Every Chinese child knows the old story about monkeys who were offered a choice of two bananas in the morning and three in the afternoon, or three in the morning and two in the afternoon. Most monkeys chose the latter, but the traditional response was that there was no difference because either choice brings in five bananas.
Actually, the majority of monkeys were right. Three bananas in the morning are better than two, because consumption now is preferred to consumption later. The two choices are not the same because there is a value attached to time, which is the interest rate. The interest rate compensates for delayed consumption, because, in the afternoon, the monkey risks not getting the third banana. If the interest rate is zero, there is no reward for consuming later.
This is the dilemma the world faces under quantitative easing, which is another phrase for printing money.
Advanced countries want interest rates to be near zero for two reasons. The first is that, after a crisis, zero interest rates mean that the central banks need not fear higher inflation. The second is that zero interest rates subsidise the borrower, and advanced economies are all highly in debt.
But zero interest rates greatly distort resource allocation. If the advanced countries are growing at 2 to 3 per cent a year, the real interest rate should be around 2 to 3 per cent a year, because savers should be compensated for the growth in the economy. Otherwise, their capital is being eroded in value.
With interest rates at zero, markets also have difficulty pricing risks. The gross interest rate or dividend should always price in the risk that the borrower may default or inflation may rise.
