Growth, Money and Interest Rates Jude Wanniski October 31, 1997

Supply-Side University Economics Lesson #8

Memo: To Website Students
From: Jude Wanniski
Re: Growth, Money and Interest Rates

The topic this week is one we covered in the spring semester as Lesson #23. I decided to recast the lesson in light of recent events and it is more extensive than that of May 16. The discussion developed out of a question posed by Michael Zilkowski of Saskatoon, Saskatchewan: "If the economy continues to expand and the demand for money rises, do interest rates have to rise also?"

This is not going to be an easy question to answer, but it is pertinent to the debate that is going on in Washington, having to do with Federal Reserve Chairman Alan Greenspan's concern that the economy might grow so fast that it would cause inflation. This led Greenspan last December to worry that the rising stock market reflects "irrational exuberance" about future economic growth and to threaten that he would raise the one interest rate the Federal Reserve directly controls — the overnight federal funds rate, now 5 1/2%. His express aim in doing so would be to slow the exuberance on Wall Street, slow growth in the economy, and thereby pre-empt the inflation that he expects would follow rapid growth. In a speech last spring, Greenspan added a new concern, which he had not expressed prior to the Fed's interest-rate increase to 5 1/2% in early April of this year. He worried about "excess credit creation." In his testimony before the Joint Economic Committee on Wednesday of this week, Greenspan announced his view that the 550-point decline in the Dow Jones Industrial Average on Monday was "salutary" in that it would likely take the pressure off the higher wages that he observes in the growing economy. If you checked this website yesterday, you saw my "Memo to Alan Greenspan," in which I took issue with his reasoning. These matters bear directly on the question, "If the economy continues to expand and the demand for money rises, do interest rates have to rise also?"

Now, eminent economists have written entire tomes attempting to answer the basic question. Das Kapital by Karl Marx devotes a chunk of its space to these mysteries. Ludwig von Mises, the great Austrian economist, devoted an entire book, Theory of Money and Credit to the subject, as did his Austrian confreres, Friedreich von Hayek, whose book Prices and Production assembles lectures on the subject he gave at the London School of Economics in 1932. From another angle, Milton Friedman has spent a good part of his career on the topic of money and credit. John Maynard Keynes expostulated on this subject as well. In my attempts to find out what they had to say, I can't say I was ever overwhelmed by any. Part one of Das Kapital — the first three chapters on "Commodities and Money" — do contain brilliant insights that I found nowhere else. It has taken many years and several careful readings before I understood Marx's concept of money and why he argued that gold is the money par excellence. Much of the book is impenetrable, at least in the Modern Library edition my grandfather gave me as a high school graduation present. If you are really serious about learning supply-side economics, you at least should read and ponder these opening chapters — parts of which I quoted in last week's discussion of the numeraire.

Robert Mundell lent me a copy of his book on monetary theory, only 200 copies of which were printed 30 years ago, and I learned a few important things from it. The most important was in letting me see paper money as non-interest-bearing debt of government, just as monetary gold earns no interest. I'd thought of the monetization of debt as part and parcel of the creation of money: But in forcing me to think of it as non-interest-bearing debt, I was allowed to see that when the Federal Reserve buys government bonds from the banking system, it is transforming that debt into something else that does not resemble debt at all. How many Americans understand that the cash in their wallets or pocketbooks is non-interest-bearing debt of our government? That is, if the government had no debt, there would be no "money" as we know it, so that in that sense government debt is a good thing, up to a point. The central role of the Federal Reserve is to determine "what fraction of the government debt should pay no interest. If you were to ask all 535 members of Congress what the Federal Reserve's central role is, my guess is not one of them would understand this — including the members of the Senate and House Banking Committees that have oversight of the Fed. It was Mundell who let me see that the Fed has one job to do — it must decide whether to buy bonds or sell them. In that process, it is deciding what fraction of the national debt to transform into the money the country and the world need for the purpose of transacting business.

From Human Action, Ludwig von Mises's magnum opus, what I learned most especially as it bears upon today's topic is the concept of deflation as being creditor relief. How simple! I'd been taught that inflation is debtor relief, but until von Mises turned over the coin I realized why deflationary monetary errors could be so destructive. The man or bank who lends me money is my creditor. If the Federal Reserve introduces a deflation into the banking system of creditors by miscalculating the fraction of debt that should pay no interest, it forces me, the borrower, to pay the lender more than I had promised to pay. How crazy that would be — forcing the party without resources to begin with to pay the party with a surplus to begin with more than had been agreed to in the contract. Creditor relief! In discussing the topic, von Mises makes the observation that because it happens so rarely on purpose, it is among the least understood of economic phenomena. That is, politicians know at times that they have to inflate in order to pay the bills, when they can't find anything else to tax or to borrow. It is almost never in the interest of the government to deflate, to give creditors relief at the expense of debtors, because when the debtors can't pay their debts, they declare bankruptcy, and the banks are left  holding the bag. This is creditor relief??? What Greenspan and the Federal Reserve are doing now is without any doubt in my mind a monetary deflation, which he clearly does not yet see, or is in denial about.

