Dr. Sennholz heads the Department of Economics at Grove City College, Pennsylvania.
"Interest rates are too high," complained J. Dewey Daane, a member of the Federal Reserve Board. But he added, high interest rates are "inevitable" if monetary policy is going to have to carry all the burden of fighting inflation.
In agreement with remarks made by Senator Douglas, Mr. Daane pointed out that "interest rates are high historically." Some are at the highest levels in 40 years. But Senator Douglas, vice chairman of the Congressional Joint Economic Committee, which has recommended guidelines for monetary policy and reform, warned that rising interest rates may precipitate a depression. To counter a foreign run on U.S. gold in 1931, the Senator said, the Federal Reserve twice raised interest rates "and deepened the depression. I certainly hope you don’t again raise interest rates to keep European hot money in the U.S." President Truman was reported having expressed similar fears.
These are some of the arguments that are filling the air in the political war over interest rates. What are the economic principles, if any, that affect and determine the rates? And what is the proper role of government in this important aspect of economic activity?
It is true, today’s interest rates are higher than those of the recent past. Bankers acceptance rates are now quoted between 5% and 6 per cent, Federal funds rates between 51/2 and 6 per cent, call money lent to brokers on Stock Exchange collateral at 6 to 61/2 per cent, commercial paper 57/8 to 63/8 per cent, certificates of deposit 51/4 to 51/2 per cent. The Treasury’s sale of one-year bills recently brought investors an average yield of 5.844 per cent, the highest ever recorded on any Treasury bills. Corporate debentures now yield 51/2 to 61/2 per cent, first mortgages 6 to 7 per cent.
All these rates are gross market composite rates consisting of three different parts. An economist who analyzes interest rates invariably finds the following components:
(1) originary or pure rate,
(2) debtor’s risk premium,
(3) inflationary risk premium. All market rates, whether acceptance or mortgage rates, certificate-of-deposit rates or debenture rates, have these components, which evidence different characteristics and flow from different sources.
The originary rate or basic component flows from a psychological factor which economists call "time preference." Suppose you inherited $1,000 and were given the choice between payment now or 10 years from now. Which of the alternatives would you choose? Or suppose you have a choice between a certain amount of cash on hand or a one-year promissory note absolutely guaranteed by the Bankers’ Trust. Which is more valuable to you? In both cases you and everyone else would prefer the present good over the future good because we all discount the latter as against the former.
This difference in valuation is the source of interest. He who exchanges a present good for a future good commands a premium, called interest, because the present good is more valuable than the same good available or accessible only in the future. In the words of Böhm-Bawerk, the Austrian economist who first elaborated the causes of interest, "We systematically undervalue our future wants and also the means which serve to satisfy them. That is a sad fact—of that there can be no doubt. Admittedly, it is so to a degree varying between extremely wide limits in particular peoples, or at different stages in life or in individual men and women. We encounter it in markedly flagrant form in children and savages. In their eyes the most trifling pleasure, provided only it can be seized at the moment, counterbalances the greatest and most lasting future advantages. How many an Indian tribe, in its foolish eagerness for pleasure, has sold to the palefaces the land of its fathers, the reservoir of its means of sustenance, in return for a few barrels of ‘firewater’! The same sort of action, unfortunately, can be observed in the very midst of our own highly civilized countries. The laborer who goes out on Saturday night and pours his week’s wages down his gullet, only to spend the remainder of the week starving with wife and child is, sad to say, the blood brother of those Indians! But the same phenomenon in lesser measure and in refined form is, I venture to say, something not unrepresented in the experience of any of us, not even men of the greatest prudence, the highest principles and the maturest deliberation."1
This observation reveals that spendthrifts, who prefer present enjoyment over future provision and income, display relatively high interest rates. But even the frugal saver who is making provisions for the future is discounting the future. Considerations of the brevity and uncertainty of human life cause him to make a deduction from the value of future goods in accordance with the degree of uncertainty. Only God who lives in eternity can ignore time preference and interest.
A related factor that gives rise to a difference in value between present and future goods is the difference between the relation of supply to demand as it exists at different points in time. If a person suffers in the present from a real or assumed lack of certain goods, he will place a higher value on immediately available goods than on the same quantity of future goods. In cases of temporary distress or of the incidence of calamity, a farmer’s crop failure or a bad fire, heavy expenses because of a death or sickness in the family, or the loss of employment, we all will place a lower value on future dollars than on ready cash which will keep us out of the worst of troubles.
