Price Fixing and Credit

Most people with a reasonable grasp of economics understand the basic issues associated with price fixing. Fix the price of bananas and there will be either a glut of bananas (if you fix too high) or a shortage of bananas (if you fix too low). Alternatively with a less fungible product you might get a shift in quality instead of quantity. So for instance if the price of cars is fixed too low then you might get a decline in quality rather than a shortage, although probably in practice you would get a bit of both (or maybe a lot of both). Free Market types generally agree that you shouldn’t fix prices but rather you should allow the market price to signal to consumers and producers the relative scarcity of a given good for a given quality. Behaviour can then adjust accordingly.

Of course there is more than one way to fix a price. Generally price fixing is achieved by laws and regulations. However what if the price of bananas was fixed high by governments going to market and buying bananas to force the price up? We have seen such interventions previously with governments buying wheat to ensure that the price of wheat wouldn’t fall below some benchmark. Gluts would follow but the government would own the excess and perhaps dump it at sea. And in fact given that they would be leading the market on price it would be the best quality grain that got dumped at sea.

Now what if the latter form of price fixing was applied to a more esoteric market such as the credit markets. What if the price of credit (ie the rate of interest) was fixed using some market intervention in the way that the price of grain has at times been fixed by market intervention. Perhaps a commitee of wise officials would meet every few months and decide the right price for credit and then use some form of market intervention to fix the price. Would we see gluts and shortages? Would we see a shift in quality away from what might be natural or optimal. For instance if the price was fixed low for a long time is it possible that we would see both a shortage of credit and a decline in the quality of credit. Or do such laws of economics only apply to wheat, bananas and cars? And is a freely adjusting price signal only relevant to those that consume or produce the likes of wheat, bananas and cars?

15 thoughts on “Price Fixing and Credit

  1. Terje

    Dude, we ARE NOT going to see a gold standard. Forget about it.

    The best we can see is a scrapping of interest targeting and a return to quantitative management of the money supply.

  2. Well, if this “commitee of wise officials” was guaranteeing to provide the credit at the price they fixed, then obviously you’re not going to see a shortage in the supply of credit.

    And the supply of credit really only comes in one form — $$$ — so I can’t see how the quality will be lower. Perhaps the dollar bills will be scruffy or having writing on them? 🙂

    The real difference between that situation and a free-market situation would be that people would decide to consume too much credit. That would mean the average quality of investment or consumption decisions would be lower.

    To take it back to bananas, this would be the same as having somebody who only likes bananas a little bit eating one… when a free-market price would mean they wouldn’t eat one.

    And perhaps more importantly, the increased supply of loanable funds leads to a higher level of money in the economy, which leads to inflation. The inflation impacts on different parts of the economy at different speeds, so the new investment is not only relatively lower quality on average, but it can also be put in to very much the wrong place, as the all important price-signals aren’t giving the right signal.

    When this problem works itself out (which it eventually will if you leave the market alone) then a few businesses will go bust and a few people will file for bankruptcy. This is the Austrian explaination for the boom-bust cycle, as caused by bad monetary policy.

  3. To get an interest rate below the natural market rate you need the wise men to sell credit not merely “provide it” (ie lend funds and receive interest). Which in practice usually means buying debt (eg receiving interest on government bonds by buying those bonds). Normally they would buy high quality debt such as government bonds leaving the other market participants to deal with the lower quality debt. However when you get bailouts the government does the opposite and buys the lowest quality debt, presumably because it suddenly thinks the other market participants need more of the quality stuff and less of the toxic stuff. Ironically they are also doing so at high rates of interest which almost acknowledges that the fixed price was too low.

    Of course to set a price for credit above the market rate you would indeed need to do the opposite. An example with some numbers might help out here.

    Lets say the market rate would be 5%. However the committee wants the rate to be 8%. In order to achieve this then need to borrow (ie buy credit by paying interest). In practice they would typically do this by selling debt. They would sell second hand government bonds. In usual terminology they would be draining liquidity from the markets.

