Fixing Interest Rates

December 20, 1965

The action of the Federal Reserve Board in raising the discount rate from 4 to 4½ percent was necessary to head off a further inflation. So far from being premature, as suggested by President Johnson, the step was overdue. Interest rates have already been held down by government policy too much and too long.

In a free economy every price has a vital function to perform. That function is to register the state of supply and demand, to guide the economic actions and decisions of all of us, to maintain a constantly balanced and synchronized output of thousands of different commodities and services. Government price-fixing can only misguide and dislocate production.

If there is one price in the economy that is more important than any other it is the interest rate. This is popularly thought of merely as the cost of borrowing “money.” Some economists have called it, more broadly, the price paid for the services of capital. It would be much better to call it the price of time. It is the discount on future goods as against present goods. It affects the price of all securities and all price relationships. The interest rate determines the relative production of capital goods as compared with consumption goods. It affects how much people spend of their income, how much they save and invest and where they invest it.

A COMPETITIVE PRICE

The market rate of interest—or, more realistically, the constellation of market rates of interest—is extremely competitive and fluid. There are more than 14,000 banks in the country, all in daily competition with each other for customers. It is preposterous to assume that they could all conspire to fix any interest rate or set of interest rates. Anybody with cash is free to decide at any moment to become a lender. Interest rates fluctuate daily and hourly in the markets of the world.

And yet the President’s economic advisers presume to know better than the market exactly how high interest rates ought to be. Mr. Johnson recently indicated that he would be gravely displeased if banks raised their “prime rate” to their best customers above 4½ percent. Secretary Fowler solemnly declared that any increase in interest rates would be “premature and unwise.”

How do government officials get that way? They get that way because they and their advisers have come to believe devoutly in the theories of the late Lord Keynes. According to Keynesian theory it is properly a function of government, and not of the market, to fix interest rates. And it is likewise always the government’s duty to fix interest rates very low. The theory is that low interest rates encourage borrowing, investment and full employment.

CAN’T GO ON FOREVER

One thing the theory overlooks is that arbitrarily low interest rates discourage saving. This does not bother the Keynesians because they forget that what is being borrowed and lent is ultimately real capital. They assume that the only thing involved is “money”—and more paper money can be printed at will. Therefore, if you want to push down interest rates all you have to do is increase the supply of money and credit. So Federal Reserve policy had been increasing the money supply in recent months at an annual rate of 8 percent.

It is true that, under certain conditions (such as we have had for the last five years), cheap money and currency expansion can bring about a temporary boom. But the process in the end defeats itself. The increased money supply raises prices and costs. Expectations of further increases in the money supply then cause an increase in interest rates to compensate lenders for an expected fall in the purchasing power of money. (As the cost of living has increased 1.8 percent in the last twelve months, a government bond with a money yield of 4.2 percent has had a real yield of only 2.4 percent.)

Our artificially low interest rates, our budget deficits, our rapid expansion of the money supply have been the basic causes of the rise in prices and costs, the deficits in our balance of payments and waning faith in the dollar. The increase in the discount rate was a step in the right direction. Let us hope that the inflationists in Congress or the Administration do not nullify it.