Professor Greaves is a free lance economist and lecturer. His recent books include Understanding the Dollar Crisis and Mises Made Easier (Glossary for Human Action).
Why would it be a mistake for Federal Reserve officials to lower interest rates?
Wouldn’t it help the building industry? It would seem that a reduction in interest rates would lead to a renewal of building activity. This would put a lot of people to work and provide a lot more homes for those who want them. In fact, wouldn’t lower interest rates be a spur to other industries and be good for the country as a whole?
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 fiat, the effects would be disastrous. As the late Professor Ludwig von Mises frequently stated, every political interference with free market processes makes matters worse, not better, even from the viewpoint of those who propose such political interferences.
The reason for this is often difficult to understand. Unfortunately, those who attempt to push down interest rates by legal edict do not foresee the inevitable undesirable consequences. In recent years many people have learned the hard way about the consequences of political price and wage controls. Learning from experience the consequences of political interest rate controls could be even more painful.
When the government attempts to maintain prices above those of the free and unhampered market, as it has with some farm products, this inevitably leads to surpluses. Too much land, labor and scarce materials are devoted to producing 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 materials are not available to produce those goods and services which consumers desire in larger quantities. We know this because there are people willing to pay more than the free market production costs of such goods and yet cannot 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 inevitably leads to shortages such as we experienced in a matter of months. In addition to the shortages, we soon had more unemployed workers, factories and transportation facilities, not to mention the increased welfare expenses this made necessary.1 Businessmen, 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.
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 underemployment with an accompanying demand for welfare payments. Such welfare payments are a burden on all who buy goods and services in the market place. The unemployment and underemployment mean higher prices because fewer goods and services are produced to compete for the consumers’ 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-made goods and services. The resulting higher prices inevitably reduce sales. This in turn reduces employment 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 unemployed 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 underemployed. 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 privileges which permit labor unions to extort higher than free market wages from society.
Such ill-fated attempts to raise wage rates above those earned in a free market inevitably force more and more unfortunate workers to take lower-paying jobs. Eventually, with the growth of labor union power, the competition 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 all wage rates then advocate minimum wage laws. Such laws compel employers to pay all their employees at least the minimum wage. Employers, being human and having limited resources, soon refuse to employ those for whom the minimum wage rate raises production costs above what customers will pay. Such unfortunate persons, including many youngsters, members 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 minimum 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 intentions of raising all 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 unemployment and underemployment. In a free market there are jobs for all and no need to subsidize in idleness those who are able to work.
The Market Produces Interest Rates
Interest rates, like prices and wage rates, are market phenomena. 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 member of society. It is thus vital that we all understand why the government should not interfere with free market interest rates.
Market interest rates are a sum of three contributing market factors.
(1) The first is true or pure interest; what Mises called "originary interest." This is payment for time preference. A person currently short of cash may wish to spend $1,000 for something now, and pay for it later when he expects 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 immediate 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 willing 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 purposes, without receiving some benefit 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 sacrifice of not spending his money now. That extra payment, 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 depends on each party’s placing a higher value on what he receives than on what he furnishes the other party. The difference between the sum loaned and the sum to be repaid is true or pure interest — a payment that will compensate a saver for postponing his own spending for the time of the loan.
(2) The second factor in market 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 minimal. 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 arriving 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.
(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 purchasing 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 factors just discussed — (1) pure interest based on time preference, (2) uncertainty of repayment and (3) change in the dollar’s purchasing power.
Current market interest rates are considered high because this third factor, reflecting an anticipated drop in the dollar’s purchasing 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 satisfactory 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 represent 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 income 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 interest 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 Federal Reserve System lower market interest rates by fiat? The answer is simply this: If the Federal Reserve lowers interest rates when there are no increased savings available for lending, there will be a bigger demand for loans at the lower interest rate than can be made with available savings. Under present laws and conditions, the banks meet this increased 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. No one else has chosen to reduce his spending so as to make his savings available to the borrower, as is always the case with free market credit transactions.
Why Interest Rate Controls Hurt
When the Federal Reserve System 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 savers 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 services 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 market 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 distinguished in the market place. In fact, most borrowers from banks do not know whether they are borrowing the funds of the bank’s stockholders and depositors or newly created funds. The borrowers 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 borrowers 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 construction industry if the borrowers buy houses — at the expense of all workers, savers and those who would have profited from supplying what the workers and savers can no longer buy.
Outstanding Contracts Affected
Although some may be helped by such artificial lowering of interest rates, all who have earned or saved money are hurt. Such creation of more dollars not only hurts all workers and savers, by reducing the value of their dollars, but it also affects the value of every outstanding contract. It means every pre-existing dollar is worth less and every contract promising to pay dollars in the future has been altered in favor of the payer and to the disadvantage of the recipient. This means a reduction in the real value of all bank accounts, insurance policies, wage rates, salaries and pensions as well as all rental contracts, time payments and other purchase agreements. When savers foresee such effects, they refuse to make any more loans unless the interest rates will more than compensate them for the expected drop in the value of the dollars they lend.
The most important, generally unrealized, effect of such artificial increases in the quantity of spendable dollars is that they redirect the whole economy. They do so in a manner that cannot be continued without an ever increasing quantity of newly created dollars to compensate for the resulting higher prices. As the political increase 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 without consequences. Once the government stops increasing the quantity of dollars artificially or even slows down the rate of artificial 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 customers. They must then lay off 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 government is continually faced with deciding whether to inflate artificially 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 contribute toward production. Those who had spent newly created dollars will have to curb their spending or earn the dollars they spend. The available supplies of workers and capital goods will be quickly redirected toward producing solely for those spending dollars they have earned or saved in the service of their fellowmen.
In short, when Federal Reserve officials lower interest rates artificially, 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 increasing inflation of the quantity of spendable dollars. If we want to end that inflation and all its undesirable consequences, we must permit the free market to determine interest rates as borrowers compete for the real savings made available by those willing to reduce their potential spending temporarily for a price, commonly called interest. Only freely determined 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 available 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, investors 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 interference with free market interest rates must upset the economy and produce results that all honest and intelligent people consider undesirable.
1 People who sanction laws which deprive some workers from earning a living for themselves and their families are honor bound to provide the necessities of life for such second class citizens.
2 See author’s "Jobs for All," The Freeman, February 1959. Copy on request.