My answer was that neither I nor any committee possesses the knowledge required to determine the correct interest rate.
Why should an interest rate sit at 5% when it could sit at 10%? Who should decide?
Modern monetary policy treats this as a job for a committee. In South Africa, the South African Reserve Bank’s (SARB) Monetary Policy Committee studies inflation, unemployment, economic growth and financial conditions before announcing a rate it considers appropriate. It raises the rate when the economy looks “overheated”, whatever that means, and lowers it when economic activity looks weak.
The procedure is so familiar that its main assumption rarely gets examined: that a “right” interest rate exists and that a central authority can find it.
Interest is a market phenomenon that grows out of human action, time preference and the way people value present goods against future goods. The question worth asking is why anyone should believe a central bank can know what the rate ought to be.
Interest Begins With Time
People act through time, and many choices involve deciding whether satisfaction should come sooner or later. Someone who prefers R100 today to R100 in a year values the present good more than the future one. That says nothing about impatience in a psychological sense. It simply describes how the person values things under the circumstances.
This is called time preference. In Austrian economics, originary interest, a term used by Ludwig von Mises, describes the premium placed on present goods over future goods.
Consider R1 million today and R1 million in ten years. The sums are numerically identical, yet they differ economically because only the first can satisfy wants today. That difference in valuation is what interest rests on.
Even if South Africa had no Reserve Bank, no commercial banks and no policy committee, people would still have to choose between present and future consumption.
Interest is often described as the reward for saving, but that gets it slightly wrong. It does not simply pay people for abstaining from consumption. People save because they value some future satisfaction enough to give up a present one, and interest is the market’s expression of that valuation.
If South Africans become more future-oriented, saving rises and the economy can support greater investment in projects that take years to complete. If they become more present-oriented, more resources flow towards current consumption.
Interest rates connect the plans of savers, consumers, entrepreneurs and investors across time.
The Knowledge Problem
Central banking is often described as adjusting a thermostat: inflation too high, raise rates; growth too weak, cut them.
But an economy consists of millions of people with different preferences, expectations, resources and plans.
Picture a Limpopo farmer weighing this season’s expenses against investing in a new irrigation system, a Durban entrepreneur deciding on a five-year expansion, and a Johannesburg manufacturer facing risks nobody else can see.
None of them knows the future, and neither does the Monetary Policy Committee.
The information needed to determine appropriate interest rates exists in scattered form among millions of individuals. Markets bring that information together through prices, and interest rates are among those prices.
This is the broader economic problem of dispersed knowledge, and it applies directly to interest.
The rate on a bank loan also incorporates several things. Beyond originary interest, it reflects risk, uncertainty and expected changes in the rand’s purchasing power.
Different borrowers, maturities and investments carry different rates. There is no single number called “the interest rate” waiting to be calculated. Yet central bank monetary policy attempts to influence this complex system through a single policy rate.
What Happens When Rates Are Pushed Too Low?
Suppose South Africans’ time preferences have not changed, but the central bank expands credit and pushes borrowing costs below where market conditions would otherwise place them.
Entrepreneurs interpret the lower rates as a sign that more resources are available for investment. Longer, more capital-intensive projects suddenly look profitable.
Cheap credit creates purchasing power. It creates no additional machines, factories, skilled workers or raw materials.
Entrepreneurs participating in this boom may be behaving perfectly rationally. The problem is that the price signal they are responding to has been distorted.
The boom looks like prosperity. Investment rises, property prices climb, construction accelerates, hiring picks up, and politicians celebrate.
But the relevant question is whether this investment is backed by real saving.
If it is not, consumers are acting as though they want present consumption while entrepreneurs are acting as though society has freed resources for future production. Both sets of plans cannot necessarily be fulfilled.
Eventually, economic reality reasserts itself. Projects are abandoned, capital is redirected, businesses fail and asset prices fall.
The recession exposes and corrects the errors made during the artificial boom.
This is the central argument of Austrian business-cycle theory: credit expansion can push market rates below the levels that coordinate saving and investment, encouraging malinvestment, or investments that cannot be sustained by the economy’s underlying resources and preferences.
Rates Can Also Be Too High
The opposite error is equally important.
An interest rate artificially maintained above the level that would emerge from voluntary market activity makes otherwise viable investments unattractive.
Projects that could have been profitable go unbuilt, entrepreneurs postpone expansion, and resources may remain idle.
The objection therefore goes further than the claim that central banks sometimes set rates too low.
No central authority should carry responsibility for determining a price that coordinates economic activity across time.
It can err in either direction because the information it needs does not exist as a single number available to policymakers.
The Problem With the “Neutral Rate”
Central banks respond that they are not arbitrarily choosing interest rates. Rather, they are attempting to estimate the rate consistent with an economy operating without excess inflationary or deflationary pressure. This is commonly called the neutral rate.
But if the objective is to discover the rate that would emerge under undistorted market conditions, why not allow markets to determine it?
There is an inherent difficulty in identifying the correct market rate while continually intervening in the process through which that rate would otherwise emerge.
Someone must set the rate, the objection goes.
In a sense, someone does.
A bank decides what to charge on a particular loan, a lender decides what return it requires, and a borrower decides whether a project justifies the cost.
None of that requires a national policy rate.
We have no national bread-price committee determining the correct price for every loaf. Prices throughout the economy emerge from the decisions of buyers and sellers, responding to changing conditions.
Why should interest rates be fundamentally different?
Indeed, the more important a price is for coordinating economic activity, the greater the potential damage caused by systematically distorting it.
Economic conditions also change constantly. Time preferences, risk, technology, capital availability and expectations all shift.
A central bank is therefore chasing a moving target. Each intervention changes the very conditions it is attempting to measure, often creating pressure for further intervention.
A private lender’s mistake imposes losses principally on that lender and those exposed to the decision. A central bank’s mistakes can transmit distortions throughout the entire economy.
What Should Replace Central Bank Rate-Setting?
The answer is to take the committee out of the job.
Interest rates should emerge from voluntary dealings among savers, borrowers, banks, investors and entrepreneurs, operating under secure property rights and enforceable contracts.
Banks should bear the consequences of their own lending decisions rather than relying on government protection from losses.
The resulting interest rates will not be perfect. Market errors are real, and private institutions can make poor decisions.
But those rates will emerge from the choices of the people whose activities they are meant to coordinate, rather than the judgement of a committee attempting to calculate what millions of individuals collectively want.
If a central bank cannot know the correct interest rate, how can we trust a monetary policy framework built around the assumption that it can?
Cheap credit can produce an impressive boom, but a low repo rate is no proof that South Africans have become more willing to postpone consumption.
New money is not the same as new resources. The economy must still reconcile what people want today with what they are prepared to postpone until tomorrow.
The market may not tell us in advance what the interest rate will be. That knowledge was never available to a central planner in the first place.
And that alone is enough reason to question an institution built on the assumption that it knows better than the market.
Econ Bro (@EconBreau and @EconBreau2 on X) is a Nigerian Austro-libertarian economist and an apprentice at the Mises Institute. Through The Freedom Institute, he teaches individual liberty, personal responsibility, private property rights, free markets and sound money, primarily to young Nigerians. He is also an Associate of the Free Market Foundation.
