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.

Gibson’s paradox demonstrates that interest rates correlate with the level of prices, and not with the rate of inflation. This is illustrated in the charts below:

It is clear from historical data that interest rates and therefore bond yields correlate, while interest rates, or bond yields, and the rate of inflation do not. Bond yields can be taken as a smoothed approximation of short-term interest rates plus, of course, something for additional credit risk.

Keynes, who named this paradox after fellow economist Arthur Gibson, wrote in his Treatise on Money that it was "one of the most completely established empirical facts in the whole field of quantitative economics". He called it a paradox because he could find no explanation for it, and both Irving Fisher and Knut Wicksell also failed to explain it. Clearly, preconceived economic notions by economists rather than a practical understanding were the problem.

The short explanation is simple and can be explained by the interests of both debtors and creditors.

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