By George P. Brockway, originally published October 7, 1991
PEOPLE are beginning to growl that recovery from the recession is being delayed by the slow growth of the nation’s money supply, which seems in danger of falling through the bottom (or “lower parameter” if you want to be fancy) of the Federal Reserve Board’s target. The said target is to keep the annual rate of increase between 2.5 and 6.5 per cent.
Now, suppose that the Reserve agrees that the money supply is in danger of falling through its bottom. Resolved to their own selves to be true, they have to increase it. What do they do? The most obvious thing would be to coin some more coins and print some more paper money. But what would they do with it?
You may be sure that they wouldn’t send a packet of the stuff to each of us by Express Mail. Nor would they add to our savings accounts (although they firmly believe we ought to save more).
Instead, the Reserve would make it easier and more profitable for the banks to lend us money. We have some credit, represented by a plastic card that we show to a shoe clerk, who makes a copy of all the numbers, has us sign it, and hands us a pair of shoes. We have spent our credit like money, except we now are in debt to the bank that sent us the card. Our credit has become money by becoming debt. Businesses create money in the same way when they take down their line of credit extended by their friendly banker.
This pleasant arrangement expands the money supply, but it is limited in various ways – the chief one being the interest rate, the price banks charge us for the use of money. There are those whose doctrine requires them to pretend that the Federal Reserve Board has no control over interest rates, that they are made in the market, if not in heaven, by an invisible hand, and no mere mortal can do anything about them. More sophisticated observers recognize that the Reserve really and truly does determine short-term interest rates. When the Board sets the Federal Funds rate or the Discount rate, it is setting a rate at which banks can borrow (short term) from each other or from the System. When the Federal Open Market Committee buys or sells bonds, it raises or lowers the price of bonds and consequently is lowering or raising the interest rate. If the Board did not set at least short-term rates in these ways, it would be hard to ascribe any significance to its activities.
Indeed, the fact is that whenever the Reserve fears the money supply will fall through the lower parameter, it lowers the interest rate. It claims to control the money supply, yet all it can actually control is the interest rate.
If that is the case, why doesn’t the Board say so? I regret to have to tell you that it is possessed by doctrines that might have made sense in the days of mercantilism but have nothing to do with a modern capitalist economy.
In the days of mercantilism money was a commodity-gold, silver, sea shells, or some such. Trade was essentially barter. You swapped grain for silver, and then you swapped the silver for candles. At any given time (say, 1492) there was a certain amount of silver in circulation, and other commodities traded at more or less stable prices in terms of silver. Christopher Columbus (whether he discovered America or not) made a historical difference. The European supply of silver multiplied rapidly, while the supplies of other commodities, being agricultural products or custom made goods, expanded slowly, if at all. Some of the increasing supply of silver was swapped for the stagnant supplies of other commodities, whose prices rose. Hence the notion that prices depend on the money supply.
Although the Federal Reserve Board seems not to have noticed, the modern economy is quite different from that of pre-Industrial Revolution days. As Karl Polyani rather sorrowfully pointed out, goods are now produced for the market, rather than on special order. While occasional shortages are far from impossible, industry is so organized that if a demand for an especially cute T-shirt suddenly develops, the supply can be replenished in a few hours or days. Since the supply of most commodities is now indefinite, if not infinite, the supply of money has no substantial effect on prices.
The way the interest rate is managed does, however, have an effect on prices. Here, again, is a historical change the Reserve has failed to notice. A frequently cited survey, published in the Harvard Business Review in 1939, reported that business people then paid little attention to the interest rate in making their plans. A few years later I was a business planner myself, and I assure you that’s the way it was. After all, the prime rate, held down by an “accord” between the Treasury and the Federal Reserve, was only 1.5 per cent. The accord was annulled in 1951, whereupon the Reserve embarked on its long and still-continuing hunt for the inflation snark, with the result hat today interest is one of the most prominent and most unpredictable costs of doing business.