This particular psychological factor explains why prosperous individuals generally manifest lower interest rates than people in want and poverty. Poor people generally display a greater willingness to borrow money for present consumption, to purchase wanted goods "on installment," than the thrifty individual who refuses to burden his future with present consumption.
It also explains why American interest rates tend to be much lower than the rates in other countries, especially in the undeveloped areas of the world. Where people are dying from want and starvation, as in Asia and Africa, present consumers goods are selling at a great premium over future goods, saving for the future is painfully difficult, and little capital is formed. If their central banks, or sometimes even commercial banks, nevertheless post rates in line with American and European rates, they are deceiving the public. At the present the central bank of India is quoting 5 per cent, Burma 4 per cent, Ceylon 4 per cent, Tunisia 4 per cent, Egypt 5 per cent, El Salvador 4 per cent, Honduras 3 per cent, and so on. But the going rates of time preference in these poor countries probably lie between 20 and 50 per cent, which makes the stated rates fictitious and meaningless. No capital other than U.S. foreign aid, which the beneficiary governments usually appropriate to themselves, can possibly be offered at posted rates so far below the general time preference rates.
Debtor’s Risk Premium
Another component part of the gross market rate quoted in credit transactions flows from the risks involved in every loan. In every act of lending there is an element of entrepreneurial venture. A credit transaction is always an entrepreneurial speculation which can possibly result in failure. The lender may lose a part or the total amount lent. This is why every interest stipulated and paid in loans includes not only originary interest but also a risk premium which is entrepreneurial profit.
There is a broad structure of interest rates for loans of different types and of varying maturities.
U.S. government securities usually yield the lowest return because they are believed to carry the lowest risk to the lender. The high degree of safety and marketability and the short maturity make the 90-day Treasury Bill desirable as a reserve for banks and for temporary employment of surplus funds by corporations. Federal funds probably rank next in the degree of safety. Broadly defined, they are sight claims on the Federal Reserve Banks consisting of balances maintained with the Reserve Banks by member banks.
Bankers’ acceptances also enjoy a high degree of safety, and consequently carry a low entrepreneurial risk premium in their gross market rates of interest. They are drafts drawn by individuals or business firms on a bank which "accepts" the drafts and thereby becomes the principal debtor. Also commercial paper, which consists of generally unsecured one-name promissory notes of well-known business concerns with strong credit ratings, enjoys a similar reputation of safety and marketability.
And finally, near the bottom of the list of loans of different types and of varying maturities, entailing the greatest entrepreneurial risk and potential profit or loss, are various consumer loans to debtors without assets or known credit ratings. This is why such debtors may pay gross interest rates of 12 per cent or more on installment loans for the purchase of new automobiles, television sets, refrigerators, and the like.
In every loan there is an element of entrepreneurial venture which acts upon the gross market rate of interest. The differences in the degree of loan risk explain not only the broad structure of interest rates in the United States, but also the much higher rates that prevail abroad. In addition to the higher originary rates mentioned above, the risk in other countries with less favorable business climates greatly exceeds ours. Where business honesty is rare, or private property is in constant jeopardy, where socialistic governments seize and confiscate private wealth or freeze it in blocked accounts, the entrepreneurial risk is very great and gross rates of interest are very high. This is why few American money lenders would accommodate a borrower in China, Russia, Cuba, Egypt, India, or the Congo at a loan rate of even 50 per cent.
Inflationary Risk Premium
In recent decades the gross market rate of interest has acquired yet another component: an inflationary risk premium. Professor Mises calls it "the price premium"(Human Action, p. 538 et seq.).
Federal Reserve Governor Daane unwittingly referred to this premium, which has been rising steadily in recent decades, when he observed that "interest rates are high historically."
Whenever the monetary authorities resort to inflation and credit expansion and consequently goods prices start to rise, the gross rate of interest tends to adjust to the monetary depreciation. That is to say, whoever expects a rise in prices is ready to allow a higher compensatory gross rate than he who expects no increase in prices. On the other hand, the lender who expects inflation will grant no loan unless he is compensated for the loss in the purchasing power of his capital. The expectation of rising prices thus makes the gross rate of interest rise, while an expectation of falling prices would make it drop. The inflation premium comes into existence when many people begin to buy in order to take advantage of the inflationary trend.
The rate of premium is determined by the expected rate of monetary depreciation. If this rate is assumed to be 2 per cent, the gross market rate of interest will rise by 2 per cent. If prices are expected to double because of monetary depreciation, the inflationary risk premium will amount to 100 per cent, and the gross market rate of interest will soar even higher.
