Lower Interest Rates by Law; P.L. Greaves, Jr.

The answer is easy. If lower interest rates were free market interest rates, business would boom and bid up wage rates. However, if lower interest rates were the result of a government Professor Greaves is a free lance economist and lecturer. His recent books include Understand ing the Dollar Crisis and Mises Made Easier (Glossary for Human Action). 740 PERCY L. GREAVES, JR. InterestRates Bylaw fiat, the effects would be disas trous. As the late Professor Lud wig von Mises frequently stated, every political interference with free market processes makes mat ters worse, not better, even from the viewpoint of those who pro pose such political interferences. The reason for this is often difficult to understand. Unfortu nately, those who attempt to push down interest rates by legal edict do not foresee the inevitable un desirable consequences. In recent years many people have learned the hard way about the conse quences of political price and wage controls. Learning from ex perience the consequences .of po litical interest rate controls could be even more painful.

When the government attempts to maintain prices above those of the free and unhampered market, 1974 LOWER INTEREST RATES BY LAW 741 as it has with some farm products, this inevitably leads to surpluses. Too much land, labor· and scarce materials are devoted to produc ing such subsidized goods. This has two results. First, there are surpluses which must be stored, destroyed or given away. Second, the land, labor and scarce rnate rials are not available to produce those goods and services which consumers desire in larger quan tities. We know this because there are people willing to pay more than the free market production costs of such goods and yet can not find them on the market. When the government attempts to maintain prices below those that would prevail in a free and unhampered market, as it recently did with price controls, this in evitably leads to shortages such as we experienced in a matter of months. In addition to· the short ages, we soon had more .unem ployed workers, factories and transportation facilities, not to mention the increased welfare ex penses this made necessary.l Busi nessmen, being human, will not continue to produce what they cannot sell at prices that cover their costs. Their available capital will not long permit it.

1 People who sanction laws which de·· prive some workers from earning a liv ing for themselves and their families are honor bound to provide the necessities of life for such second class citizens. When the government attempts to raise wage rates above those that would prevail in a free and unhampered market, as it has for some forty years, it inevitably produces unemployment or under employment with an accompany ing demand for welfare payments. Such welfare payments are a bur den on all who buy goods and services in the market place. The unemployment and underemploy ment mean higher prices because fewer goods and services are pro duced to compete for the con sumers' limited number of dollars. When the government grants privileges to labor unions to raise wage rates above those of a free and competitive market, it raises the costs of producing union-m~de goods and services. The resulting higher prices inevitably reduce sales. This in turn reduces em ployment in such industries, or in other industries whose sales fall off because consumers, paying higher prices for union-made goods and services, have less for other things. This means that those who could have worked in the curtailed industries must look elsewhere for jobs and accept lower wages or remain unem ployed and eventually increase the need for welfare payments.

Those who take jobs at lower wage rates than they could have had in a free market will be un742 THE FREEMAN December deremployed. That is, they will be producing goods or services less desired by consumers than those that have been priced out of the market by the legal privi leges which permit labor unions to extort higher than free market wages from society. Such illfated attempts to raise wage rates above those earned in a free market inevitably force more and more unfortunate work ers to take lower-paying jobs. Eventually, with the growth of labor union power, the competi tion' for" such lower-paying jobs drives some wages so low that many workers find it difficult to maintain their previous standard of living. Those who believe that political power can raise aU wage rates then advocate minimum wage laws. Such laws compel em ployers to pay all their employees at least the minimum wage.' Em ployers, being human and having limi ted resources, soon refuse to employ those for whom the min imum wage rate raises production costs above what customers will pay. Such unfortunate persons, including many youngsters, mem bers of minority races and others with limited skills, then become legally unemployable. Their bleak choice is between a life of crime or subsistence on welfare payments until the value of the dollar is reduced by inflation to the point where they become employable at the legal minim urn wage rate.

There was no long term mass unemployment in this country when everyone was free to take the highest wage rate that any employer could and would offer for his or her services. Market competition forced employers to pay their workers the full market value of their contribution. If they failed to do so, other employers would ,bid away such underpaid workers. Political interferences in the labor market, with the inten.., tions of raising aU wage rates, have created our present mass unemployment, underemployment and the growing need for welfare payments. Only a return to a free and unhampered labor market will bring to an end such unemploy ment and underemployment. In a free market there are jobs for all2 and no need to subsidize in idle.,. ness those who are able to work. The Marlcet Produces Interest Rates Interest rates, like prices and wage rates, are market phenom ena. Political interferences with interest rates, like price and wage controls, create economic chaos.

Such chaos leads to a general loss of freedom and inevitably reduces the living standards of every mem2 See author's "Jobs for All," The Freeman, February 1959. Copy on request.

