Easy Money Has an End

August 19, 1957

When four Federal Reserve Banks raised their discount rates as of Aug. 9 to 3½ percent instead of 3, bringing the level to the highest since 1934, there was the usual explosion by the Patmans and Kerrs in Congress against “tight money.” But as the Guaranty Trust Co. of New York pointed out in its July Survey, present rates appear high only in comparison with the abnormally low rates of the depression years and the artificially maintained rates of the war and early postwar periods.

Longer-run comparisons show, in fact, that present interest rates are still quite moderate for a time of active business. Rates on commercial paper, averaging about 4 percent, compare with 6 percent in 1929 and 7½ percent in 1920. Before 1929, a rate below 4 percent was exceptional. As for the preceding 3 percent Federal Reserve discount rate, never until 1930 did any Federal Reserve Bank set a rate below that level.

Nor is the rate structure in the United States high in relation to those elsewhere. Of the 32 foreign central-bank rates listed in the Federal Reserve Bulletin for July, only five are below that in the United States. This is in spite of the fact that many countries still maintain unjustifiably low central-bank rates. The maintenance of short-term interest rates at too low a level, in fact, is one of the main explanations of the continuance of inflation in those countries. Excessively low rates always encourage overborrowing, which means an expansion in the supply of money and credit, which in turn causes commodity prices to rise even further.

IT CAN’T GO ON FOREVER

What the Federal Reserve authorities and the Treasury Department have been doing in the last two and a half years has not been to make money tighter, but simply to allow the money market to tighten itself as the demand for credit increased.

It is possible, of course, for a government or a central bank to keep money rates low for a long time, either by printing money directly or by permitting the overborrowing and consequent expansion of credit to which excessively low money rates inevitably lead. What is less well understood is that cheap money cannot be continued indefinitely. It sets in motion forces that eventually drive interest rates higher than if a cheap-money policy had never been followed.

The expansion of money and credit that is necessary to hold interest rates down also raises commodity prices and wages. Higher commodity prices and wages make it necessary for businessmen to borrow correspondingly more in order to do the same volume of business. Therefore the demand for credit soon increases as fast as the supply. Later on, still another factor comes in. When both borrowers and lenders begin to fear that inflation is going to continue, prices and wages begin to go up more than the increase in the supply of money and credit. Borrowers want to borrow still more to take advantage of the expected further rise in prices, and lenders insist on higher interest rates as an insurance premium against expected depreciation in the purchasing power of the money they lend.

THE BRITISH EXAMPLE

When this happens in an extreme degree, we get a situation like that in Germany in November of 1923, when rates for “call money” went up to 30 percent per day. This phenomenon in mild degree is already evident in Britain. The First National City Bank of New York has just pointed out in its August letter, for example, that while the U.S. Treasury 2½s were trading around 86 in June, the British Treasury 2½s issued in 1946, “during the last dying gasp of the cheap-money policy of the United Kingdom,” could be bought at 50, or half the original purchase price. Yet corporate shares in Britain have been bid up to levels where returns to the investor are in many cases substantially lower than on gilt-edge bonds. As one London investment house explains the matter, “The argument is, indeed, put forward that, since the pound has been depreciating in the past decade at an average rate of 4¾ percent per annum, any investment likely to show a total net return on income and capital accounts over a given period of less than this amount is giving a negative yield and should be discarded.”