Rigging Interest Rates

July 13, 1964

In the issue of June 15 I referred briefly to the disturbing speech of Secretary Dillon in Vienna on May 21, in which he chided European governments for keeping their long-term interest rates too high, and told them that this was not an appropriate way to fight inflation. That speech calls for further examination.

The reason for Dillon’s concern is not mysterious. If long-term interest rates in Europe average around 6 percent, while they range here between 4 and 5 percent, then foreign and even American investors will want to invest in Europe, where they can get a higher return, rather than here. The result, as Secretary Dillon and his advisers see it, is that this will prolong and increase that “deficit in the balance of payments” about which the Administration is so concerned. “Europe’s” inconsiderateness in pushing its interest rates so high “left us,” according to the Secretary, “no recourse but direct government action.” That action was to recommend a stiff tax penalty on American purchases of foreign securities.

Let us look at some of the dubious assumptions behind this reasoning.

A PRICE PREMIUM

Dillon talks as if “Europe” is intentionally keeping long-term interest rates high. But European governments and private borrowers certainly don’t want to pay any higher interest rates than they have to. What has happened is simply this. European governments had alreadybeen following for the last few years the inflationary policies that Dillon assumes to be needed. (He declares that “the prevention of inflation remains vitally necessary,” but the policies he has been carrying out increase inflation.)

European inflation over the three years 1961 to the end of 1963 led to average price rises of 9.8 percent in Germany, 10.9 percent in Britain, 13.6 percent in France, and 14.7 percent in Italy. (See this column May 18.) European long-term interest rates are high because they contain a “price premium” which reflects a fear of further inflation. Even Dillon concedes that “relatively recent experience with inflation has discouraged postwar European investors from the purchase of bonds.”

It is not Europe that has been artificially holding long-term interest rates up, but our government that has been artificially holding them down. We have done this by increasing the money supply. Since the end of 1957 the money supply, including time deposits, has been increased $79 billion, or 40 percent. One of the chief ways in which it has been increased is by the purchase and monetization, by the Federal Reserve System, of $34.5 billion of U.S. Government securities—$10.5 billion more than at the end of 1957, $3 billion more than a year ago.

‘INCOME POLICIES’

It is our money-creation, bond-buying, low-interestrate, budget-deficit policy-in brief, our inflation—that has caused the very deficit in the balance of payments that the Administration wants to cure. And as long as these inflationary policies continue, any tax penalty or prohibition on foreign investment, “temporary” or permanent, is not going to cure the balance-of-payments deficit. In the long run any reduction in our foreign investment will tend to reduce our exports by a corresponding amount. It will reduce the dollars available to foreigners to buy our goods.

If the Administration persists in its inflationary policies, and tries to offset them with direct controls on foreign investment, it will only plunge deeper and deeper into controls. Dillon’s own words foreshadow this. He advocates “income policies to restrain upward pushes on the cost-price structure” caused by inflation. “Income policies,” a phrase ominously familiar in Europe, means controls of wages, salaries, profits, rents, interest, and other forms of income. It means moving toward a regimented economy.

And all because the Administration clings to the exploded Keynesian assumption that a perpetual creeping inflation—caused by chronic budget deficits, ever-increasing money supplies, and perpetual low interest rates—is necessary to full employment. It is neither necessary nor sufficient. What is indispensable, however, is a coordination of wages, costs, and prices achieved through a restoration of real freedom of markets.