Federal Reserve Chairman Ben Bernanke’s remarks last summer about the debt limit and risk of default amounted to a stunning contradiction of Keynes and Keynesian economics. But few seem to have noticed.
In response to questions by U.S. Senator Jack Reed (D-RI), Bernanke joined in the chorus of those predicting skyrocketing interest rates in the United States and abroad if the federal government defaulted on its debt obligations because Congress did not raise the debt ceiling. It was not a given that the federal government would have defaulted if the ceiling had not been raised. But ignoring that fact, Bernanke argued that the “loss of investor confidence [following default] could potentially raise interest rates quite significantly. . . . But if interest rates rise, that’s clearly going to reduce investment, uncertainty will rise, that will reduce the abilityness [sic] of firms to hire and invest. . . . So I can only conclude that this would be very bad for—for jobs.”
Did the person supposedly in charge of determining interest rates in the United States through Federal Reserve credit creation really say that? What was the rationale for QE1 and QE2 (quantitative easing) if not to lower interest rates and promote economic prosperity? And who inspired that mistaken thinking? John Maynard Keynes, of course.
Keynes argued in the General Theory (1936) that interest rates are determined by the supply and demand for central-bank money (cash) and not by the supply and demand for savings (or lendable capital), as his predecessors from David Hume and Adam Smith on down to Alfred Marshall had explained. Therefore, in Keynes’s view, it is the responsibility of a central bank to increase its supply of money enough to depress interest rates to such a low level as to result in the “euthanasia of the rentier, of the functionless investor,” who relies on “the cumulative oppressive power of the capitalist to exploit the scarcity-value of capital” to demand interest payments. That is, money should become so plentiful that no one would be obliged to pay interest to borrow it. (Of course, Keynes here confuses money with savings or wealth.)
The money (cash) supply-and-demand theory of interest rates was the predominant view among Mercantilist thinkers from the sixteenth to eighteenth centuries. It was to correct that mistaken view that Hume, in his essay “Of Interest,” explained that although interest rates may be influenced temporarily by the abundance or scarcity of money, they are permanently determined by the flow of savings relative to their demand:
High interest arises from three circumstances: A great demand for borrowing; little riches to supply that demand; and great profits arising from commerce [hence the desirability of demanding more loans]: And these circumstances are a clear proof of the small advance of commerce and industry, not of the scarcity of gold and silver [money]. Low interest, on the other hand, proceeds from the opposite circumstances: A small demand for borrowing; great riches to supply that demand; and small profits arising from commerce: And these circumstances are all connected together, and proceed from the increase of industry and commerce, not of gold and silver.
Hume’s elaboration on that point was the basis of subsequent classical writers’ explanation of interest-rate determination by the supply and demand for savings. Keynes, on the other hand, denied all such explanation and declared in his 1939 preface to the French edition of the General Theory that, in arguing that interest rates rather are determined by “the demand and the supply of money, that is to say [by] the demand for liquidity and the means of satisfying this demand [he is] returning to the doctrine of the older, pre-nineteenth century economists. Montesquieu, for example, saw this truth with considerable clarity—Montesquieu who was the real French equivalent of Adam Smith, the greatest of your [French] economists, head and shoulders above the Physiocrats in penetration, clear-headedness and good sense (which are the qualities an economist should have).”
Has Bernanke now abandoned his adherence to Keynes’s money, or liquidity supply-and-demand, theory of interest rates, or was he merely participating in the debt-default scare to further the federal government’s agenda of raising the debt ceiling to accommodate its profligate spending?
After all, Bernanke also acknowledged to Senator Reed that besides the Chinese, the Fed is “the largest holder of our Treasury debt.” Why wouldn’t the Fed simply cancel the Treasury’s debt and purchase some more to save the federal government from its predicted default? To support the political-posturing view of Bernanke’s statements, one could legitimately cite his similar proclamations in fall 2008 that without the Troubled Asset Relief Program (TARP), giving the Treasury secretary $700 billion to purchase “toxic assets” mainly from investment banks, businesses could not meet their payrolls. The claim wasn’t true. Businesses borrow from commercial banks, not investment banks, to meet payroll. And commercial banks rely mainly on the public’s deposits to lend to businesses. The public would not have stopped making deposits with banks had TARP not passed. Besides, then-Treasury Secretary Hank Paulson didn’t initially use the money for the bill’s stated purposes. But the scare worked to push Congress to vote for the legislation.
