Freeman

ARTICLE

Interest Rates Are Rising

NOVEMBER 01, 1966 by HANS SENNHOLZ

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.

Originary Rate

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.

Differing Circumstances

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.

Government Intervention

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.

Managed Currency

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.

 

—FOOTNOTES—

1 Capital and Interest, Vol. II. (South Holland, Illinois: Libertarian Press, 1959), pp. 268, 269.

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November 1966

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