Cheap Money Causes Inflation

October 18, 1948

Artificially low interest rates are a direct and major cause of inflation. I tried to point this out in a previous article, “Cheap Money Means Inflation” (Newsweek, Dec. 8, 1947). But the proposition is frequently denied by government monetary managers who want to maintain cheap money for political purposes. Not until the causation is so well and so widely understood that it can no longer be successfully disputed will inflation be halted abroad or at home.

The interest rate is a price like any other. Free prices balance the supply of and demand for commodities. Free interest rates balance the supply of and demand for loanable capital. When government edict holds a commodity below its free market price, an increased amount of that commodity is demanded. Exactly the same thing happens with credit. Artificially low interest rates increase both the number of borrowers and the amount that each of them wants to borrow.

People are confused by some experiences that seem on the surface to contradict this. They point out that interest rates can sometimes fall almost to nothing and still fail to stimulate borrowing, and can at other times rise very high before they discourage borrowing. But this is simply because the demand for loanable funds is largely a derived demand. It is a joint demand with other things. Interest rates are merely part of a composite cost of production.

The case is no different in principle from the demand for bricks. When all other costs are too high in relation to the price at which new houses can be sold, brickmakers might not increase their sales even if they offered their bricks for next to nothing. On the other hand, a 100 percent increase in price of bricks might mean, say, less than a 10 percent increase in the overall cost of building. So in good times a sharp rise in the price of bricks alone might not appreciably cut down the demand for housing or the derived demand for bricks.

But on the supply side there is a profound difference between credit and commodities. An excessively low price cuts down the supply of a commodity because it cuts profits and drives marginal producers out of business. But the creation of new credit has practically no cost of production. When a bank makes a new loan to a customer, it simply enters a deposit credit on its books for the amount. It creates new money with a stroke of the pen. Artificially low interest rates increase the demand for bank loans; increased bank loans mean increased bank deposits; increased deposits mean an increased volume of money; an increased volume of money means an increased monetary purchasing power pushing up the prices of goods. Cheap money means inflation.

Conversely, an accelerative increase in the creation of new credit and new money is necessary to keep interest rates down artificially.

This chain of causation is denied by our present monetary managers. Or rather, they admit its application to private credit, but not to government credit. They admit its application to the Federal Reserve member banks, but not to the Federal Reserve Banks themselves. Hence we have the preposterous situation in which the Federal Reserve authorities, in a “disinflationary” gesture, crack down on member-bank excess reserves under $1,000,000,000 (near a minimum working level), while the Federal Reserve Banks themselves hold government securities of more than $23,000,000,000. In the last year the Federal Reserve Banks have bought $8,800,000,000 of government bonds, of which $3,300,000,000 were bought in the last three months alone.

All this is the result of trying to hold down the interest yield on long-term government bonds to 2½ percent. As the Committee on Public Debt Policy declared in its final report last week: “Central banks and treasuries . . . cannot exercise controls over excessive credit expansion and at the same time keep money excessively cheap for government borrowing. When a Federal Reserve Bank buys government bonds to peg the price, Federal Reserve money flows out and increases the money supply. This is wholly inconsistent with the effort to fight inflation by reducing the money supply in other ways.”