7. Interest Rates and Inflation*

Wherever Government economic policy, the business policy of an individual firm, or the future trends of stock or commodity markets are discussed, the topic of inflation plays a major role. Generally speaking inflation is considered dangerously imminent.

A FORGOTTEN DEVICE

If inflation had been feared ten years ago, the raising of interest rates would have been suggested as the simplest and most natural means of defense. Raising of discount rates—the interest rates applied by central banks—recommended itself as the classical and traditional policy of central banking developed for more than a century. It appeared also as the logical consequence of the monetary business-cycle theories prevailing at that time. The theorists, and especially the followers of the eminent Swedish economist, Knut Wicksell, were of the opinion that in order to stabilize the price level, one had only to regulate the quantity of money; and that this, in turn, could and should be achieved by making the supply of credits from the money-issuing authorities more expensive.

Today, the recommendation or the mere mention of a restrictive discount and interest policy as a means of checking inflation appears almost ludicrous to the overwhelming majority of economists and businessmen in this country. This shows the extent to which ideas on this subject have changed and traditional views been replaced by what, in the opinion of this author, must be called a general confusion of minds.

UNCERTAINTY OF DIAGNOSIS

This confusion begins even at an earlier stage when the existence of inflation is questioned. Besides much inflation talk, there is much deflation talk around; and the danger of the divergence of opinion is that it seems to be especially pronounced in the government. The O.P.A. is decidedly inflation-minded, whereas the Secretary of Commerce has frequently expressed his fear of deflation. Incidentally, this uncertainty of the government in the inflation and deflation controversy supplies an early and conclusive confirmation of those skeptics who have doubted governmental ability to stabilize the business cycle. It is clear that governmental business-cycle stabilization is possible only under the assumption that private enterprise can err in regard to the future development and therefore be prone to indulge in overoptimism or overpessimism, whereas the government that must counteract the excessive expectation of private enterprise has a clear and certain vision of the future. Now, on the first occasion when cycle stabilization is put to a practical test, it turns out that government officials are subject to errors and uncertainties like other human beings, so that their ability to stabilize the cycle cannot be relied upon.

Those in government as well as in business who fear inflation base their diagnosis, as is well known, on the presence of a huge pent-up demand and purchasing power. This author considers this diagnosis basically correct. Pent-up purchasing power is nothing else than deferred inflation, as the history of almost all postwar periods proves.

Those who are deflation-minded base their opinion on the fear that lowering of the “bring-home pay” would create a deficit in effective demand. This argument is of course in many cases political rather than scientific. It is presented to show the necessity for raising hourly wages. Where it is seriously meant as an economic argument, it does not take into account that the demand pent up through many years of war, the credit expansion of the rehabilitation and reconstruction period ahead, and the usual waste of postwar years will add so much purchasing power to the wages of the production period itself that a deficit in the latter, even if it really occurred, would be compensated and overcompensated.

THE “CART BEFORE THE HORSE” THERAPY

As far as the actual policy is intended to be an anti-inflationary policy, it concentrates exclusively on the fight against the symptoms rather than the causes of inflation. It does not endeavor to reduce the quantity of money spendable at the markets, but to prevent the natural effects of the enlarged money quantity—the raising of the price level. It is generally not realized what fundamental changes from previous policies this implies. The laws of the market which alone formerly prevented price-raising, are replaced by criminal laws which penalize the raising of prices according to the market laws. The smooth and inexpensive price-fixing by means of the market is replaced by a very expensive and complicated price-fixing and law-enforcing organization. This, incidentally, creates the very unwelcome phenomenon of hundreds of thousands of businessmen becoming transgressors of the law who otherwise would have never come in contact with the courts; this, because of the paradoxical situation in which they are placed by a system of prices fixed contrary to the laws of the market.

The reasons why neither the O.P.A. nor any other governmental agency has even considered fighting inflation by monetary measures are manifold:

First of all, it seems to be entirely forgotten that it is not only possible but natural for a currency to be held scarce in order to uphold its purchasing power over goods. Forgotten seems to be the method whereby under the gold standard the value of the currency was preserved, the so-called discount policy of the central banks. Nobody thinks any longer of reducing the quantity of money when the coverage of bills by gold deteriorates. One either reduces the coverage requirements or devaluates. The concept of a totally elastic currency seems to have replaced the concept of the currency in which the quantity is restricted in one way or the other. It is natural that, in a world in which the supply of money is thus considered as unlimited, the feeling for the necessity of curtailment of the quantity of money is weakened.