    To get an interest rate below the 5% market rate, say 2%, they would need to lend (ie sell credit by receiving interest). In practice they would typically do this by buying debt. They would buy second hand government bonds. In usual terminology they would be providing liquidity to the market.

    In selling excess credit and lowering the market price of credit they will discourage people from lending to banks. They should also discourage banks from lending to people. However given that the banking industry has lots of fixed costs it needs to maintain volume. As such it needs to try and maintain the volume of credit it is selling. This means lowering margins. Eventually something has to give because the banking sector is too big for the new artifical rate. A non-orderly adjustment will be the result.

    To save the banking sector at it’s current size you need to restore their profit margins. The quickest way to do that is to raise real interest rates. Perhaps counter intuitive in a crisis but it is the remedy required. I doubt however that many people are in the mood to listen.

    Looking at it another way. Let us say that the government ran a car manufacturing business called the “Car Seller of Last Resort”. Now lets say that the car industry found itself with in a situation where the price for cars had fallen so far that it was no longer profitable to build cars. Lets say that car companies started collapsing. “Car Seller of Last Restort” comes along and starts selling cheap cars. How does this help?

  4. What on earth are you on about? A committee could, if given the legal power, set a price for credit without also providing a supply of credit. This used to happen with home mortgages. If the interest rate is fixed to low then suppliers of credit will find something better to do with their money.

    The wool floor price debacle may be the best Oz example of when prices are fixed high.

    Why would raising interest rates save the banking sector in its current size? Why wouldn’t that lead to more foreclosures and a reduction the demand for loans? Thus poisoning the existing business and reducing the potential for new business.

    In the short term you don’t have to restore profit margins to save a business, you just need to reduce the losses to a sustainable level.

  5. Assume for a minite that there are no central banks and the market sets the interest rate freely. Now if there was a lack of confidence in banks then some depositors may feel an incentive to show up wanting cash out and hence put a squeeze on the banks cash flow. In which case the logical response by the bank would be to increase the incentive to leave funds deposited and/or increase the the incentive for lenders to pay down their debt or else extract more from the lenders in exchange for debt. This would in practice mean higher interest rates in each instance. Higher interest rates are what a lack of confidence demands.

    The current solution says carry on lending and get more cash from the central bank to stop gap the cash flow issue. And no price signal regarding scarcity gets transmitted to other market players. Fixing the price of credit is a key source of instability.

  6. p.s. Pedro – central banks fix interest rates using a mechanism called open market operations. It is not unlike fixing the wool price.

  7. TP I know how they set the interest rate and yes it is like fixing a wool price, though the other side of the supply coin. Obviously the RBA does not fix interest rates generally, they just influence market conditions.

    However, your theory on the benefits of increasing interest rates assumes outcomes that might not happen.

    Surely increasing rates would lead to a reduction in the demand for loan funds and thus a reduction in new business and also contributing to a general reduction in business conditions (at some level). Thus increasing reliance on existing borrowers who may not have the capacity to pay the increased rates.

    Increasing interest rates could lead to aggravated foreclosures and a downward spiral. The long term health of a bank might be enhanced if it reduced interest rates to borrowers while increasing rates on deposits and thus accepting a small profit/loss situation for a period to keep borrowers going while improving its own funding position.

    Your post makes the point that markets get out of whack when prices are fixed. The central banks influence interest rates by manipulating the supply of money, which has the same effect as fixing a price, but is not quite so obvious and thus the problem it creates is hidden(ish) for a while.

  8. Pedro – I would agree that raising interest rates may not save the day. Although if loans are not performing it is more an issue with quality rather than an issue with the price of credit. Keeping the price low will not encourage an improvement in quality and will also not restore quality to existing credit that has none.

