Mervyn King, Governor of the Bank of England, complained recently that he lacked the powers required to fulfil his new statutory role of ensuring stability in the banking system. A more powerful Bank of England would do a better job.

He is wrong. The economy would benefit from a weaker Bank of England, stripped of its principal power: namely, the power to set interest rates. This is not intended as a criticism of Mr King or of the other members of his Monetary Policy Committee. No one should be allowed to set interest rates.

Interest rates are simply prices for borrowing. As with all prices, they should be determined by supply and demand in a free market. When they are fixed by a wise man, or by a wise committee, they no longer carry information about the preferences of consumers and the scarcity of resources. On the contrary, no matter how wise the dictator, interest rates set by diktat are sure to be a kind of misinformation, leading those who act on them into error.

To see why, start with the price of something more straightforward. Suppose that global warming changed the popularity of British summer holiday destinations, so that more people wanted to visit Edinburgh and fewer wanted to visit Brighton. Competition for the limited supply of hotel rooms in Edinburgh would bid up their prices, while Brighton hoteliers would have to cut prices to find willing buyers.

Because hotels in Edinburgh would now be more profitable, profit seekers would build new hotels there. Equally, the fall of prices in Brighton would make some hotels there go broke, and the number of rooms would decline. Without anyone planning it, the supply of hotel rooms would adapt to the changing demand for them.

But only with market prices. The process breaks down if prices are set by diktat. Suppose the Bank of England had a Hotel Policy Committee that specified the price of hotel rooms. Then the increasing demand for rooms in Edinburgh would not cause their price to rise. Profit seekers would not get the “price signal” to build more hotel rooms there, and the allocation of resources would not respond to changes in consumer demand.

Now return to interest rates. Suppose the demand for borrowing rose, perhaps because technological advance leads to entirely new products, and investment in businesses making them. This would increase competition for access to the limited supply of savings and drive up interest rates. Saving — that is, deferring consumption — would now be more rewarding. So more people would do it, and the supply of savings would rise in response to the increased demand for borrowing.

At least, it would if we had a free market in interest rates. When interest rates are set by a central bank, demand for borrowing can increase without interest rates increasing and hence without the price signal that would cause people to save more. When dictated, interest rates stop playing their market role of optimally allocating resources between current consumption and investment that will deliver future consumption.

Central banks control interest rates by their “open market operations”. They enter the capital markets as buyers or sellers of debt, thereby increasing the demand or the supply of it until they have shifted the interest rate to their target. When they aim to lower interest rates, these open market operations increase the amount of money held in bank deposits, and so increase the funds that banks have available to lend. This is what would happen if the savings rate had increased, if people had deferred consumption to make resources available for investment. But no such thing has happened. The central bank has merely created the illusion of increased savings.

This illusion creates waste, because it makes people overestimate the available resources. Ventures that would have been unprofitable if interest rates were not artificially low are now embarked upon, drawing scarce resources away from better uses. According to Friedrich von Hayek and other advocates of the Austrian theory of the business cycle, it is this interference with interest rates and the money supply that causes an unsustainable combination of consumption and investment — a boom that inevitably leads to a bust.

Conventional wisdom contends that the current recession was caused by the free-market zealotry of recent economic policy and by excessively low interest rates. It is an absurd view, given that interest rates are not determined by market forces. Interest rates are manipulated by central banks with a government-mandated monopoly in the issuance of money.

Some of those still defending free markets protest that, contrary to popular opinion, banks were heavily regulated before the financial crisis. So they were. But this is quibbling. The role of central banks means that, at its core, we did not have a free market financial system. We had a command economy.

Command economies do not fail because the central planning agencies lack the powers required to bring about the best outcomes. They fail because, without market prices, nobody has the information required to adapt the allocation of scarce resources to the demand for them. They fail because central planners have an impossible job. The Bank of England should not get tougher or try harder. It should give up.

Jamie Whyte is a banker and philosopher and the author of Bad Thoughts: A Guide to Clear Thinking

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