Furthermore, fear that the low interest rates of the Federal Reserve Banks could lead to inflation has been abated by the experiences of the ’thirties, when the supply of extremely cheap money led not to an inflationary but rather to a deflationary situation. One forgets, however, that this was the result of the abnormally low investment demand created by various, especially political, factors of that time. Today, expectation of unlimited markets due to pent-up demand must create a very strong need for money through withdrawals of bank deposits and requests for new credits from the side of business—not to mention the demand from the side of the still entirely unbalanced government budget. In such a situation on the demand side, low interest rates create inflation, whereas raising of interest rates could prevent inflation.

Finally, there seems to be a certain inclination to deny the effectiveness of higher interest rates on the grounds of an alleged inelasticity of the demand for credits. One argues that the interest rate is nowadays of such minor importance in the cost calculation of industry that even a very high rate would not deter demand, other conditions being favorable. To this it must be replied that this argument—besides being inapplicable in industries requiring vast amounts of capital, as in the building industry—forgets entirely the indirect effects of low interest rates. Low interest rates, enduring over a period of time, raise the price of common stocks whose earnings seem reasonably assured because the public capitalizes these earnings at a much higher price-earning ratio. This means that venture capital can be raised through the issuance of new stocks at cheap rates and in practically unlimited amounts, at least by the big corporations of the country. Thus, during the boom of the ’twenties in the period before the crash, an extremely high price-earning ratio—at that time created through crazy earning expectations—allowed industry to obtain any amount of money which, spent in one way or another, strengthened the forces of inflation.

HIGH INTEREST RATES NOT NECESSARILY COINCIDENT WITH UNEMPLOYMENT

The aversion to raising interest rates has its roots also, of course, in the widely held theory that easy money means high employment and tight money means low employment. If this theory were correct, high employment could in times of a strong demand for credits be achieved only at the price of inflation. However, the theory is basically wrong. True, if the supply of credit is kept scarce, enterprises requiring large amounts of capital are doomed. But enterprises requiring lesser amounts of capital but more labor can carry on provided only that too high wages do not render these enterprises unprofitable. Full employment can be achieved at any interest rate level, as shown by experience in colonial countries. If low interest rates threaten to lead to inflation, the relief of business enterprises has to be sought through other means, especially through a reasonable tax and wage policy.

FISCAL POLICY VERSUS ECONOMIC POLICY

The appeal that low interest rates offer is derived, too, from the fact that they enable the Treasury to finance and refinance the government debt on cheap terms. That the government is, so to speak, creditor and debtor in one person, because it fixes the rediscount rates of the Federal Reserve System, leads indeed to large savings for the government and thus for the tax-payer. However, the artificially low interest rates on government securities create an artificial abundance on the entire credit market. All other creditors—private as well as institutional—have to revise their interest claims downwards in order not to be excluded from a market where they are in competition with the cheap money coming directly or indirectly from the Federal Reserve Banks.

Without wanting to argue whether fiscal considerations should be taken at all into account when economic policy is discussed, it may incidentally be pointed out that the structure of the war debt would have to be changed before one could return to an orthodox interest policy. Substantial parts of the debt, especially those financed by the Savings Bonds A to G, practically represent what one used to call a floating debt. Therefore, in case of a marked rise in interest rates, necessitated for instance by an inflationary boom, billions in bonds would be presented for redemption in cash which would increase the forces of inflation. Obviously, this floating debt would have to be consolidated in the traditional way into a truly long-term debt through offering higher interest rates for truly long-term bonds. This might not even mean an additional burden on the Treasury, for there would always remain a strong spread between long-term and short-term interest rates. So the Treasury could easily pay no interest at all, or relatively low interest, to those who wanted to retain, for reasons of liquidity, bonds payable at sight—and who now, paradoxically, receive interest equal to those on long-term bonds; whereas, on equally liquid bank accounts, no interest is received.

