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By George P. Brockway, originally published January 11, 1999

1-11-1999 Interest Rates I have Known titleFRIENDS have been congratulating me on bringing the Federal Reserve Board around to my way of thinking about the interest rate. It is, to be sure, true that over the years I have scolded Chairman Alan Greenspan many more times than once about his interest rate policy, and that I scolded his predecessor, Paul A. Volcker, even more harshly (because his notions were indeed worse). Well, I am still at it: I don’t think the Federal Reserve Board has gone far enough.

Greenspan himself had the Federal Funds rate lower than it is at present from November 1991 through November 1994, and he kept it hovering around 3 per cent from mid-1992 through early 1994. Somehow it seems impossible for most people, especially financial reporters and bankers’ advertising agents, to remember what happened that long ago. Every day we read in the business pages that truck and minivan sales are responding vigorously to the current “low” interest rates, and that the real estate market is strong thanks to “low” mortgage rates. Commercials running on television have been touting mortgages at 6.5 per cent as “the lowest they’ve ever been!”

My own memory goes back somewhat farther. In 1940, like millions of our fellow citizens, my wife and I had an FHA mortgage at 4 per cent. In 1947, we refinanced it with a GI mortgage that started at 4 per cent and ultimately dropped to 3.5 per cent. At that time, anything above 6 per cent was condemned as usury by state law.

In 1947, too, I became a junior officer of a small firm and quickly learned the importance of a low interest rate to any company whose business is at all seasonal (you borrow money in one half of the year and pay it back in the next). The prime rate (what the majority of banks charge their most reliable customers) was then 1.5 per cent (it is now 7.75 per cent).

Two years later the prime was up to 1.75 per cent. I remember especially the concern with which our legal counsel telephoned us a few months later to tell us that he had just seen on the ticker that the prime had jumped to 2 per cent. He strongly recommended that we raise prices and go slow with some of the projects we were working on.

The point I’m trying to make is that, contrary to what you read in the newspapers or hear on the radio or TV, interest rates in this country are high by historical standards. They are higher than they have been in most of the years since the end of World War II, higher than in most of the years since the creation of the Federal Reserve Board in 1913, higher than of the Constitution.

In fact, they are so high that it will take a good long time to get them down to where they ought to be. How long is a good long time? Well, Milton Friedman says his empirical work convinces him that it takes at least two years for monetary policy to have a substantial effect in the world of action. Given the $15 trillion of mortgages, bonds and other long term indebtedness now outstanding, and given the number of leases and other long-term contracts with settled prices, I expect it will take nearer five years, and perhaps 10, to squeeze an appreciable amount of the inflation out of the system.

AS I HAVE SAID many times before, our capitalist system runs on borrowing, and borrowing is paid for by interest. Interest is a direct or indirect cost of every business and every farm in the land. The direct cost is what you pay to whoever lends you money. The indirect cost (technically termed “opportunity cost”) is what you pay yourself for using your own money in your own business, instead of taking the opportunity of lending it to another firm and making an effortless profit from the interest you would receive. Your business¬†has to earn its opportunity cost, or it is not worth doing, except for fun; and it has to earn the direct cost, or it goes bankrupt. I’m all for having fun running a business (or a farm, though that seems more like hard labor to me)-after all, it is how you spend most of your waking hours-but you have to pay for it directly or indirectly¬†or both.

Direct and indirect interest costs are therefore factors in the prices you charge. They are not the only factors, but they are unavoidable factors. You can’t escape them. If the interest rate falls, competition is likely to persuade you to lower your prices. If the interest rate goes up, the prices you charge have to go up too, or your profits go down.

In all this, you are not alone. That’s the way our economy works, and it works better than any other yet invented. But, to paraphrase President Calvin Coolidge, as I like to do, when many people raise prices, inflation results.

Last year, and for at least the past half century, the total indebtedness of the nonfinancial sectors of the economy ran fairly close to double the Gross Domestic Product. On this basis, a shift of one percentage point in the interest rate should cause a shift of almost two percentage points in the price level. Like most economic calculations, this one is far from precise. There are too many gaps and lags and crosscurrents and arguable assumptions and downright errors in the statistics.

We don’t need precision in this case, however. We merely need a direction, because the desired end is an interest rate barely high enough to cover transaction costs (which will, I hasten to say, include loan officers and clearinghouses and deposit insurance and much of the other paraphernalia of modern banking). The record here is so clear that it does not overstate the matter to say that a rise of one percentage point in the interest rate will cause a rise of at least one percentage point in the price level, and that a fall of one percentage point in the interest rate will cause a roughly corresponding fall in the price level. (Constant readers will recognize that the foregoing is a restatement of what appeared in this space 10 years ago as “Brockway’s Law No.2: Raising the interest rate doesn’t cure inflation; it causes it.”)

