What do a salesman, a prisoner, and an investor have in common?

So a few friends got into a debate over fed's influence on the interest rate - if it should be completely left at the hands of the market, ie, the central banks should not set a target rate and hence influence the market interest rate.

The opposite of my argument is that the market does a better job at setting an interest rate, one that will benefit the economy in the long term.

I thought the idea to not 'manage' the interest rate is a wild one. But it is nevertheless interesting to talk about.

Few of my relatives were visiting Hong Kong from the mainland, and as all HK visitors will do, they went to shop for electronics.

It took them a mere couple of hours to buy a digital camera, one that costed HKD $2300. However, luckily, or unlickly, they soon find out that the same camera was selling for HKD $1900 at another store of the same chain, only had they paid for it with cash. So the salesperson took advantage of them by withholding information of the cash discount.

My relatives were definitely not pleased. Fortunately, they managed to get a full refund, but you can bet they would be extra cautious next time they shop here in HK. On that day, the entire retail industry in HK took a hit at the doing of that greedy salesman, what tried to score higher commision by not disclosing the cash discount offer.

So what does this have to do with a pure market-based interest rate system?

It proves that it just won’t work. It is a classical Prisoner’s Dilemma problem. Each prisoner will confess because he thinks his counterpart will. That is, each individual will only try to maximize his local gain, resulting in a sub-optimal equilibrium of the system. See more on Prisoner's Delemma here - http://en.wikipedia.org/wiki/Prisoner's_dilemma.

As in retailing, every salesman will do what he could to maximize his commission pay, and that is often at the expense of the uninformed customers. But this hurts the industry, because customers will learn to compare prices from one store to another before the purchase (even stores of the same chain), and subsequently bringing down the average price (as the consumers become more informed, the market gets more competitive on pricing), and therefore margins for the industry.

In a pure market-based interest rate system, banks and investors will only look to ride the current market, make as much money as they can and try to get out just before everyone else does. They would argue that it is the other banks who should be more rational and responsible for the economy.

So in an overheated the market, the interest rate will only adjust, just right before a market crash.