Needless to say, the return to orthodox financing methods would also result in serious difficulties for banks and other government bond-holding institutions. The long-term bonds they hold would of course depreciate with higher interest rates, creating catastrophic losses which would have to be taken over by the government in order to prevent socially and politically unbearable bankruptcies. The return to a sound way of financing is always as costly and difficult as the departure from this way seems easy and advantageous.

Summing up, we may say: the fight against inflation concentrates indeed on the suppression of the results rather than the causes of money abundance. The O.P.A. and the law enforcement agencies have taken over responsibilities that formerly were the Federal Reserve Board’s. Increase of the quantity of money is tolerated, but its natural effect on prices in accordance with the “Quantity Theory of Money” is prevented. One is reminded that during the high days of the Nazis, the German president of the Reichsbank boasted that the National Socialists had won a victory even over the Quantity Theory. But it turned out to be a Pyrrhic victory.

PRICE STABILITY WITH WAGE INSTABILITY

The policy of fighting inflation with price ceilings is, however, not consistently carried through. The policy of ceiling prices must logically be combined with the policy of ceiling wages. Such a combination of policies was pursued and to a certain degree achieved during the war. It has now been replaced with a policy of fixing prices but not wages: wages are to be determined by collective bargaining according to the ability of the individual industry to absorb higher wages through increasing productivity. It has already been mentioned that a wage-boosting policy is unnecessary so far as it is meant as an antideflation device. For whatever reasons it is advocated, it is obvious that it intermingles in a peculiar way with the otherwise anti-inflationary policy of the government. It is true that it will not create inflation, at least not directly. However, if wages are no longer—as in a free labor market—fixed according to the productivity of the marginal but of the intermarginal enterprise, this must obviously lead to a stoppage of the former. For, if in the large enterprises, which derive high profits from gigantic turnover, labor is entitled to share these profits, then workers will just leave the smaller enterprises and join the larger and largest ones. This must lead, at first, to unemployment and thus even to deflation and later to a concentration process that is surely highly undesirable for many reasons. If, and as soon as, prices are raised under pressure of small businesses so that they too can pay the high wages of their large competitors, then unemployment and the concentration process is, of course, halted, but an inflationary spiral is started.

THE PILING UP OF PURCHASING POWER

In spite of everything that has been said above and could be said further, one has to reckon with a continuation of the prevailing policy. Government as well as public opinion is too strongly committed to it. Nevertheless, our analysis is not just of theoretical but of highly practical importance, for it leads to the perception of what can be reasonably expected as results of this policy; if one cannot change a policy, one should at least be prepared for its consequences.

The immediate consequence of the policy must be a huge and unprecedented piling up of spendable purchasing power in the economy through money and credit creation. For there will be a practically unlimited and undefended supply of money and credit facing a huge demand. Governmental expenditures financed by deficits will go on, though on a smaller scale than during the war. Furthermore, private enterprise and the government will proceed with huge investments in this country as well as abroad. They will believe they are entitled to make these investments because the huge amounts of idle funds held in the form of cash or short-term government securities will create the illusion of a tremendous abundance of wealth. In reality, all these funds are already invested directly or indirectly in loans to the government and to business firms. The fact that they can actually be invested anew arises exclusively from the possibility that every owner of these funds can dispose of them without incurring losses. This again is caused by the preparedness of the Federal Reserve System to rediscount government securities at negligible rates. The rate of interest that forms when demand and supply for credit are forced to balance without the additional money obtainable through the Federal Reserve System was formerly called in theory the “natural interest rate.” There is no doubt that the “natural interest rate” is very high at this juncture. If one allowed it to become effective, the illusion of the abundance of the capital markets would disappear. Nobody considers funds “idle” when he receives high interest on them.

Low interest rates are—at least partly—responsible for the boom on the stock market and could be responsible for additional strong price advances—especially if the interest-lowering is carried still further in accordance with the British precedent. These advances would not represent an inflationary boom in the ordinary sense where people anticipate higher earnings through inflated asset values. It would be a recapitalization boom, caused by the fact that earnings are capitalized by ever lower interest rates. It creates a situation in which venture capital, too, can be obtained abundantly and at low interest rates. This again means, of course, that dormant purchasing power is transferred into actual inflationary purchasing power.

