The praxeological view. The interest rate is usually presented as a tool of economic policy, a number that the central bank raises or lowers as it sees fit. In reality it is a price: the price of time. It expresses how much more each of us values a good available today than the same good a year from now. Like every price, it is formed on the market, where those who can wait, and therefore save, meet those who need resources now in order to produce something later. Murray N. Rothbard, in Man, Economy, and State, leaves no room for any third party:

“This pure rate of interest, then, is determined solely by the time preferences of the individuals in the society, and by no other factor.”

The time preferences of millions of people change constantly, with each person’s plans, needs, and expectations; they cannot be condensed into a single number decided every six weeks. The central bank has no way of knowing them. What it does is set the terms on which it lends to the banks and pays interest on their deposits, and through these terms it influences the cost of borrowing for households and firms in 21 countries. When the interest rate is held below the level to which real savings would bring it, the banks make loans with money that nobody saved. This credit expansion sends a misleading signal to every entrepreneur who is planning an investment: it persuades him that more resources are available than actually exist.

“The banks’ credit expansion had tampered with that indispensable ‘signal’—the interest rate—that tells businessmen how much savings are available and what length of projects will be profitable.”

On the strength of this distorted signal, long-term projects are started that would not pay if the interest rate reflected real savings. These are the malinvestments of the boom. For a while they look profitable, but the resources needed to complete them do not exist, and sooner or later the mismatch comes to light. Ludwig von Mises, in Human Action, describes how the story ends:

“There is no means of avoiding the final collapse of a boom brought about by credit expansion.”

Moreover, the cost is not shared equally, because the new money does not reach everyone at the same time. The first to receive it are the banks and those who borrow from them, who spend it before prices have risen. The last to see it are the wage earner, the pensioner, and anyone who holds cash, by which time prices have already gone up (Cantillon effect). As Murray N. Rothbard puts it in What Has Government Done to Our Money?, inflation is, in effect, “a race—to see who can get the new money earliest.” The saver sees this in his account: if prices keep rising at September’s pace, even the 2.50% that the ECB pays on the banks’ deposits falls short of their rise. A euro set aside for a year buys less at the end of it, and waiting, instead of being rewarded, is penalized.

In February a new face will take the top job at the ECB; but a change of person does not touch what matters. The question is not who will set the price of time, but why anyone other than those who save and borrow should set it at all.