Against the Tide

VIII

Set the Rate of Interest Free*

If an individual constantly violates all the elementary and proven rules of good health, if he disregards all warnings and thinks he can just go on living on his physical reserves, he will indeed for some time be able to laugh at the admonitions of his friends and ridicule them as pedantic fussbudgets. For years he will have astonishing achievements to his credit, and as there appear to be no visible harmful consequences, the classical rules of reasonable living seem to be contradicted. But the day will come, after some prior warning symptoms, when his reserves are used up and suddenly the bill has to be footed for all the sins of the past. His health gives way at the weakest point, and since this usually is the circulatory system, he will feel the concentrated consequences of his former life in a pathologically high blood pressure with all its further effects. Once more the eternal laws of life will triumph over human foolishness.

Things are not very different in the case of society’s social organism, which is no less intricate than that of the human body. Here, too, we may in a happy-go-lucky way sin for a long time, often an astonishingly long time, against the proven rules of reasonable economic conduct and laugh at the warners as “reactionaries” who do not appreciate that we now live in an inspired age when everything is different from what it was before. But if there is anything that we can learn from the present, it is how alarmingly ephemeral are such triumphs over sound common sense. Think of all the promises of the national-socialist economic futurists and of the pitiful collapse that followed. Think how they and their distressingly numerous followers in other countries took an altogether childish pleasure in standing economics on its head and making fun of the “liberalists.” But again it has been shown that he who laughs last, laughs best—provided he feels like laughing in such tragic circumstances.

FINANCIAL “HYPERTONY”

At first, the reckless futurists seem to be right in economic life as well. Even though the promised beneficial effects of their “new economic policy” do not always materialize, the adverse effects expected by the level-headed are often astonishingly long in coming. Here, too, the hidden effects of irrationality keep accumulating at first, until all the reserves are exhausted, and they suddenly come out into the open. What happens then is much the same as what happens to the human body. Here, our liabilities are usually debited to the account of the circulatory system, until eventually the body has to be declared bankrupt; in the economy, the consequences of our constant sins against economic reason usually devolve upon public finance, when all other resistances have crumbled. Just as a steadily rising blood pressure insidiously registers our careless way of life, so does the steadily mounting pressure of public finance register our careless conduct of the economy. The result is a sort of financial hypertony that ends up in increasingly open inflation, possibly after an increasingly totalitarian government has tried to repress inflation by price, wage, capital, and exchange controls and thus to postpone the breakdown1—rather like the pathological thickening of the walls of our arteries in the case of high blood pressure in the human body.

It seems to me the time has come when we must draw the balance sheet of the sins against economic reason and do so without mercy according to the biblical saying: “By their fruits ye shall know them.” It would have to be shown how we are having to pay the price for our contempt of proven principles in hunger on the one side and an alarmingly overheated boom on the other, in growing insecurity and shrinking profit margins, and not least in the race between the state’s mounting tyranny and the piling up of economic and social calamities. It would have to be illustrated in detail where it has led us to smash one form of economic order, the market economy that rests on free price formation and has proved its worth, without being able to replace it with another economic order, that of collectivist compulsion. It would have to be demonstrated at length that the sensitive mechanism of prices and costs has been upset more and more, and that we are continuously creating conditions which paralyze men’s voluntary effort. Taking one country after another, it would have to be proved that the economy’s violation by an ambitious government leads to ever-new absurdities and to ever-new violations of the economy, which such a government then has the presumption to blame on the market economy and to take as an excuse for yet more violations. And we would have to draw the picture of a world in which wages and public expenditure seem to be mobile only upward and the rate of interest only downward, and we would have to point to the immense dangers of such a policy. But the warning is addressed to an age in which an alarmingly large number of people seem to have forgotten that the economy not only does not need the commands and punishments of bureaucracy but is merely hampered and disturbed by them, and that bureaucracy itself eventually becomes the chain by which the Leviathan of the modern state shackles mankind.

INTEREST AS A PRICE

This is the broad setting in which we must test one of the favorite dogmas of the modern economic futurists. I have in mind their opinion, which really has become almost an article of faith, that everything must be done to keep the rate of interest as low as possible and thus to make a permanent fixture of what is known as cheap money policy. Seen in its true light, this modernistic dogma is tantamount to the demand that interest should cease to be an important instrument of monetary, credit, and counter-cyclical policy and thus of the control of the economic process. More than anything else, it was the influence of the late Lord Keynes that helped this revolutionary view of the nature and function of interest to win through and gain growing acceptance as a basis of practical policy. It was he who outdid all others in his advocacy not indeed of completely inactivating the lever of interest, but of blocking it in such a way that it serves only expansion, not containment.