The books by Marx and von Mises and Keynes and Friedman and Mundell have plenty of loose ends, which suggest to me that the definitive book on money and credit has yet to be written. Whoever writes that book will benefit from my 1977 thesis that the stock market crash of 1929 was caused by the likelihood that the Smoot-Hawley Tariff Act would be passed.

Why? Because all the great modern books mentioned above proceeded from the assumption that the cataclysmic crash and the Great Depression that followed were largely a monetary phenomenon. That is, even von Mises and von Hayek went along with the conventional wisdom of the monetarists and the Keynesians that the Federal Reserve and the private banking system combined to screw things up, resulting in the puncturing of the Wall Street "bubble." Proceeding from that assumption, every one of these great minds were misled at least in some way, large or small, in their understanding of the connections between growth, money and interest rates. Because they had no correct theory of why the Crash occurred, they were forced to provide answers that required the New York stock market to be inefficient. It is what leads Alan Greenspan to this day to say the market may be overpriced out of irrational exuberance, and that a sharp decline in the values of assets around the world could be "salutary." Milton Friedman, for example, argues that in 1929 the banks had a surplus of money, which they loaned to speculators who bought equities with it, thereby producing values that were really not there. If the market is as efficient, as I believe it is, the optimists who are paying "too much" will put the borrowed cash in the hands of a less optimistic seller who believes he can better make use of the cash. Friedman's inefficient market theory fails to account for the fact that we were on a gold standard in 1929, and "surplus" money could buy gold from the Treasury at $20.67 an ounce. Similar theories by von Mises and even Mundell were forced into making these arguments, which in each case rested on the assumption that a few smart people could outperform the market. In his testimony Wednesday, Greenspan again and again spoke of the wonders of the free market, yet at the same time one could infer that he believed he could outperform it.

With this as background, my answer to the original question has to be no, I do not believe interest rates need rise in an expanding economy. The argument that interest rates must rise when there is an economic expansion is based on the simple law of supply and demand, which says there is always a price that clears the market — where supply exactly equals demand. If there is an expansion of demand for credit while the supply of credit is held constant, interest rates will rise to allocate the available credit to those who bid the most. If, though, the supply of credit is increasing even faster than the increase in demand for it, those seeking credit are in the driver's seat, with interest rates falling to bring in new borrowers. In this scenario, economic growth will occur against a background of falling interest rates. The belief that interest rates will rise in an expansion follows the assumption that the borrower of  capital is more interested in borrowing than the lender of capital is in lending. This does occur at times, and when it does economic expansion will occur against a background of rising interest rates. Interest rates also must rise when economic expansion has reached a point where the supply of fresh capital has been depleted and cannot be replenished with superior monetary and fiscal policies. Then, interest rates must rise to allocate marginal capital.

[Please note that when we are talking about "credit," we do not mean "money." The price of credit is the interest rate required to acquire it. When you acquire credit, you are borrowing with the promise to pay back. The price of money is its purchasing power in real things. In accordance with Say's Law of markets, which we covered in Lesson #4, the "price of a dollar" is an apple or an orange or a loaf of bread. We normally think of the price of money as the interest rate to acquire it, because demand-side economists think in terms of the consumer, not the producer. The terms money and credit get mixed up as a result. The Federal Reserve, as a central bank, does not provide "credit" when it increases the amount of money in the banking system by buying bonds from the banks with non-interest-bearing debt. No bank really supplies "credit," but rather they serve as intermediaries for those who have surplus capital and those who are in deficit. The banks produce no apples, oranges, or loaves of bread.]

Start from a point of equilibrium in order to follow one scenario or another. That is, all the capital that wishes to be employed is employed, the price of capital having cleared the market, and all the labor that wishes to be employed is employed, the price of labor having cleared the market. The lenders have loaned all the resources they wish to lend and the borrowers have borrowed all they wish to borrow. Now, hit the equilibrium with an outside (what economists call "exogenous") shock. This might likely be an event that causes the expected return on the investment of capital to enjoy an increase. Lenders of capital (creditors) will be more willing to lend or invest, and will increase their lending at no increase in interest rates. The supplier of capital will lead the parade. The previous borrowers who, at the margin, had all the capital they desired, would ignore his new offer of capital. This would allow those who wished to borrow, but could not find takers for their stocks and bonds, to suddenly find suppliers willing to take it in exchange for real goods, or claims on real goods, i.e., money. In other words, I will buy your bond or your stock with money and you will use the money to pay the factors of production in your enterprise. Where did I get my money? I got it by deciding to sell some of my unused time, energy or talent for money in order to buy your stocks or bonds. In the broad marketplace, you are using the money to buy an equal amount of my time, energy or talent in order to pay the factors of production in your enterprise.

In The Way the World Works, I noted that between 1815 and 1851, the United Kingdom experienced the most explosive economic growth that civilization had ever experienced. It did so having begun the stretch with a national debt that had grown to monumental proportions during 22 years of war with Napoleon. Throughout the expansion, interest rates steadily declined until they leveled off at about 2% where they remained for the rest of the 19th century. In the United States, the most explosive growth occurred in the decade from 1879 on, with interest rates also in the 2% range.