    Either way I do strongly suspect that keeping interest rates low in the USA has been a primary cause of the problems we are now seeing there. It has lowered the opportunity for banks to make margins and pushed them (metaphorically speaking) into chasing volume via a lowering of quality. Any long term solution that entails the continuation of interest rate price fixing is going to entail recurring gluts and shortages in the credit markets and recurring issues of quality. It is flawed monterary approach perpetrated by deeply flawed government institutions.

    Ideally credit prices should be almost entirely deregulated and liberated. In so far as we continue to have fiat currencies we should have monetary authorities that manage the value of those currencies via benchmarks against real commodities with real production costs related to market reality. The notion of a central “bank” or lender of last resort should be purged from our societies.

  9. Changing the price on existing loans can’t improve the quality of those loans either. I suppose the question is this: if you have a bad loan book how do you improve the quality of it? Raising rates will not improve the quality of your loan book unless the increased rate means that bettter quality borrowers will come to you for loans. It will improve the risk/reward balance provided that it does not create a large scale problem for you current borrowers.

    As far as I can see, the only way to improve the quality of the loan book is better DD on the borrowers and assets. A lower interest rate will attract more borrowers and give you the opportunity to increase your DD while keeping up the level of loans made.

    with respect to current borrowers, I only said that keeping the interest rate low will reduce the chance of defaults, but in a sense, the quality of a borrower is relative to the burden on the loan, so lower interest rates does increase the quality of the loan book to that limited extent.

    I agree that low interest rates is the major cause of the problem in the US, but not because of bank margins, rather it is the malinvestments produced by the unsustainably low rates that is the problem.

    I think JC and john humphreys answered your last paragraph on another thread.

  10. I won’t stay on this thread – the other one is enough for me.

    But you guys are crazy if you think price fixing is ever going away. Price fixing always happens sooner or later. Get rid of it in one form it comes back in another, legal or illegal. When big business is involved if it starts illegal it normally ends up legal 😉 Thats one for you FR lovers !!

    But there should be some control of the money supply right? The temptation to abuse is too great without any control. As soon as you have that control in place, you by default have price fixing of a type.

  11. You need to recognise the difference between market dynamics (which can result in a stable price) and price fixing by Government mandate.

    Clearly the mandate creates inflexibility which creates shortages and gluts – i.e the things we see in recessions and depressions. A central bank can at best mimic private issuance of currency which has an incentive to keep currency stable. Government at best can have a goal of currency stability which is undermined by institutional and political factors.

    Price fixing by private firms in the monopolist sense is good. Yes, it is good. It encourages other firms to compete or create alternative substitutes.

    Without the price signal, the market remains underserviced or short of R&D funding.

  12. People are spending less and saving less — which means their hording. This change in liquidity preference is the same as a decrease in broad money supply. If nothing is done about it, it will drive up interest rates to the point of recession.

    The controllers of the money need to increase the supply of money. Currently that is done by controlling the overnight interest rate that banks pay. Maybe they should do it differently, but that’s not the main point right now.

    Just because the overnight interest rate is lowered, that doesn’t mean the banks would necessarily lower their interest rates. Indeed, they probably shouldn’t (for the reasons Terje points out). They would have a good excuse for not cutting their rates — and that is that they need higher rates to attract the savings.

  13. Temujin – I presume though that not all banks are in the same problematic position in terms of cash flow. So those better off banks can access the low rates essentially provided by the central bank and coast through the troubles. However if the central bank set the rate higher (or floated the rate) then the good banks would probably lift their rate and the troubled banks would have more scope to also raise their price of credit.

  14. p.s. They may not be hording. They may be investing. In other words they may be taking an equity stake in the processes of production rather than a debt position.

  15. Somebody on another web forum pointed out that fixing the price of bananas high may not cause much in the way of an initial glut because banana trees take time to grow. Instead it will initially create malinvestment in the banana farming business as extra trees get planted. Only latter (possibly years later) will the supply become truely excessive. Other products, such as wheat, will have a much faster reaction time. The difference being the level of malinvestment in time and money required to achieve the glut.

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