WELL, as you have no doubt guessed, I am in favor of the Federal Reserve Board continuing the policy of nibbling away at the interest rate started last summer. It might be risky to do this too fast, but it should be done steadily, and there is a recent example that should give the Board confidence. The Reserve brought the Federal Funds rate down from 9.21 per cent in 1989 to 3.02 per cent in 1993. That is a fall of about 67 per cent in four years. Such a fall, starting today, would give us in 2003 a Federal Funds rate of 1.5 per cent-just about what it should be.

Also in the years from 1989 to 1993, the annual change in the Consumer Price Index fell from 4.6 per cent to 2.7 per cent, a fall of about 60 per cent. This may be little more than a coincidence, rather than a consequence of the fall in the Federal Funds rate, but at least it’s a happy one and does not contradict our theory that the interest rate and the inflation rate tend to go up and down together, with the former causing the latter.

There are certainly occasional cases where a short supply, natural or man-devised, of a quasi-essential resource allows the ancient “law” of supply and demand to drive a particular price up, whereupon a one-time shock runs through the economy. In ordinary commerce today, though, price is the independent variable, usually set by the seller, while supply and demand are dependent upon it.

If the foregoing analysis is correct, the role of the Federal Reserve Board should be largely restricted to regulating banking (or some of it), to running a clearinghouse, and to maintaining a truly low and steady pattern of interest rates in order to stabilize the price level. Most of the other great desiderata of a good economy must necessarily be left to Congress and the President, provided they can get their minds off sex.

The New Leader

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By George P. Brockway, originally published November 2, 1998

1998-11-2 Learning From Russia title

THIS IS OUR learning year. At least it is a year of learning opportunities. Whether we’re capable of actually learning remains to be seen.

In January the debacle of Southeast Asia taught us, as I pointed out at the time in this space, that “In the special branch of ethics that is economics, any system built on the backs of the downtrodden will be forever unstable.” A couple of months ago I observed that Japan “is as successful a supply-side economy as the modern world has seen, and as such its difficulties should be a warning to the United States.” Today the object lesson is Russia, and what it teaches is that a sound government is the sine qua non of a sound economy.

Please note that sound government comes before sound economy. To the extent that the Soviet Union was Marxist, things were the other way around before Communism’s collapse seven years ago. They are still the wrong way around in Russia’s brave new world of privatization, plunging rubles and other economic shock treatments.

In a footnote in Capital, Karl Marx wrote, “The middle ages could not live on Catholicism, nor the ancient world on politics. On the contrary, it is the mode in which they gained a livelihood that explains why here politics, and there Catholicism, played the chief part.”

That bothered his collaborator, Friedrich Engels. “Without making oneself ridiculous,” he wrote to Joseph Bloch, “it would be a difficult thing to explain in terms of economics the existence of every small state in Germany, past and present, or the origin of the High German consonant shifts.” Nevertheless, Engels did not doubt that the “economic situation is the basis” of everything even though “the various elements of the superstructure … also exercise their influence ….”

The form of government Lenin instituted, said to be a “dictatorship of the proletariat,” was certainly some kind of dictatorship. lts civil law concerned orders and commands, but not customs and contracts. So Mikhail S. Gorbachev and Boris N. Yeltsin found no legal system in place to regulate the revolution to a market economy.

It should be noticed that the high-powered “reform” economic advisers from Harvard and MIT and the International Monetary Fund were not dismayed by the lack of a free-market legal system. They were all convinced that the vice of the Western world is excessive regulation, and that the former Soviet Union and its former Warsaw Pact allies would benefit from the shock treatment of being thrust to sink or swim in the turbulent waters of the new global economy. Although this might cause some suffering and even some inefficiency (which in standard economics is evidently more blameworthy than suffering), they contended that it would be better to get rid of the bad old ways at one fell swoop than to creep along incrementally. Once the market was freed and assets were privatized, the reformers promised, everything would efficiently fall into place.

Of course, that is not what happened. In some respects Russia may be the American West all over again, but there are significant differences. Our “privatization” was better managed as a result of long experience with land settlement, and blatant corruption was at least reined in by posses of settlers eager and able to take the law in their own hands. Furthermore, our pioneers could maintain themselves by subsistence farming and small-scale mining; in Russia there is little to fall back on when large-scale privatization misfires. Most important, our banking and taxation systems grew with the country, whereas in Russia they are struggling to be transmogrified from Soviet systems utterly unsuited for their present purposes.

Suppose for a moment that you live in Minsk and have gotten your hands on a factory that produces something used in Pinsk. Ten years ago a commissar periodically instructed you to send x amount of the stuff to Pinsk and gave good grades for fulfilling the quotas. The people in Pinsk accepted whatever they received.

Since the orders were large enough to keep the factory busy-that’s one reason you went after the shares when it was privatized-you pursue them. “Sure,” the Pinsk people say. “What do we have to do now that we’re free?” You explain that you will have a lawyer draw up a contract. It takes some time, because the lawyer never did such a document before and has trouble literally digging up a water soaked 1912 textbook. Finally, you send the contract to the Pinsk peopIe, who naturally have to get a lawyer to read it. Meanwhile, they say: “By the way, we went to some lectures on free enterprise, where we heard there are factories in Omsk and Tomsk, not to mention some in Krakow, Kinshasa, Kyoto, and Kalamazoo, that can make what we want. We were told you should be competing with them for our business.”