This characteristic of the price premium makes the gross rate of interest highly volatile and erratic, which has given rise to considerable confusion. Some writers on economics even deny the validity of any logical interdependence, believing that the interest rate directly springs from government policies and manipulations. Still others blame bankers and money lenders for any upward move of the market rate.
Serious students of economics are convinced that the chief reason for the upward surge of American interest rates in recent years has been the rampant 19611966 inflation which caused most prices to rise and the price premium to emerge. Central bank credit was expanded from $29.1 billion on December 31, 1960, to $43.9 billion at the end of 1965. At the present (September 5) it stands at $45.2 billion. Except for the World War II inflation, this has been the most phenomenal expansion of our currency since the Civil War. Consequently, goods prices have been rising sharply. The consumer price index has been hitting high after high in practically every month.
Stable monetary conditions are of the greatest importance to the steady development of business and banking. When currency and credit begin to fluctuate, an element of uncertainty is injected into both domestic and international business with disruptive effects on all phases of economic life. The erratic movements of the gross market rates of interest create a great degree of uncertainty and often signal the coming of a business recession.
Managed currency aims at influencing business conditions by means of the monetary powers of the Federal government. Money and credit become instruments for executing economic, fiscal, and social policies of the government, which usually aim at creating and prolonging a feverish boom. The monetary policies of the Great Society Administration were very successful in kindling a long and boiling boom through accelerated currency and credit expansion. The price we all must pay now for this popular policy is monetary depreciation and rising interest rates.
The discount rate is one of the instruments of currency management. It is the rate of interest charged by the central bank — the Federal Reserve System — on loans to member banks. At the present this rate stands at 4.5 per cent on advances secured by government obligations and discounts of, and advances secured by, eligible paper.
Realistic Rates, or Not?
It makes no sense to speak of "high" or "low" discount rates. We can conceive only of rates that are below the market rate, or concur with this rate, or are above the rate established by the capital market. If the Federal Reserve sets its discount rate below the unhampered market rate the demand for its accommodation will rise, which will cause the Federal Reserve to inflate its volume of discounts and advances. That is to say, if the gross market rate stands at 5 per cent and the Federal Reserve discount rate at 4½ per cent, the latter will be inflationary as it induces member banks to borrow newly created central bank funds. If, in a runaway inflation, the gross market rate of interest should rise, to let us say 100 per cent, any discount rate below 100 will be inflationary. During the 1923 run-away inflation of the German Mark the Reichsbank charged 95 per cent and yet rapidly inflated the German currency through its discount instrument.
If the central bank establishes a discount rate that concurs with the market rate, no demand for its funds can possibly develop as the market funds offered will equal the market demand. In fact, such a discount rate forces the central bank into inactivity, which may conflict with its avowed goal of currency management and boom policy.
If, finally, the central bank should set a discount rate that lies above the market rate, the situation will be similar to the one just described. But in case the member banks were indebted to the central bank because of prior discount expansion, a reflux of funds to the central bank will develop, which is tantamount to deflation. After long periods of inflation central banks have occasionally conducted deflationary policies through discount rates that lay above the market rates.
There is no indication that the 4½ per cent discount rate presently in effect lies above the market rate. In fact, the volume of Federal Reserve discounts and advances to member banks swelled from $490 million at the end of 1965 to $719 million at the end of August, 1966. This expansion of Federal Reserve credit through the discount instrument proves the 4½ per cent discount rate to be inflationary. Although it is admittedly higher than at any time during the last 35 years, it nevertheless lies below the market rate.
Moreover, the present discount rate is probably much more inflationary than the modest expansion of Federal Reserve discounts seems to indicate. Instead of raising its rate to the market equilibrium rate, e.g., 6 or 7 per cent which would be very unpopular and conducive to political repercussions, the Federal Reserve System now relies on "moral suasion" to manage the credit demand. That is to say, the central bank discount rate has lost its former significance to "moral suasion" which constitutes "qualitative" credit control. Our monetary authorities prefer an inflationary discount rate; but when credit demand swells to embarrassing proportions, they regulate and allocate their own inflationary funds through "moral suasion," that is, distribute them to favored borrowers. In the words of William McChesney Martin, Jr., Chairman of the Board of Governors of the Federal Reserve System: "As a tool of credit regulation, moral suasion in its narrowest meaning can be taken to refer to purposeful influence on credit extensions by the banking and monetary authorities through oral or written statements, appeals, or warnings to all or special groups of lenders. Generally speaking, such influence is exercised through policy statements released through the press and other publications, correspondence, speeches, and testimony before Congressional Committees. Moral suasion, however, can also be said to embrace what is sometimes called direct action and direct contacts with individual banks or other financial institutions."2
The "Federal Funds" Rate
Because of the discount rate’s loss of significance, we now look on the Federal funds rate as a revealing indicator of actual monetary policy. The term "Federal funds" refers to the amount of reserve balances the individual member banks have in excess of legal requirements and are willing to lend to banks deficient in reserves. Deals in Federal funds are day-to-day loans between banks made through the transfer of reserve balances on the books of the Federal Reserve banks. The Federal funds rate is the rate paid by banks for the use of such reserves. It is published daily by such newspapers as the Wall Street Journal under the heading "Money Rates."
