Reaganomics and the Interest Syndrome

How to control interest rates? Should the Federal Reserve lower its lending rate, push more reserves into the banking system, or use some other mechanisms? Professor Milton Friedman, an advocate of steady increase in what is called money supply, has complained that the FED did not use the right tools, and added that there was no historical precedent for the constant interest rate fluctuations of the past few years.

For decades the Federal Reserve has assumed responsibility for determining how much money/debt/ credit the country needs, and in 1978 was required by law to set and announce “targets” for money supply. An Open Market Committee—a group of twelve—meets periodically and with the assistance of batteries of computers and reams of charts decides the amount of “money” needed by the economy to maintain steady growth at reasonable interest rates. Its main device is to buy or sell in the market its own debt instruments (notes or deposit credits) which thereafter become money equivalents and reserves in the banks. This system permits the banks to extend their own debt commitments through deposit liabilities and thereby increase the “money supply.”

Whipping a Dead Horse

“Money supply,” taken to represent the current purchasing power in the economy, is generally defined as the note liabilities of the Federal Reserve Banks plus the demand liabilities of banking and like institutions; it is called M1 (or M1b). A simpler definition is the amount of demand debt in the economy.

The futility in trying to control “money supply,” and thereby interest rates, was illustrated by a speech by Anthony M. Solomon, president of the Federal Reserve Bank of New York before the American Economic and American Finance Associations on December 28, 1981. Mr. Solomon pointed out that during the first eleven months of 1981, the money supply figure used by the Federal Reserve (M1) rose at a modest 2.5 percentage rate; the figure, however, was deceptive; other money equivalents in the form of Eurodollars, money market funds and the like, called M2 and M3, rose at 10.1 per cent and 11.1 per cent respectively.

In short, as Mr. Solomon conceded, “A fundamental re-evaluation of our use of monetary targets may be necessary.”

Vestigial Marxism

This observation is one that should have been apparent years ago to monetary historians and students of monetary phenomena. That money supply through debt formation can be controlled by a select group of experts sitting in a marble mausoleum on Washington’s Constitution Avenue is a vestigial relic of Marxist economics—the theory that the state is the repository of all economic wisdom and hence the ultimate authority for economic planning.

The reason debt and money supply and interest rates can not be controlled, but will continue to increase, lies in the nature of what passes for money. The currency in circulation, apart from debased token coinage, consists mainly of Federal Reserve notes. Until 1934 these notes were payable on demand in gold coin. Since 1934, the notes have been redeemable only in other notes—a perpetual rollover of debt without maturity, with the interest payable only in more debt. Debt multiplies upon itself without limit, with each increment lowering the purchasing power of the total.

Here is the basic explanation of the upward pressure on interest rates, the effects of which filter through into the general price structure. Until 1946 these effects were hidden by reason of the great influx of gold during the preceding decade, an influx that anesthetized the inflationary effects of Federal Reserve policy. The awakening came after the close of World War II, when the flow of gold seeking security here ceased, and a reverse movement began.

As prices rose, investors grew increasingly reluctant to put funds out at long term except at the higher rates of interest required to offset the loss of purchasing power of the dollars received at maturity. This is reflected statistically in the amount of government debt that increasingly had to be incurred at short term. In 1946, the mean interest rate on government bonds was 2.19 per cent, and 23 per cent of the public debt was at long term. In 1981, the mean interest rate was 12.87 per cent, and only 6 per cent of government debt was long term.

How Much Debt?

The Federal Reserve System sits over the economy, breeding debt like a queen bee of a hive spending its existence in laying eggs. Can a stable price level and stable interest rates be achieved while this debt creation continues? Total dollar debt that ten years ago was calculated at around $1.8 trillion is today around $5.5 trillion, the largest increase occurring during the past 5 years.

During 1981, M3, the broadest measure of “money supply,” increased by $222 billion. Federal debt in the hands of the public increased by $93 billion. Who were the other borrowers? Billions were lent to finance mergers and acquisitions, like those by du Pont and U.S. Steel. One bank alone (First Boston Corporation) boasted that it had underwritten or participated in mergers and acquisitions involving over $30 billion. Other amounts were sunk in loans to indigent foreigners, like Poland and Turkey.

Reduction of interest rates, the price level, and the debt burden, demand what neither the Administration, nor the Federal Reserve, nor the monetarist school yet accept, namely, a restoration of a money of substance. The country can not prosper on a system of perpetual debt, or a system in which the only means of debt payment is another I.O.U. []

Francis Adams Truslow

The citizen who calls on government to supply him with security from the cradle to the grave, thereby encouraging government spending, is a danger to himself and his fellow citizens. If his pleas are successful, he can lose his freedom and gain no security in exchange.