FRUSTRATED INFLATION

In the ordinary course of events this would mean strong and general advances of all prices of goods and services. However, as mentioned above, such general price advances have been and will be forbidden. This is why many people believe that all the accumulation of purchasing power can do no harm, as long as the O.P.A. remains in power. To this one has to reply: first, there is no doubt that for a certain time what can be called a “frustrated inflation” will work. And it must be admitted that, as long as it works, the ensuing prosperity is of an ideal character, inasmuch as it represents prosperity without price increases—a “turnover prosperity,” as one could call it. Not only does this prosperity lack the essential prerequisite for the development of the depression, the price inflation, but it would be of a comparatively long duration. The pent-up purchasing power, not being able to spend itself in price increases, guarantees effective demand for goods over a much longer period of time than does a purchasing power that is allowed to push prices upward.

However, this sort of “frustrated inflation” cannot go on forever—especially in peacetime when the psychological and patriotic inhibitions against breaking the price ceiling no longer work so strongly as during the war. Price ceilings can never be applied universally. There are always realms—for example, the market for used furniture or for certain services—which will not and practically cannot be controlled. On these markets the prices will show a slow but decisive increase. The resulting distortion of price and wages—the margin developing between those that are controlled and those that are uncontrolled—will eventually result in just that general raising of the price and wage level which one wished to avoid, and which will render the economy vulnerable and exposed to reverses.

But even where price rises are avoided, the economy will prove increasingly vulnerable. Wages are under the permanent upward pressure. The ensuing wage increases—where they do not lead to unemployment—are bearable only because the huge turnover due to the enormous pent-up demand cheapens and alleviates production and distribution. It is a very high-strung system, in which the price-cost relationship remains tolerable only so long as everything works full blast and at high speed. As soon as the slightest slackening in demand sets in, many enterprises will have to shut down because of the losses they suffer. Exactly as at the onset of every depression, the boom will collapse through the losses that the marginal enterprises begin to undergo; except that this time not the decline of prices, but the decline of turnover will be the initiating cause.

CYCLE AS USUAL

Our conclusion is: the prevailing monetary policy—and incidentally the prevailing fiscal policy, too—will prove to have been not contracyclical, but procyclical and contrastabilizing. There will develop a situation that will embrace, if not all, at any rate many of the features that are usually called unhealthy; whereas the healthy aspects of the boom—increasing employment—may not necessarily be present. For it could be that labor, during this boom, would tend to be progressively replaced by labor-saving capital investment if the policy is continued of making the use of labor more expensive and of making the use of capital cheaper.

Furthermore, there is bound to develop an additional upward movement on the stock markets, for it is the peculiarity of the aforementioned “victory over the quantity theory” (on the markets for goods and services) that more and more unspendable funds accumulate, of which at least parts are never converted into government securities, but seek to be exchanged into stocks of private corporations.

But after this boom there will follow a collapse of serious proportions as soon as a slackening of demand sets in or is feared. For with this slackening of demand the cost-price relation and therewith the profit situation will deteriorate rapidly. Nor will the continuation of easy money give any protection against depression when the forces of this boom have exhausted themselves.

If one wants to prevent a deflationary depression, one must prevent an inflationary boom. If one wants to prevent an inflationary boom, one must prevent inflation in every form. If one wants to prevent inflation in times of strong need for credits—by the government or by private industry—one must make money scarce. And if one believes that this method is antiquated and can be replaced by other devices—an opinion which is not at all so original as its originators believe, but which has been held over and over again during the course of history—one will face disappointment. Interest rates are not, as seems to be assumed nowadays, a vicious invention of creditors. They have the function of rationing a scarce supply of credit among those who need it. As long as one wants to avoid the step incompatible with a free economy—of having credits rationed through the government—a revision of interest rates upward remains the only method of keeping inflation in check.

At the end of World War I, the above-mentioned economist, Knut Wicksell, wrote an article called “Put the Discount Rates Up,” in which he warned that maintaining interest rate far below the natural interest rate would inevitably lead to worldwide inflation. The article was much praised, but nowhere heeded. Inflation ensued, even in those countries where the budgetary situation would have not necessitated it. In view of the prevailing state of mind, it is very probable, and to be feared, that history will repeat itself.

^* Written before the abolishment of the O.P.A. in July 1946: the article appeared first in The Commercial and Financial Chronicle, December 22, 1946.