How can this happen? It can happen because growth is the result of risk-taking. Not all risks produce growth, but if there is enough risk-taking, growth will occur. If the risks that stand in the way of growth are reduced, more growth will occur. If the rewards to successful risk are increased, more risks will be taken and more growth will occur. The concept of "excess credit creation11 that Greenspan mentioned earlier this year to Congress means that someone who wants to extend credit to someone who wants to accept credit, under conditions they both agree upon, are doing something excessive. Von Mises believes it is possible for excess credit creation to occur, but only briefly if it occurs under a gold standard. That is, the credits that are extended can only extend so far before the absence of liquidity causes the inflationary boom to be corrected by a deflationary bust.

Von Mises, if he were still alive, would agree that if gold were anchoring the system, preventing excess liquidity from building up, "excess credit creation" could not be significant. Gold "self-corrects" because it signals the central bank, when its dollar price rises, that there is more money (non-interest-bearing debt) or "liquidity," which amounts to the same thing, than non-inflationary commerce requires. The banks get stuck with the losses for their imprudence, in lending to projects of lesser and lesser quality, or the stock market knocks down the value of equity issued to support projects of lesser quality. Without gold as an anchor, the central bank can err in the direction of too much liquidity leading to inflation, or too little liquidity leading to deflation. If the market sees either occurring on a sustained basis, it automatically has to factor in higher risk to all enterprise, which puts up interest rates. As a result, marginal enterprise that otherwise might have been financed, is not. Growth slows. In the current world, Greenspan's dithering about what he and his colleagues have in mind for the future tells the markets that the Fed really doesn't know what it is doing. Every time he has spoken in the last several months, he has changed his theory of growth and inflation. The markets do not have a coherent understanding of "the Greenspan Standard." This is why interest rates are so high, higher than 6% on a 30-year bond, even though the federal deficit is approaching zero and gold at $315 is much lower than where it was in October 1993, when the long bond was 5.87%.

In Zilkowsky's question, remember he asked if the economy expands and the demand for money continues to rise, do interest rates have to rise also. The phrase "demand for money" is something I had a hard time understanding. At first I thought of a bank robber "demanding money." But Art Laffer reminded me that my method of demanding money was to offer my supply of labor to the market. I could also "demand money" by offering goods I had produced to the market. You demand bread and I demand wine, you supply wine and I supply bread, so we make a deal. For most of the history of the world, gold (or silver) had been the proxy for all goods offered to the market. There are several uses of "money," one being a medium of exchange, another being a  store of value, which means people "demand money" for different reasons. The most important function of money, though, does not involve supply or demand at all. The highest purpose it serves is as a unit of account. A "dollar" is fundamentally a concept, not a thing. People don't demand concepts with their labor or goods. They demand things. But a unit of account is critical for the world of commerce. It's how everyone on earth who is exchanging labor or capital for goods or services or fiduciary media keeps track of the values involved in these transactions or contracts. A unit of account without integrity, means every one of the billions of transactions made every day are costlier than they need to be. The easiest way for President Clinton to lower transaction costs around the planet would be to end Greenspan's dithering and fix the dollar/gold rate to re-establish an honest accounting unit.

As the economy expands, there is an increase in the demand for money not in the sense that the economy needs more accounting units. One is enough. It is because expansion requires more circulating media. The Federal Reserve can only know this demand is consistent with an honest unit of account if demand shows up as a fall in the price of gold. If gold falls from $350 to $349, we know, and Greenspan and his colleagues should know, that the world would like a little bit more liquidity — in the form of non interest-bearing debt of the U.S. Government — either cash or bank reserves. So if economic expansion should be occurring coincident with an increase in the demand for money, interest rates would not have to rise, and they could even fall, if the market understands that the U.S. government is going to maintain an honest accounting unit indefinitely.

When I presented the core of this lesson last May 16, the gold price was more or less at $350, although it had declined to $340 for a while. Even at $350, the dollar had become more valuable relative to gold by $35, a 10% deflation. This in itself would cause some grief to dollar debtors who had borrowed when gold was at $385, especially if they had used gold for collateral. Gold had risen to $385 from $350 in November 1993, so it did not have time to cause a general rise in the entire price level of 10%. A return to $350 would not cause terrible damage, only distress here and there. The distress was also limited by the cut in the capital gains tax, which increased the rewards to successful risk-taking. The tax cut in itself powered an increase in the demand for dollar liquidity that produced the deflation in gold. To see the dollar/gold price decline to $310 in five months since we presented this lesson in May requires an entirely new set of anxieties. Because gold has not been at this level for 17 years, except for brief dips in 1982 and 1985, our model leads us to believe that unless Greenspan adds liquidity, it will cause painful adjustments for as long as it takes to bankrupt dollar debtors, businesses and households, all around the world. The United States itself may experience only a slowing of growth, not recession, because the tax cut this year lifts activity in the exchange economy while the deflation lowers it. For those countries, like Japan, Thailand and others in Asia that are both deflating their money and adding taxes on commerce, there would have to be a fall from the current equilibrium, which is what we mean by recession.