Making Economic Sense
Making
Economic Sense
by Murray Rothbard
(Contents
by Publication Date)
Chapter 8
The Interest Rate Question
The Marxists call it "impressionism": taking social
or economic trends of the last few
weeks or months and assuming that they will last forever. The problem
is not realizing that there
are underlying economic laws at work. Im pressionism has always been
rampant; and never more
so than in public discussion of interest rates. For most of 1987,
interest rates were inexorably
high; for a short while after Black Monday, interest rates fell, and
financial opinion turned
around 180 degrees, and started talking as if interest rates were on a
permanent downward trend.
No group is more prone to this day-to-day blowin'
with the wind than the financial press.
This syndrome comes from lack of understanding of economics and hence
being reduced to
reacting blindly to rapidly changing events. Sometimes this basic
confusion is reflected within
the same article. Thus, in the not-so-long ago days of double-digit
inflation, the same article
would predict that interest rates would fall because the Fed was buying
securities in the
open market, and also say that rates would be
going up because the market would be expecting
increased inflation.
Nowadays, too, we read that fixed exchange rates
are bad because interest rates will have
to rise to keep foreign capital in the U.S., but also that falling
exchange rates are bad because
interest rates will have to rise for the same reason. If financial
writers are mired in hopeless
confusion, how can we expect the public to make any sense of what is
going on?
In truth, interest rates, like any important price,
are complex phenomena that are
determined by several factors, each of which can change in varying, or
even contradictory, ways.
As in the case of other prices, interest rates move inversely with the
supply, but directly with the
demand, for credit. If the Fed enters the open market to buy
securities, it thereby increases the
supply of credit, which will tend to lower interest rates; and since
this same act will increase
bank reserves by the same extent, the banks will now inflate money and
credit out of thin air by a
multiple of the initial jolt, nowadays about ten to one. So if the Fed
buys $1 billion of securities,
bank reserves will rise by the same amount, and bank loans and the
money supply will then
increase by $10 billion. The supply of credit has thereby increased
further, and interest rates will
fall some more.
But it would be folly to conclude,
impressionistically, that interest rates are destined to
fall indefinitely. In the first place, the supply and demand for credit
are themselves determined by
deeper economic forces, in particular the amount of their income that
people in the economy
wish to save and invest, as opposed to the amount they decide to
consume. The more they save,
the lower the interest rate; the more they consume, the higher.
Increased bank loans may mimic
an increase in genuine savings, yet they are very far from the same
thing.
Inflationary bank credit is artificial, created out
of thin air; it does not reflect the
underlying saving or consumption preferences of the public. Some
earlier economists referred to
this phenomenon as "forced" savings; more importantly, they are only
temporary. As the
increased money supply works its way through the system, prices and all
values in money terms
rise, and interest rates will then bounce back to something like their
original level. Only a
repeated injection of inflationary bank credit by the Fed
will keep interest rates artificially low,
and thereby keep the artificial and unsound economic boom going; and
this is precisely the
hallmark of the boom phase of the boom-bust business cycle.
But something else happens, too. As prices rise,
and as people begin to anticipate further
price increases, an inflation premium is placed on interest rates.
Creditors tack an inflation
premium onto rates because they don't propose to continue being wiped
out by a fall in the value
of the dollar; and debtors will be willing to pay the premium because
they too realize that they
have been enjoying a windfall.
And this is why, when the public comes to expect
further inflation, Fed increases in
reserves will raise, rather than lower, the rate
of interest. And when the acceleration of
inflationary credit finally stops, the higher interest rate puts a
sharp end to the boom in the capital
markets (stocks and bonds), and an inevitable recession liquidates the
unsound investments of
the inflationary boom.
An extra twist to the interest rate problem is the
international aspect. As a long-run
tendency, capital moves from low-return investments (whether profit
rates or interest rates)
toward high-return investments until rates of return are equal. This is
true within every country
and also throughout the world. Internationally, capital will tend to
flow from low-interest to
high-interest rate countries, raising interest rates in the former and
lowering them in the latter.
In the days of the international gold standard, the
process was simple. Nowadays, under
fiat money, the process continues, but results in a series of alleged
crises. When governments try
to fix exchange rates (as they did from the Louvre agreement of
February 1987 until Black
Monday), then interest rates cannot fall in the United States without
losing capital or savings to
foreign countries.
In the current era of a huge balance of trade
deficit in the U.S., the U.S. cannot maintain a
fixed dollar if foreign capital flows outward; the pressure for the
dollar to fall would then be
enormous. Hence, after Black Monday, the Fed decided to allow the
dollar to resume its market
tendency to fall, so that the Fed could then inflate credit and lower
interest rates.
But it should be clear that that interest rate fall
could only be ephemeral and strictly
temporary, and indeed interest rates resumed their inexorable upward
march. Price inflation is the
consequence of the monetary inflation pumped in by the Federal Reserve
for several years before
the spring of 1987, and interest rates were therefore bound to rise as
well.
Moreover, the Fed, as in many other matters, is
caught in a trap of its own making; for the
long-run trend to equalize interest rates throughout the world is a
drive to equalize not simply
money, or nominal, returns, but real returns
corrected for inflation. But if foreign creditors and
investors begin to receive dollars worth less and less in value, they
will require higher money
interest rates to compensate--and we will be back again, very shortly,
with a redoubled reason
for interest rates to rise.
In trying to explain the complexities of interest
rates, inflation, money and banking,
exchange rates and business cycles to my students, I leave them with
this comforting thought:
Don't blame me for all this, blame the government. Without the
interference of government, the
entire topic would be duck soup.
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