More likely Bernanke simply employed the common-sense view of interest-rate determination through the supply and demand for financial assets (interest rates thus being inversely related to the price of financial assets), which is the classical economics view, in contradiction to Keynes, but without consciously intending to be anti-Keynes. Buyers of such assets (IOUs) are the savers while sellers of financial assets are the borrowers. Clearly, many U.S. Treasury bond holders would be inclined to sell them should a default occur. Such selling would reduce their price and thus raise their yield (interest). Therein lies the contradiction of Keynes and the affirmation of the classical principle he denied—namely, that the supply and demand for savings are the principal or permanent determinants of interest rates. Bernanke couldn’t deny the obvious, even as he exaggerated the consequences of a government default.
So what if the U.S. defaulted on its debt obligations and the yield on its debt rose? Must all interest rates rise as a result of the nonzero default risk on Treasuries? Not necessarily. There would simply be a narrowing of the risk premium between U.S. government bonds and other private-sector securities. Treasury securities would lose their default-risk advantage over other securities but retain their liquidity-risk advantage, given the Federal Reserve’s readiness, hence commercial banks’ readiness, to redeem Treasury securities on sight. There is no reason that the default risk of the bonds and stocks of such corporations as Apple, Microsoft, Google, or Walmart should rise just because that of the U.S. government has risen. Thus the yield on private securities may decline (as investors flee Treasuries) while that on U.S. government securities rises, leaving the average unchanged.
Savers are constantly looking for instruments (financial assets) through which they can earn returns on their savings. There may be some diversion of savings into gold, driving up its price further. But investors in gold also know that, like all other commodities, the bubble created by current fears about Treasuries will also burst in due course. Thus the predicted skyrocketing of worldwide interest rates from a possible U.S. government debt default was an exaggeration. If interest rates rise it will be the result of a contraction in the rate of savings worldwide.
Besides, high interest rates, as Hume explained in his 1752 essay, are not necessarily injurious to a high rate of economic growth. It is high interest rates resulting from a contraction in savings that reduce economic growth. One easily can verify this from the level of interest rates in the United States during the economic boom from 2003 to the fall of 2008. The yield on a one-month Treasury rose steadily from 0.91 percent in May 2004 to 5.16 percent in June 2006 while the unemployment rate declined from 5.6 to 4.6 percent. On the other hand, the one-month rate stood at 0.02 percent in June 2011 because of the Fed’s massive injection of credit while the economy has continued to be mired in anemic growth and the unemployment rate has risen to over 9 percent.
Raising taxes to balance the federal budget would not necessarily lower interest rates. Rather, higher taxes would reduce disposable income and thus the flow of savings. The high level of government spending—financed either by debt or high taxes—would put pressure on interest rates to rise. It also would divert more savings from private-sector investments that would otherwise promote sustained employment and economic growth. These are the insights of classical macroeconomics that Keynes failed to appreciate and his modern followers continue to miss.
Current low U.S. interest rates are unsustainable. They are going to rise with or without an increase in the federal government’s debt ceiling. Savers will not forever endure the current negative real interest rates. Cutting federal spending is the surer path to resumption in robust economic growth and reduction in the rate of unemployment. As David Ricardo acutely observed in his 1810 pamphlet, “The High Price of Bullion”:
To suppose that any increased issues of the Bank [of England] can have the effect of permanently lowering the rate of interest, and satisfying the demands of all borrowers, so that there will be none to apply for new loans, . . . is to attribute a power to the circulating medium [money] which it can never possess. Banks would, if this were possible, become powerful engines indeed. By creating paper money, and lending it at three or two per cent. under the present market rate of interest, the Bank would reduce the profits on trade in the same proportion; and if they were sufficiently patriotic to lend their notes at an interest no higher than necessary to pay the expences of their establishment, profits would be still further reduced; no nation, but by similar means, could enter into competition with us, we should engross the trade of the world. To what absurdities would not such a theory lead us! Profits can only be lowered by a competition of capitals not consisting of circulating medium. As the increase of Bank-notes does not add to this species of capital, as it neither increases our exportable commodities, our machinery, or our raw materials, it cannot add to our profits nor lower interest [permanently].
Experience around the world repeatedly has confirmed Ricardo’s warning against the belief in a central bank’s money creation as the engine of economic growth instead of the pursuit of policies that encourage increased private savings.