Why Government Shouldn't Set Interest Rates

Interest Rates Are a Price

Most people think of interest rates as “the cost of borrowing money.” A number set by the Bank of Korea or the Federal Reserve.

In Austrian Economics, interest rates are something far more fundamental. They are a price reflecting the time preferences of society as a whole.

When more people want to save for the future, interest rates fall. When more people want to consume now, they rise. Where the saving and spending decisions of hundreds of millions of people intersect, the natural rate of interest is formed, and this number conveys crucial information to markets: how much real savings exists in society and what scale of investment is possible.

When Markets Set Rates

When people save more, lending funds accumulate at banks and interest rates fall. It sends a signal to businesses — savings are plentiful, so long-term investment is viable. Build factories, develop technology. These investments are backed by real savings and can actually be completed.

When savings decline and consumption rises, interest rates go up. It is a signal to hold back on long-term investment.

The dispersed information of hundreds of millions of people is distilled into a single number that coordinates resource allocation across the entire economy. This is the price system. No committee can replace this information.

When Central Banks Intervene

In reality, interest rates are set by central banks. Seven members of the Bank of Korea’s Monetary Policy Board. Twelve members of the Federal Reserve’s FOMC.

No matter how brilliant, they cannot calculate the time preferences of hundreds of millions on everyone’s behalf. This is not a matter of ability — it is the economic calculation problem. Dispersed knowledge cannot be centrally aggregated.

When a central bank holds rates below the natural level, the process described by Business Cycle Theory begins.

Artificially low rates send a false signal that “savings are abundant.” In reality, savings have not increased — the central bank has simply injected newly created money into credit markets. Deceived by this false signal, businesses rush into long-term projects. Real estate, infrastructure, and startup investments explode. On the surface, it looks like a boom. The problem is that the foundation is manufactured credit, not real savings.

Then reality returns. You can print money, but you cannot print steel, cement, or engineers. As projects compete for resources, costs soar and inflation erupts. The central bank is eventually forced to raise rates, and only then does it become clear that many projects were never profitable in the first place. Recession.

2008

After the dot-com bubble of 2001, Greenspan’s Fed cut rates from 6.5% to 1%. Cheap money poured into real estate. Subprime mortgages exploded, and house prices rose 85% between 2000 and 2006.

When rates were raised starting in 2004, everything collapsed. Lehman Brothers bankruptcy, the global financial system on the brink, millions lost their homes and savings.

Calling this a “market failure” is like watching an arsonist at work and calling it a “failure of fire.” Of course, the 2008 crisis cannot be attributed to the central bank alone. Excessive leverage at private financial institutions, regulatory failures, mortgage fraud, and other factors played a role. However, it is hard to deny that the fundamental condition enabling all these excesses was artificially low interest rates.

2020-2022

In response to COVID, the Fed cut rates to nearly 0% and unleashed $4.8 trillion in quantitative easing. The Bank of Korea also hit a record-low 0.5%.

The results came as predicted. U.S. home prices up 40% (2020-2022). Seoul-area apartments up over 30%. Stocks at all-time highs.

Then inflation. U.S. CPI hit 9.1% in June 2022; Korea hit 6.3% in July 2022, the highest in 24 years. The Fed rushed from 0% to 5.5%, and the Bank of Korea followed from 0.5% to 3.5%. Economic slowdown, real estate cooling, exploding debt service costs. A textbook unfolding of Austrian Business Cycle Theory.

Korea’s Real Estate

Korea is the country that most starkly demonstrates the consequences of interest rate manipulation.

Under a prolonged low-rate environment after 2008, household debt exploded — and most of it went into real estate. As of 2024, total household debt stands at approximately 1,900 trillion won, about 100% of GDP — among the highest in the world. The average Seoul apartment costs 1.2 billion won, 15-18 times household income. Compare that to New York at 9 times (metropolitan area basis) and Tokyo at 11 times — the ratio is abnormal.

The word “영끌” emerged — meaning “borrowing to the bone, even pledging your soul.” This is not individual greed. It is a structural problem created by interest rate manipulation. A product of a system in which borrowing cheap to buy property became the rational choice.

Zombie Companies

Another consequence of artificially low interest rates. Zombie companies are businesses that cannot cover their interest payments with operating profits. Companies that would have been eliminated under normal rates survive on cheap borrowing costs.

BIS research shows the proportion of zombie companies in developed economies grew from about 2% in the 1980s to 15-20% by the 2020s. According to Bank of Korea reports, in some years up to 40% of externally audited companies had an interest coverage ratio below 1.

Zombie companies tie up labor and capital unproductively. These resources fail to flow to better uses, slowing the entire economy. This is the substance of malinvestment.

Without a Central Bank

“Won’t there be chaos if no one sets interest rates?”

It is not that no one sets them. Everyone sets them together. When hundreds of millions save and borrow according to their own time preferences, interest rates emerge — just as no one designed language, yet everyone created it together. Spontaneous order.

Under free-market interest rates, investment is backed by real savings, so there are no artificial booms and no destructive busts. Zombie companies are eliminated and resources flow productively. Governments cannot borrow without limit, so fiscal discipline is maintained.

Even during the classical gold standard from 1870 to 1914, business cycles existed. Some argue the amplitude was smaller than in the fiat era, but severe downturns like the Panic of 1873 and the Panic of 1907 also occurred. However, recoveries after crises were swift, and markets demonstrated the ability to self-correct without government intervention.

The Bitcoin Standard

In a Bitcoin world, interest rates are set by the market. Under a sound money system, central banks cannot expand credit by printing money. Lending funds come only from real savings. Interest rates reflect society’s true time preferences. How interest rates would be determined in a Bitcoin economy still falls largely in the realm of theory. How to respond to financial panics without a lender of last resort is also an important unresolved question.

The current system — where a few people set interest rates — is a decades-long experiment. The results are in. Repeated bubbles and crashes, chronic inflation, deepening inequality, unsustainable debt. Interest rates are a price. Prices should be set by markets. Just as no single institution should set the price of oil, no single institution should set the price of time.