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Bad News for Our Money

Mises Daily: Thursday, June 04, 2009 by

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Evan Wondolowski, Guillotine

Suppressing Interest Rates

Suppressing market interest rates to the lowest level possible seems to have become a key objective for central banks around the world as they respond to the turmoil in financial markets, the decline in output and the deterioration in the labor market.

However, it is a fatal policy: it amounts to fighting the correction of the debacle which has been caused by central banks' downward manipulation of interest rates through a relentless increase in bank circulation credit and the money supply.[1]

But the monetary policy of suppressing the interest rate is widely hailed by mainstream economists as paving the way towards economic recovery — and this publicly accepted view provides governments and their central bankers with the intellectual support for continuing with the policy that has caused the disaster in the first place.

Ludwig von Mises knew about the public's ideological aversion against the interest rate, and he put the ensuing tragic chain of events succinctly:

In the opinion of the public, more inflation and more credit expansion are the only remedy against the evils which inflation and credit expansion have brought about.[2]

While central banks have succeeded in bringing short-term interest rates to record lows, long-term interest rates have shown a (much) less pronounced decline. For instance, US short-term interest rates have fallen sharply, whereas credit costs for high quality corporate issuers have hardly declined, and those for lower-rated issuers have even increased.[3]

Figure 1

The policy of suppressing the interest rate is an attempt to evade the costs of the debt that has been heaped up over the last decades as a result of money production under government-controlled fiat-money systems: if market interest rates no longer fall, or do not stay down, the credit pyramid would come crashing down.

Figure 2

Viewed from this perspective the so-called credit crisis might be much more than just a crisis that will, and can, be overcome shortly: it could herald an overindebtedness situation, in which borrowers have become heavily overstretched, and in which lenders are plagued by a growing concern that much of their lending decisions may turn out badly.

Lenders, in particular commercial banks, have become increasingly concerned about the possibility that borrowers might fail to service their debt as promised. As a result, they refrain from rolling-over loans falling due, let alone increasing their credit exposure.

At the same time, borrowers find it difficult — in some cases impossible — to repay their maturing debt, and they would find it also hard, even impossible, to shoulder higher borrowing costs when rolling-over their debt.

In particular chronically debt-financed governments would see their room for maneuvering (and their power) severely restricted if access to credit funding at favorable terms ends all of a sudden.

All this might suggest that the "fight against the interest rate" is about to reach a new dimension.

The Way Towards Taking Full Control Of Interest Rates

In the United States, the Federal Open Market Committee reiterated on April 29, 2009,

to provide support to mortgage lending and housing markets and to improve overall conditions in private credit markets, the Federal Reserve will purchase a total of up to $1.25 trillion of agency mortgage-backed securities and up to $200 billion of agency debt by the end of the year. In addition, the Federal Reserve will buy up to $300 billion of Treasury securities by autumn.[4]

There are at least two important aspects to these measures that need to be highlighted. First, purchasing bonds outright is a policy of increasing the money stock: sellers of bonds receive base money from the Fed. If commercial banks sell their bonds holdings, banks' excess reserves increase, and their potential to create more credit and money rises. If nonbanks (such as insurance companies, funds, etc.) sell their securities to the Fed, the stock of money in the hands outside the banking sector increases.

Second, if the government can sell newly issued debt directly to the central bank, the latter will increase the government's account (held either with the central bank or with commercial banks) by an equivalent amount. As the government uses the new money to pay its bills, the money stock in the hands of recipients (typically nonbanks such as government contractors and employees, the unemployed, etc.) rises.

Third, central-bank purchases in the open market will exert a major impact on the pricing and the interest rate of the bonds.[5] So far, central banks buy and sell short-dated bonds (like T-bills) for affecting the money supply. If the central bank confines itself to buying and selling short-term paper, it controls short-term rates, but its control on long-term interest rates is far from being perfect. [6]

However, the central bank can secure control over the whole yield curve if it also intervenes in the markets for bonds with medium-to-long-term maturities. By effectively fixing bond prices across the maturity spectrum, the central bank can determine short-, medium- and long-term interest rates according to political considerations. This is actually what happened in the United States in the early 1940s.