This is, of course, one of the most difficult and most controversial questions in the whole of economics. We therefore have to limit ourselves to saying the essentials in the most concise form possible. We begin with an elementary statement. Interest is the price of a certain scarce good, namely, the use of capital. If it is, like any other price, to fulfill its function of ensuring the most rational allocation of a scarce good, it must accurately reflect the degree of capital scarcity at any given moment. If a government or a central bank, which nowadays is more or less the same thing, is asked to pursue a cheap money policy, this really means asking it to make the good concerned as inexpensive as possible. But this presupposes that this specific price (interest) is entirely at the discretion of government. Just how strange this assumption is will be seen at once if we imagine the same clamor being raised for the government to adopt a “cheap butter policy.” It is instructive to compare the two cases, because they clearly bring to light the peculiar quality of capital and interest. Leaving aside the fact that butter-producers are likely to put up a much stiffer defense against a cheapening of their product than the politically as-good-as-powerless producers of capital, that is, the savers, a policy of “cheap butter” appears ridiculous for the mere reason that it presupposes an appropriately abundant production of butter on the part of the government. If, therefore, interest is the price for the use of capital, and if the government promises a cheap money policy, this presupposes that the government can produce capital. Is it true?

REAL AND MONETARY FACTORS

It is. The government, or, in more general and better terms, the authority ruling the credit system in a modern economy, can in fact produce capital within certain limits and at the price of certain consequences, and that is the peculiarity of capital and interest that has to be grasped. In theoretically somewhat unpretentious terms, this can be expressed by saying that capital not only can be produced by the savers but also by the credit system, in other words, not only by individuals’ curtailing their current consumption and putting the means of payment so released at the disposal of the capital market but also by supplying the capital market with means of payment created additionally (credit creation). Butter scarcity depends upon conditions determined by demand and supply; it is a “real” phenomenon. Scarcity of capital, as registered by the rate of interest, does not depend only upon the conditions determined by demand for capital and by saving, that is, by the willingness of individuals temporarily to forgo the consumption of real goods. Capital scarcity is at the same time influenced by the economy’s largely arbitrary supply of money, which is the prime manifestation of capital. Capital and interest are not a “real” phenomenon, as classical theory maintains, nor are they a “monetary” phenomenon, as modernistic theory maintains. They are both simultaneously a real and a monetary phenomenon. The volume of capital and the level of interest depend both upon the “real” factors that are the concern of classical theory from Adam Smith to Böhm-Bawerk and upon the “monetary” factors of monetary and credit policy. The merit of having been the first to expose with full clarity this difficult double nature of capital and interest belongs to the Swedish economist Knut Wicksell. It is on his shoulders that rests the whole edifice of subsequent research, including the Keynesian school with its exaggerations and confusions.

The essential point for a correct understanding of the problem and for a sensible credit policy is to grasp that double aspect of capital and interest and to avoid exaggerations in either direction. It must not be overlooked that capital can be increased by credit creation and in certain circumstances should be so increased, nor, on the other hand, must it be overlooked that credit creation has its limits in the “real” factors of demand for credit and the volume of saving. Which particular circumstance merits most attention at any given moment depends upon whether the economy is moving more in the direction of deflation or more in that of inflation. In the first case, the right monetary and credit policy is one that does not feel unduly constrained by the real factors, in the second case, by contrast, one that accepts that constraint. From this follows an important consequence. While we shall be well advised to leave the butter market to the regulatory forces of free price formation, the capital market is the one point in our economic system that requires continuous control governed by definite principles. The reason is that capital is not only a “real” but also a “monetary” phenomenon. Nobody knew that better than the English liberals who a hundred years ago created the repeatedly proven foundations of all our thinking in questions of money and credit. The peculiarity of money is the reason for the absence, in its case, of the autonomous regulatory forces on which everywhere else, where “real” goods are concerned, we can on the average rely much more safely than on the wisdom of bureaucracy.