In recent weeks this Federal funds rate has fluctuated wildly between 1 and 63/s per cent, indicating a nervous and erratic monetary policy. But mostly the rate has hovered around 6 per cent, pointing at a money market similar to that of 1929, prior to the infamous stock market crash.
Interest Rates in Boom and Bust
We need not here emphasize that the rapid inflation of money and credit during the last six years has initiated the trade cycle with all its phases from boom to bust. We have enjoyed a long and pleasant boom. In the terminology of our central planners, the annual rate of gross national product gained 10 to 20 billion dollars every quarter. The increase is expected to bring GNP soon to an annual rate of more than $700 billion. This gain, according to the Commerce Department, indicates a business expansion which in its sixth year "has already become the longest expansion of the postwar period."
A mere glance at some monetary reports immediately reveals the secret of the Great Society boom. Total commercial bank credit (loans and investments) has risen at an 11.5 per cent annual rate. Loans have risen at a 17.3 per cent rate. Since the beginning of the Kennedy-Johnson era, the American money supply plus time deposits has risen 8.8 per cent annually, and the supply of Federal Reserve currency approximately 10 per cent annually. It is obvious that the boom was built on inflation and credit expansion.
The boom causes economic malinvestments and maladjustments. The money and credit expansion artificially lowers interest rates, falsely indicating growing supplies of savings and genuine capital. This falsification of interest rates causes many a businessman to embark upon expansion and modernization projects. The boom is born from illusion and lives on more illusion through ever-increasing supplies of money and credit. When goods prices begin to rise on account of this inflation, the gross market rate of interest must adjust upwards to allow for the price premium. But in addition, the feverish boom activity at rising prices and costs augments the demand for working capital of nearly every enterprise. Interest rates soar unless the central bank feeds the boom with ever larger injections of money and credit. In this case the boom accelerates, goods prices soar, and the price premium in the gross market rate of interest continues to climb.
If the currency is not to be destroyed completely, the inflation must come to an end. But when the monetary authorities finally refrain from further currency expansion, the readjustment, i.e., recession, necessarily sets in. Also, in this case, interest rates ascend because of spreading uncertainty and fear. In periods of crisis and crash the gross market rate may no longer embody an inflationary risk premium, but usually is magnified by the entrepreneurial component here called "debtor’s risk premium." Only when the economy has completed its readjustment to market data, and the disastrous effects of previous inflation have been alleviated through new capital formation, does the gross market rate of interest return to "normal."
Other Controls the Government May Try
It seems improbable that present monetary authorities would deliberately invite readjustment or recession rather than return to full-speed inflation. Without inflation, the Great Society would immediately sink into deep depression under the growing burden of government. It is true, the present rate of inflation of approximately 10 per cent annual currency and credit expansion may not suffice to sustain a boiling boom, which may cause it to falter occasionally. But accelerated inflation might restore it again temporarily. Of course, if the Great Society Administration should decide to repeat the dreadful blunders of the Roosevelt New Deal, if it should continually raise business taxes and deliver American business into the lethal grip of hungry labor unions, anything may happen.
Accelerated inflation may be accompanied by new government controls that aim at fighting the inevitable inflation symptoms. Besides a "price stop" one might expect various credit controls designed to prevent the flow of inflation funds to certain individuals and direct it at others, especially the government and its favored groups. Toward this end the Federal government may resort to the following credit control instruments: (1) further restrictions of security loans, (2) further increases in margin requirements, (3) suspension of the borrowing privilege of individual banks from their respective Reserve banks, (4) further limitation of eligible paper, (5) stringent control of consumer credit, (6) control of real estate construction credit, and (7) more moral suasion.
Under such controls the interest rates, which are manifestations of the market order, are replaced by official credit allocation and rationing. Of course, the interest phenomenon, which flows from the very nature of man, cannot be suppressed.
1 Capital and Interest, Vol. II. (South Holland, Illinois: Libertarian Press, 1959), pp. 268, 269.