The Parable of the Broken Traffic Lights

In a free market, interest rates and the banking system coordinate the plans of the cross-traffic of lender-savers and borrower-spenders.  If saving increases, it means consumers are more willing to wait for goods.  Their saving leads banks to offer lower interest rates, providing a traffic signal (and an incentive) for borrowers to borrow for longer-term projects that match the greater patience of consumers.  If consumers are more impatient and save less, banks raise rates, leading borrowers to go more short term to match this preference.  Each side???s behavior is consistent with the other???s, thanks to the traffic-signal role of the interest rate.

When the central bank intervenes [with an expansionary monetary policy], however, it turns all the lights green.

Prices are signals like traffic lights. Although they emerge (unlike traffic lights which are purposefully designed) they serve a similar coordination role.
When they don’t function properly, or are tampered with, the result is discoordination. The interest rate is a critical price which signals the relative priority of consumption versus investment.
If people prioritize consumption higher but the central bank lowers the interest rate, then incompatible and unsustainable activities (consumption and long-term projects) clash instead of yielding to one another. Bubbles emerge not from people being suddenly irrational, but from people being misled by false signals.


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