Interest rates are a price just like any other price. They are the price of money. When the price of money is low people are inclined to take the cheap money and misallocate it, buying second homes or starting businesses with little regard for their profitability. This creates asset bubbles.
If however you have to pay a lot for money, you are likely to be careful how you use it – in this regard high interest rates help enforce fiscal discipline. As the chart of Bank of England Base Rates below shows, over the past couple of decades the price of money has become significantly cheaper.
Chart of Bank of England Base Rates – 1980 to 2009
Source: Bank of England
So as much as we like to blame the ‘greedy bankers’ for the global financial crisis, those responsible for setting interest rates must also share the blame. Had interest rates been set by the free market rather than governments and central bankers who kept them artificially low for many years, much of the speculation we saw in the run up to the global financial crisis might have been avoided.
For now at least the price of money looks set to remain cheap, penalising the prudent and encouraging speculation. Only when this is corrected can it be said that we are on the road to a truly sustainable recovery.