1974 LOWER INTEREST RATES BY LAW 743 her of society. It is thus vital that we all understand why the. gov ernment should not interfere with free market interest rates. Market interest rates are a sum of three contributing market fac tors. (1) The first is true or pure interest; what Mises called "origi nary interest." This is payment for time preference. A person cur rently short of cash may wish to spend $1,000 for something now, and pay for it later when he ex pects to have more cash. If he wants that object so badly now that he is willing to promise to pay $1,100 a year from now, he may be able to obtain an imme diate loan of $1,000. That would mean he values spending the $1,000 now so much more than waiting a year to do so that he is willing to pay 10 per cent, or $100, more to have the object now. In order to borrow this $1,000, the borrower must find someone who has saved $1,000 and is will ing to lend it to him for one year for an interest rate of 10 per cent or less. Few people will lend their savings, except for charitable pur poses, without receiving some ben efit in return. The prospective lender may want to buy a car or take a trip at the end of a year.

He will make the loan only on condition that he be repaid an extra sum for making the sacri fice of not spending his money now. That extra paym~nt, called interest, must be high enough for the prospective lender to value the future repayment, with interest, higher than he values spending the $1,000 now. So the loan de pends on each party's placing a higher value on what he receives than on what he furnishes the other party. The difference be tween the sum loaned and the sum to be repaid is true or pure inter est - a payment that will compen sate a saver for postponing his own spending for the· time of the loan. (2) The second factor in mar ket interest rates is the certainty or uncertainty that the loan will be repaid as specified.· If there is valuable collateral or if the lender thinks the chances of repayment are good, this factor will be min imal. However, if the borrower has few resources and there is reason to believe that the loan might not be repaid if he died or lost his job, this would be a factor the lender would consider in arriv ing at the total interest rate he would request before making a loan to that specific person. This factor would differ from person to person and from loan to loan, but it is present to some extent in the interest rate on every loan.

744 THE FREEMAN December (3) The third and currently most important factor in market interest rates is what is expected to happen to the purchasing power of the dollar during the term of the loan. If the lender expects prices to rise 10 per cent in the next year and he only gets 10 per cent more dollars back from the borrower at the end of the year, he does not receive one cent of pure interest. Pure interest is only the amount the lender gets back over and above the purchas ing power he has lent. So in times of inflation, when the value of the dollar is going down, this third factor must rise. As it rises, so does the market interest rate, which is the total of the three fac tors just discussed - (1) pure in terest based on time preference, (2) uncertainty of repayment and (3) change in the dollar's pur chasing power. Current market interest rates are considered high because this third factor, reflecting an antici pated drop in the dollar's purchas·· ing power, is high. The way to reduce this factor is to reduce the expectation" that the purchasing power of the dollar will drop in the next year. So the only satis factory way to reduce current high interest rates is to eliminate the expectation that future prices will be ever higher. This means we must stop the inflation.

More Savings are Needed Lower interest rates that repre sent free market interest rates are always helpful to society in general. Lower interest rates in a free market society mean there are comparatively more savers with funds they want to lend than there are borrowers who will·pay high interest rates. These savers seek to lend their funds so as to earn as much money as possible. Rather than spend their savings now, they seek more funds at a later date when their current in come may be lower, as when they retire, or when their expenses may be higher, as when they may want to buy a car or a house or send a child to college. It is the higher amounts of such savings, bidding in the market place for borrowers, that produce lower in terest rates in a free society . To bring about such lower interest rates, government should protect and encourage voluntary loans made with the expectation they will be repaid in dollars with the same or an increasing purchasing power.

But the question in many minds today is, why not have the Fed eral Reserve System lower market interest rates by fiat? The answer is simply this: If the FederalRe serve lowers interest rates when there are no increased savings available for lending, there will 1974 LOWER INTEREST RATES BY LAW 745 be a bigger demand for loans at the lower interest rate than can be made with available savings. Under present laws and condi tions, the banks meet this in creased demand for loans at the lower interest rates by creating more loan money out of thin air (or should we say paper?). The borrowers get their loans in the form of an addition to their bank accounts on which they can draw checks. Noone else has chosen to reduce his spending so as to make his savings available to the bor rower, as is always the case with free market credit transactions. Why Interest Rate Controls Hurt When the Federal Reserve Sys tem reduces interest rates by fiat, it must create more spendable money than was previously earned or saved. It puts into the market dollars which do not represent any contribution to society. You have more dollars in the hands of borrowers and no reduction in the numbers of dollars which sav ers may spend currently. This has several undesirable effects, some obvious and others largely unseen.

The most obvious effect is that with more .money bidding for the same quantity of goods and ser vices in the market .place, prices must be higher than they would otherwise be. Largely unseen are the ways in which this increased quantity of money enters the mar ket place and how it affects the structure of production and the welfare of different· individuals. Those who borrow the savings of people who must reduce their current expenditures and those who borrow artificially created bank money cannot be distingu ished in the market place. In fact, most borrowers from banks do not know whether they are bor rowing the funds of the bank's stockholders and depositors or newly created funds. The borrow ers of the newly created funds are in a position to bid away available goods from the earners and savers who would have bought them if the quantity of dollars had not been increased. What such borr9wers buy drives prices up and leaves less for all who earned or saved the money they take to market. In the short run, these artificially lower interest rates help borrowers and those who sell to them - the construc tion industry if the borrowers buy houses-at the expense of all workers, savers and those who would have profited from supply ing what the workers and savers can no longer buy.