Here, yet again, is a historical turning – one that has been missed by most mainstream economists but has been forcefully called to the attention of most businesspeople. If you have ever met a payroll, you know that your costs are an inescapable factor of the prices you charge. When your costs go up, so must your prices, if you propose to stay in business. For 40 years now the Reserve has been idiotically trying to control inflation by inflating the cost of doing business.
In short, the price of money matters. Unhappily, it is widely believed – even by many who agree the Reserve can set short-term rates – that long-term rates are set by the “market” anticipating what the future will bring. Some say that the market anticipates the future rate of inflation; others that the market anticipates the short-term rates the Reserve will set in the future. In the former case, long-term lenders think of themselves as lending purchasing power and want to get their purchasing power back, with interest. In the latter case, long term borrowers guess that borrowing will be more expensive in the future than in the resent because the Reserve will, in its anti-inflation battle, allow (or force) short-term rates to rise.
It will be seen that the customary policies of the Federal Reserve Board work to reinforce both groups. Inflation, of course, is the Board’s panatrophy, and raising the interest rate is the Board’s panacea. What borrowers and lenders anticipate in, the long future is that the Board will continue to pursue the policies it is pursuing today. They may be wrong, just as prophets may be wrong about what the Board will do tomorrow morning. he point is that, regardless of the Federal Reserve Board’s intentions, its actions effectively control the long-term interest rate as well as the short-term rate.
THE SAME POINT may be reached from another direction. Keynes deplored the fact that most professional investors and speculators “are concerned, not with what an investment is really worth to a man who buys it ‘for keeps,’ but with what the market will value it at, under the influence of mass psychology, three months or a year hence.” In the 55 years that have passed since Keynes published this judgment, three months or a year has come to seem an unusually long time to hold an investment.
The bond market is a place where people buy and sell bonds in which at least the seller did not intend to invest for keeps. Portfolio managers and professional traders treat long bonds and short bonds alike, and treat both as they treat stocks. They rank them according to their relative safety and relative liquidity and so on; and in that ranking it will happen that some long bonds are judged more liquid than any common stock. (After all, common stocks are “longer” than long bonds because they do not promise to return your money.) In all cases, long-term or short-term, the traders’ question is what the market will bear tomorrow, not what will happen over the next 30 years.
This being so, the long-term interest rate is not a separate problem. Even new bond issues are priced in relation to the current market, and that is priced in relation to short -term interest rates. Therefore, all interest rates respond to the activities of the Federal Reserve Board.
But may not international rates restrain those activities? In response to that question apologists for the present system will surely warn us about a flight from the dollar. We will be reminded that former Board Chairman Paul A. Volcker was tireless in arguing that interest rates had to rise to attract foreign money to finance our budget deficit. Rates had to stay high to keep the foreigners from pulling their money rugs out from under us. Treasury Secretary Nicholas F. Brady has a similar fear of flying.
Who are the foreigners whose money is so important to us? Everyone knows that mainly they’re the Japanese. That knowledge should give us furiously to think. For the money that lands on our shores takes off from theirs. The flights to the dollar are flights from the yen. Yet their economy has been outperforming ours for the past many years. Have they outperformed us because they sent their money to us? Hardly. But their domestic saving and their currency’s flight had the same cause. Both were the result of their comparatively low interest rates and correspondingly high production (not productivity, but production). It was their expansion of employment and plant and output that made them prosperous.
Don’t let anyone tell you that Japan’s interest rate was so low because Japan’s savings rate was so high. In the first place, you have to produce a lot before you have a lot to save. You can’t save what does not exist. In the second place, Japan’s recent hike in its interest rate was not caused by a fall in savings but by the cold -blooded and wrong-headed decision of its central bank. The increased interest rate will reduce economic activity, and reduced savings will follow as a consequence, not as a cause.
The Federal Reserve Board’s money growth target is irrelevant. The Reserve should set the short-term interest rate at least as low as it did during the 1942-51 accord with the Treasury. The long-term rate conformed then, and it would do so today.
The New Leader