Government Manipulation of the Interest Rate

For financing World War II, the US Treasury and the Fed decided early to pursue a policy of keeping market interest rates low and stable: T-bills were to yield 3/8 of 1 percent, while long-term government bonds were to yield 2½ percent.[7] The Fed effectively became a market maker for government debt.

Whenever the yield on, say, long-term government bonds rose above 2½ percent, the Fed could buy long-term bonds, bidding up their prices and lowering bond yields back to the politically desired level.

Likewise, if long-term yields fell below 2½ percent, the Fed could sell securities, thereby increasing the market supply of securities, lowering bond prices and increasing yields back to the politically desired level.

In the early 1940s, the US government kept running up huge war-related deficits. The low-yielding T-bills were monetized by the Fed, while commercial banks received sufficient reserves to support the increased amount of deposit money they would create for the Treasury for purchasing its long-term debt.

Until the end of the policy of interest-rate pegging in March 1951 ("Treasury-Fed Accord"), the Fed had actually lost control of its balance-sheet volume and, as a result, the money supply. The Fed's stabilizing of market interest rates on government debt resulted in a massive increase in the money supply.

As a consequence, prices for, for instance, consumer goods increased strongly, actually increasing well above nominal interest rates. The "inflation tax" was imposed heavily on bond investors in general, as yields on private-sector debt remained relatively closely aligned to government debt yields.

Figure 3

The US monetary base had been rising sharply from the late 1930s, and the increase in the money stock also showed rising stock prices. But the latter started inflating from around the time the interest-rate-pegging policy was put in place — which made possible the drastic expansion of the money stock without causing interest rates to rise.

Figure 4

The Economic Evils of Inflation

Needless to say, a policy of pegging the interest rate is a particularly vicious strategy. If it is put into practice, it causes economic damage on a grand scale.

First and foremost, it is an inflation policy, and as such it brings all the economic and political evils that typically come with inflation.

It allows borrowers to issue even more debt, refund maturing debt at artificially suppressed interest rates, and reduce their real debt burden at the expense of money holders.

The downward manipulation of the interest rate drives a wedge between the (real) market interest rate and the societal time-preference rate, and therefore wreaks havoc with the economy's intertemporal production structure.

It leads to economic impoverishment, as it would stimulate consumption at the expense of savings and encourage malinvestment of scarce resources.

What is more, suppressing the interest rate does not provide a solution to the overindebtedness problem, which is a result of government-controlled fiat money produced by banks extending credit in excess of real savings.

As Mises put it, inflation "could not last forever even if inflation and credit expansion were to go on endlessly. It would then encounter the barriers, which prevent the boundless expansion of circulation credit. It would lead to the crack-up boom and the breakdown of the whole monetary system."[8]

The future could hold in store a bad surprise for bond investors and money holders if governments and their central banks push their current policy consequently to the end. Tragically, there are not yet any signs that suggest governments and their central bankers will abandon their destructive policy.

Notes

[1] By "bank circulation credit," Ludwig von Mises meant bank credit (and money issued) that is not backed by savings. In contrast, "bank commodity credit" is credit (and money issued) that is fully backed by savings.

[2] Ludwig von Mises, Human Action, chapter 20 section 9.

[3] It should be noted that even unchanged funding costs would cause growing financial pain to the borrower if and when his return on investment declines.

[4] Federal Reserve, Press Release from April 29, 2009.

[5] Note that there is an inverse relation between the market price of a coupon-paying bond and its yield: if the market price of the bond rises (falls), the yield on the bond falls (rises).

[6] Of course, there is an economic connection between short- and long-term interest rates as, for instance, explained by theories of the term structure of interest rates.

[7] In this context see, for instance, Sproul, A. (1964), "The 'Accord' — A Landmark in the First Fifty Years of the Federal Reserve System," Federal Reserve Bank of New York, Monthly Review, pp. 227–236; Hetzel, R. L., Leach, R. F. (2001), "The Treasury-Fed Accord: A New Narrative Account," Federal Reserve Bank of Richmond, Economic Quarterly, Vol. 87/1, Winter, pp. 33–55; also Harriss, C. L. (1961), Money and Banking, Allyn and Bacon, Inc., Boston, pp. 481–487.

[8] Ludwig von Mises, Human Action, chapter 20 section 6 .