By George P. Brockway, originally published February 6, 1989
Providence is supposed to have provided them with the same cure: raising the interest rate or – if you prefer to do things indirectly – restricting the money supply. Last time out (“Bankers Have the Classic COLA,”NL, January 9), we looked at the panacea macro-economically and came up with the heretical conclusion that it caused inflation, rather than cured it. This should have occasioned no surprise, since medicine is a lot older than economics, and it was not until about a hundred years ago that your odds were better if you consulted a doctor than if you didn’t. Neoclassical economics has about caught up with Paracelsus.
The interest-rate panacea is, nevertheless, so solidly fixed in everyone’s pharmacopoeia that we’d better look at it micro-economically to try to discover its supposed merits. I should confess, at the outset, though, that having once met a payroll, as they used to say, I can’t imagine how raising the interest rate is expected to inhibit or prevent businesses from raising prices in response to the increased cost.
Every business must have money, and it therefore has to consider the cost of money, which is interest, whether it is a borrower or not. If it needs to borrow, interest is obviously a cost of doing business. If it is cash rich and doesn’t need to borrow, interest is an opportunity cost. By investing in its own business, it passes up the opportunity of lending its money to someone else and thereby earning the going rate of interest without working; so unless its own business can earn at least that much, it’s not worth continuing.
Interest is thus an inescapable element in doing business, and hardly a trivial one. Moreover, raising the rate not only affects every business, it does so geometrically. An increase in the interest rate is continuously compounded; the push is to an upward slope that becomes steadily steeper. Consequently, if the problem is cost-push inflation, upping the rate makes it worse.
In contrast, an increase in the price of oil is a one-time affair: It pushes most costs (not all, but most) up to a higher plateau, because oil is essential for the contemporary economy. At any given moment – now, for example – a certain quantity of it is used in myriad ways. At another moment – tomorrow, for example – the price may be doubled, thus doubling the economy’s outlay for oil and of course the percentage of total costs devoted to it. Producers, faced with the new cost, will raise their prices. They could maintain their profits if they just covered the increased cost of oil. In all probability, however, they will have been brought up to set their prices as a percentage markup on costs, and workers will have been brought up to expect their wages to be a certain percentage of costs.
Whether or not the new prices are enough to restore the balance among the factors of industry, they pretty quick-1yr each a new level and settle down there. Some industries and companies and workers may make out better than others, especially in the short run, yet by and large business soon goes on about as before. Prices are somewhat higher, to the detriment of people living on fixed incomes and of people who have lent money-and to the benefit of people who have borrowed money. But there is no reason for prices to rise above the new plateau unless the interest rate is tampered with.
When the Organization of Petroleum Exporting Countries (OPEC) made its successful moves, the Federal Reserve Board characteristically reacted in precisely the wrong way. OPEC raised costs for almost all businesses, and they now needed more money to continue. The Reserve Board perversely tightened the money supply, hiking the interest rate. I suppose they thought that by hurting business they would reduce the need for oil and OPEC would then be forced to lower the price. If so, they forgot that we had, as Art Buchwald wrote, encouraged the sheiks to send their sons to Harvard Business School rather than to Bowling Green State to learn basketball. At any rate, OPEC’S response was the standard one of a modem business faced with falling demand. Instead of cutting the price (as a neoclassical economist would have done), they cut production (as a modern businessman would do).
To be sure, the Reserve Board did manage to induce a recession, and that did, after eight years of trying, eventually result in an oil glut and lower oil prices. Just as in Vietnam some of our more thoughtful military leaders occasionally destroyed a village in order to save it, the Reserve Board caused massive unemployment, widespread bankruptcies, a growing Federal deficit, disaster in Latin America and the Third World, and a loss of much of our overseas business – all in the effort to control the price of oil. It was not a rational trade-off; and micro-economically the fact remains that raising the cost of any of the factors of production, of which interest is one, is not the way to inhibit cost-push inflation.
Demand-pull inflation is described by the popular cliché of too much money chasing too few goods. What is in the back of everyone’s mind is either an auction where millions of dollars are unexpectedly bid for a painting, or the hyperinflation that occurred in Weimar Germany, or the bread riots of pre-Revolutionary France. Briefly let us note that modern business is nothing like an auction, that hyperinflation occurs only when a nation has un-payable debts denominated in a foreign currency, and that the failure of the bread supply caused, not general inflation, but a deflation of all other prices as desperate people sold whatever they could at distress prices in order to pay for bread.
Putting to one side the probability that there is no such thing as demand pull inflation, we may doubt whether raising the interest rate will prevent too much money from chasing too few goods. A high interest rate no doubt chills the ardor of borrowers and thus may be thought to hold down the amount of money in circulation. Not all borrowers, however, are chilled equally. Speculators find high rates stimulating. Of course, money that goes into speculating doesn’t go into consuming; it chases paper, not goods; as far as consumption (or production, for that matter) is concerned, it might as well not exist.
Consumers, for reasons thought important by Professor Franco Modigliani and others, are said to try to maintain their accustomed or desired standard of living. They will shoulder heavy debts at usurious rates to do so. Hence their readiness to assume mortgages at more than double the maximum legal interest rate of a few years ago; hence the cavalier expansion of credit-card borrowing; and hence the failure of high interest rates to impede the chase for goods. In fact, because high interest rates have proved acceptable to consumers, the consumer loan business, once left to frowned-upon outsiders, has become attractive to banks-with the paradoxical probability that high rates have resulted in more money chasing goods, not less.
The famed bottom line, on the other hand, forces a more circumspect demeanor on businesses; few of them find it profitable to expand when the cost of financing is well up in the double-digit range. Many find it impossible to go on (right now, in this supposedly prosperous time, corporations are going bankrupt at a greater rate than at any time since the Great Depression). So high interest rates, while having only a minor effect on demand, have a major effect on supply. Whether or not there is more money in the chase, there are fewer goods in the running. To put it more generally, there are fewer goods than there might have been otherwise.
OUR HALF-CENTURY-LONG preoccupation with inflation is a sign of a profound confusion of American-even of global mind and will. Since World War II, inflation has been regarded as a pandemic disease, and a panacea has been sought. But social ills are specific, not universal, and corrective policies must be similarly specific.
If inflation were all prices going up together, a few people would be befuddled, but no one would be hurt much. As early as David Hume it was recognized that moderately rising prices stimulate the vital juices of entrepreneurs. As recently as the current “prosperity” it has been evident that business can readily accommodate itself to pretty steep inflation if it is fairly steady.
The trouble is that even moderately rising prices can be devastating to people living on fixed incomes, because they have no way of protecting themselves. This is a specific ill (there are others). Specific treatments are available, and some of them have been successfully applied. In 1966 Medicare began to protect the aged from one of the most crushing burdens of old age, and at the same time to provide millions with health care that otherwise would have been denied them. Since 1972 the Social Security COLAS have done much to prevent many of the retired from falling into poverty.
Some now say that the aged have it too good. This is a dubious proposition, but it is not to the point. The point is that the mentioned policies have had an effect. A specific ill was perceived, a specific treatment was devised, specific cures were effected, the cures may be judged, and specific improvements in them can be made. In contrast, the conventional theory of inflation that regards it as a pandemic ailment can propose only the panacea of a growing underclass of the chronically unemployed, and a narrowing overclass of those who have been able to make the Bankers’ COLA work for them.
Because interest payments are made pursuant to contract and continue years, often decades, into the future, the heavy hand of the Bankers’ COLA will be upon us, no matter what we do, for years to come. In the meantime our urgent task is to free ourselves, our politicians and our bankers from thralldom to the most dismal view of this dismal science.
The New Leader