Outstanding Contracts Affected Although some may be helped by such artificial lowering of in terest rates, all who have earned 746 THE FREEMAN December or saved money are hurt. Such creation of more dollars not only hurts all workers and savers, by reducing the value of their dol lars, but it also affects the value of every outstanding contract. It means every preexisting dollar is worth less and every contract promising to pay dollars iIi· the future has been altered in favor of the payer and to the disadvan tage of the recipient. This means a reduction in the real value of all bank accounts, insurance poli cies, wage rates, salaries and pen sions as well as all rental con tracts, time payments and other purchase agreements. When sav ers foresee such effects, they re fuse to make any more loans un less the interest rates will more than compensate them for the ex pected drop in the value of the dollars they lend.

The most important, generally unrealized, effect of such artificial increases in the quantity of spend able dollars is that they redirect the whole economy. They do so in a manner that cannot be contin ued without an ever increasing quantity of newly created dollars to compensate for the resulting higher prices. As the· political in crease in the quantity of dollars accelerates, more and more of the nation's production facilities are devoted to supplying the spenders of the newly created dollars. This means a smaller and smaller part of the production facilities are devoted to supplying the nation's workers and savers. Eventually, if the process is not stopped in time, the system breaks down and the dollars become worthless. Stopping Inflation Has a Price Of course, the process can be stopped at any time, but not with out consequences. Once the gov ernment stops increasing the quantity of dollars artificially or even slows down the rate of arti ficial increase in the quantity of dollars, producers supplying goods and services to the spenders of newly created unearned dollars lose a large number of their cus tomers. They must then layoff men and there is a recession or depression - until production is adjusted to supplying only those with earned or saved dollars to spend.

Under present policies the gov ernment is continually faced with deciding whether to inflate arti ficially the quantity of spendable dollars or permit market forces to readjust the economy. If free and unhampered market forces are permitted to emerge, free market prices, wage rates and interest rates will quickly redirect the economy toward a more efficient satisfaction of all those who con tribute toward production. Those 1974 LOWER INTEREST RATES BY LAW 747 who had spent newly-created dol lars will have to curb their spend ing or earn the dollars they spend. The available supplies of workers and capital goods will be quickly redirected toward producing sole ly for those spending dollars they have earned or saved in the ser vice of their fellowmen. In short, when Federal Reserve officials .lower interest rates arti ficially, they send a part of the economy off on a spree at the expense of the nation's workers and savers. The spree can only be continued by an ever increas ing inflation of the quantity of spendable dollars. If we want to end that inflation and all its un desirable consequences, we must permit the free market to deter mine interest rates as borrowers compete for the real savings made available by those willing to re duce their potential spending tem porarily for a price, commonly called interest. Only freely deter mined interest rates, without any artificial manipulation or control of the quantity of dollars, will eliminate the inflation problem from our economy.

The best way to reduce market interest rates is to remove the expectancy of further inflation. Once this is done, more people will be encouraged to save more dollars and their competition for borrowers will bring lower market interest rates. Then there can be a profitable expansion of those industries that will direct avail able supplies of labor and capital into producing more of the things that workers and savers want most. The only way Federal Reserve officials can help workers, in vestors and consumers is to stop increasing the quantity of dollars - stop inflating - and permit free market forces to set interest rates that reflect the actual supply of, and demand for, such savings as are available for lending. Any in terference with free market inter est rates must upset the economy and produce results that all hon est and intelligent people consider undesirable. ~ IDEAS ON $ LIBERTY Monetary Madness As MONEY is the sinews of every business, the introducing of a doubtful medium - and forcing it into currency by penal laws must weaken and lessen every branch of business in proportion to the diminution of inducement found in the money.

PELATIAH WEBSTER, Strictures on Tender Acts, 1780 Talesof ThreeCities JOAN WILKE A RECENT ENVIRONMENTALIST LAW in Montana prohibits changes, and developments that have an adverse social impact on a community. The law is being invoked by some to prevent expansion of Montana Power Company's gen erating facility at Colstrip. It is argued that the school facilities would be overburdened by new residents. Actually, the company is pro viding temporary classrooms until new school facilities can be built. And that's not all. Having had the community master-planned, the company is also building houses, apartments, motels, mobile home facilities and a. commercial com plexwith air-conditioned mall, shops, stores, professional offices, medical facilities ... even a post office. In addition, it is providing a 748 community center with bowling alleys, tennis courts, park and pic nic areas and other recreation, as well as providing fire protection and' putting in sidewalks, sewers, water lines and other street im provements.