However, in correspondence with the double nature of capital and interest, this need for continuous and deliberate control works both ways. Too little control is to be avoided no less than too much, deflation no less than inflation. The Great Depression of the early 1930’s was an unusual time when, in view of the plethora of unutilized factors of production, we were justified in almost forgetting for a time that there are limits to credit expansion. At that time it made sense to enlarge the volume of credit by every possible means and, among them, to put the greatest emphasis on a cheap money policy. It was what the situation urgently required. But there is no point today in still worrying about how to get out of the Great Depression of 1931-1933. However, that is precisely what those who think and talk in the terms formulated at that time by Keynes have been doing until recently, until they could no longer refuse to admit that the situation has changed radically. Today it is not merely meaningless, it is outright dangerous to pursue such a policy, because, in the belief of still having to fight the ghost of deflation, it leads straight into inflation. The danger is especially great in those countries where gigantic foreign loans combine with a generous wages policy to push up prices and costs in any case (United States, Sweden, and Switzerland).

INTEREST RATE AS A CONTROL INSTRUMENT

It has long been predictable that the situation after the war would be the exact opposite of that catastrophic depression which fifteen years earlier had given birth to the dogma of cheap money policy as a permanent practice presumed beneficial.2 The “real” factors (demand for capital on the one hand and the formation of savings on the other) have long unmistakably pointed to a period of considerable capital scarcity, when the rate of interest has a natural tendency to rise. If, nevertheless, one insists on the doctrinaire policy of cheap money and continues to hold the rate of interest down to abnormal levels, this can be done only with the help of a credit expansion that at present, unlike the time of the Great Depression, does not have a salutary compensatory effect, but a dangerous, inflationary one. There are only two cases in which these effects can be avoided, either when the bureaucracy succeeds in curtailing the demand for capital by deliberate economic policy measures, or else when the formation of capital by saving rises. Fifteen years ago it was right to stress the monetary side of capital and permissible to neglect its real side. Now the opposite is true. Now it must be pointed out that the monetary increase of capital is brought up short by the real factors. The question is no longer whether governments and central banks decide, at their discretion, on a higher or a lower rate of interest and in so doing weigh the advantages of a low rate for debtors, especially for the state as the biggest among them, against the disadvantages for creditors. The question now is whether they can go on doing without the rate of interest as an instrument for controlling the economic process and getting the better of the dangerous inflationary tendencies.

If there is one lesson to be drawn from today’s situation, it is that to refrain from using the rate of interest as an instrument leads to consequences that force governments to employ increasingly bizarre means in their battle against inflationary tendencies. They are means that encroach more and more up-on what little freedom is left in the economy, and that threaten to become more and more reckless and indiscriminate without thereby gaining in efficacy. One of the characteristics of these means is that they keep on putting some new calamity in the place of an old one, and then take the latest calamity as an excuse for another odd form of intervention. As one watches this pulling this way and that way in all its abruptly changing phases, the expression “vaudeville of economic policy” comes to mind, and it does not seem to be too harsh.3 The worst is that in the course of all this the economic order disintegrates and gives way to increasing anarchy. Everything is tried, except one thing: to pull the lever of interest sharply upward, as would previously have been done as a matter of course and as Wicksell only thirty years ago insisted in a famous article under the title “Up with Bank Rates.”

The trouble is that, in view of the enormous public debt and of the flood of government stock in the credit system, it has become very hard to reverse course—a public debt, incidentally, which, as in the case of the United States, is largely a legacy of the time when it was thought that deficit spending could merrily go on forever. The first condition for reversing course is to understand that the Great Depression’s formulas and dogmas—which Keynes seems to have had in mind when he contemptuously spoke of “modernistic stuff” in his posthumous article4—are now not merely inapplicable, but dangerous. The reader will be left, on this occasion, to draw his own conclusions in regard to monetary, credit, financial, and wages policy.

Most of the Utopias and works of political fiction known to us describe a strictly collectivist economy. Today, when so much of this has come true, they bore us, and we marvel at their naiveness. But who will write us a new “Retrospect from the Year 2000,” in which one of our great-grandsons tells of a wonderful world in which all prices are free, and the government regulates only the discount rate, according to Wicksell’s rules?

* Zeitschrift für das gesamte Kreditwesen, 1948, No. 1.

1 Cf. my article “Offene und zurückgestaute Inflation” in Kyklos, Vol. I, No. 1 (1947), as well as my later article, in English, “Repressed Inflation,” ibid. Vol. I, No. 3 (1947).

2 So that this should not seem as vaticinium post eventum, I refer the reader to the beginning of my book Internationale Ordnung, which was published early in 1945 (Eugen Rentsch, Erlenbach-Zurich).

3 The most blatant case is that of Sweden, where cheap money policy was largely responsible for plunging a prosperous economy, and one rich in capital, into a series of catastrophes and for solving in a jiffy the difficult problem of how to convert a “hard” currency into a “soft” one and how to create a balance-of-payments crisis.

4 Economic Journal, June, 1946.