Well, you can see this is going to be a drawn-out affair and you may get nothing for your trouble. Moreover, you find that your bank and the Pinsk bank have no satisfactory clearinghouse arrangements (they’re working on them). Assuming you get the order, your payment will be slow and uncertain.

In the meantime, it turns out that you already have staggering taxes to pay. A trip to the tax office enlightens you: The local bureaucrats have not been paid for months. But you are confidentially told the taxes can be taken care of with a few dollars or marks (and cautious winks tell you where to get hold of some) in the proper hands, plus several samples of what you manufacture. You resist with all your patriotic heart. Then you learn that the local big-time operators (known as “moguls”), whose Mercedes and dachas you have envied, have embraced this system (and it is, after all, not unlike what you were taught to expect of capitalism). You go along.

The Harvard and IMF economists are possessed of the notion that the ruble keeps falling in value because neither the national budget nor the foreign trade account is balanced. (The same was true of the United States for decades, and our dollar remained embarrassingly strong, but let that pass.) The economists’ models convinced them that Russia required an austere tightening of the public belt that could be accomplished by downsizing the government, including the tax offices. As might have been expected, tax collections shrank further, just as they did in Nigeria and other emerging markets of the global village.

The problem with the ruble is that only suckers now have much need of them. Almost everyone else takes care of taxes under the table-or simply disregards them altogether.

Money is a funny thing. If no one has to pay taxes, it‘s not of much use for other purposes. There is no gold or anything else “behind” it, and it can hardly serve any practical purpose, even as wall decoration. The Federal Reserve bills I have in my pocket say on their face in small capitals, “This note is legal tender for all debts, public and private.” That means I can settle all debts I now owe by offering Federal Reserve notes to my creditors, including the government. It does not mean that anyone has to sell me something I want because I offer to pay in dollars.

Storekeepers could demand cigarettes or Confederate currency or a bag of barley seeds (the money of account in some prehistoric societies), or they might just say no. It’s a free country. But if they have bills and taxes to pay-why else would anyone maintain a store? -they will need dollars.

For my part, I need a good many dollars to settle things with the various tax collectors (Federal, state and local). And I don’t have much trouble getting rid of whatever dollars I have left, since the country is full of people willing to sell me things because they need dollars to pay taxes, and there are plenty of bureaucrats ready to see that they do. We’re all happy to work to earn dollars. We know that we will be able to use them to buy what we want as long as-but only as long as taxes are as certain as death.

Russia recently announced that it would print rubles to help meet the government’s payroll and bills. Commentators in the American media have expressed horror at this use of the printing press. But the question is not how rubles are manufactured, it is whether enough taxes are levied and collected to ensure that there is a great demand for rubles by both individuals and businesses. As I’ve remarked before, the notes issued during our Revolution were “not worth a Continental” because the Continental Congress had no power to collect taxes.

THE LESSON of our story is as promised at the beginning: A sound government is the sine qua non of a sound economy. Russia’s troubles are not primarily economic. Seven years ago its economic “fundamentals” were strong enough to scare us silly, as some of us are scared silly by China today. Its population was large and better educated than China’s. Its natural resources were greater. Its infrastructure was more highly developed. Russia had gone about as far as it could go peacefully, but it has a long way to go before its legal system can support a free economy.

As we review our own political campaigns of the past couple of decades, we must doubt whether we have learned the lesson. Recent slogans have included “Balance the budget by 2002,” “It’s the economy, stupid,” “Read my lips. No new taxes,” “It’s your money,” “Abolish the IRS.”

Our new slogan, greeted with cheers on both sides of the Congressional aisle, is “The era of big government is over.” Marx would have been delighted with it. The state, you will remember, was supposed to wither away.

We have recently shown our allegiance to this slogan in at least four major ways. First, we led the way for NAFTA and GATT, both of which subordinate national sovereignty, human rights, and labor and environmental protection to commerce. Second, we extended most favored nation status to China on the fanciful ground that association with our business representatives would teach the Chinese not to torture or execute an untold number of political prisoners every year. Third, we are preparing to use our long-sought budget surplus, not to repair our torn social fabric, but to cut taxes, mainly for the well to-do. Fourth, it is not improbable that majorities in both houses of Congress could be whipped up in favor of abolishing or privatizing the Internal Revenue Service.

Big government has a special and indispensable role in a free market economy. As the late Hyman Minsky pointed out, although we had three full-fledged depressions in the first third of this century (1907, 1921 and 1929), we have had none in the last two thirds, mainly because of two institutions bequeathed to

us by the New Deal and World War II: (1) The New Deal gave us bank regulations and deposit insurance that have forestalled bank runs, and (2) World War II gave us our “big government”-24 per cent of GDP as opposed to the prewar 3 per cent-that provides a solid foundation of demand on which the supply side of the private economy can build with confidence, regardless of what happens in the rest of the world.

Will we ever learn?

The New Leader

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