How high must interest rates rise?
Gerard Jackson
Before trying to explain why interest rates can rise significantly during an inflationary boom, even when general price rises are modest, I shall first dispose of the myth that has gained support among the economic illiterati that using interest rates to curtail spending proved a failure during the Australian boom of the1980s and only resulted in causing interest rates to rocket into the 20 per cent range.
I distinctly recall that in 1988 journalist after journalist complained that tight money wasn't working even though interest rates were steadily climbing, which only proved how economically ignorant and lazy most journalists are. Let us get down to some basic facts. Under the chairmanship of Bernie Fraser the RBA (Reserve Bank of Australia) virtually froze credit expansion from 1989 to July 1991. From August of that year it rapidly accelerated again.
From January 1983 to January 1989 deposits zoomed by 121 per cent and M1 by 110 per cent. (Fraser did not become RBA chairman until 1989). This policy of unleashing an avalanche of credit into the economy triggered an inflationary boom that eventually forced interest rates to rise. This rise convinced lazy journalists and incompetent media commentators that the RBA must have tightened the money supply. After all, they reasoned, a tight monetary policy is always the cause of rising interest rates. No it isn’t.
This invites the question of what made interest rates rise even when credit expansion came to a virtual halt. I doubt that it could have been the price premium given the wide gap between rates and the CPI. The clue, I believe, could be seen on our cities’ skylines which were dotted with cranes and sprouting office blocks. Austrians understand that forcing interest rates below their market rates ignites inflationary forces that induce overinvestment in certain stages of production. These excess investments (what Austrians call malinvestments) eventually appear as idle capital.
The Austrians also point out that when capitalists make an investment it is on the expectation that the necessary complementary investments are also being made and that interest rates will not rise, at least not by a significant amount. Unless these conditions are met the investment will fail. As interest is not only the means of equating the supply of capital with the demand for capital but is also the instrument that allocates capital through time, so to speak, it is the most vital price in the economy.
The proposition is that the demand for savings will depend on the extent to which the investment has been completed. Clearly, where projects have already advanced there will tend to be little response in demand to changes in interest rates, meaning that the demand for capital will be inelastic with respect to significant changes in rates. Hayek demonstrated that if capitalists expected an interest rate of, for example, 4 per cent to be the norm they would, under certain circumstances, continue their activities until interest rates rose to about 12 per cent. (Profits, Interest and Investment, Augustus M. Kelley, Clifton 1975, pp. 77-9).
There was nothing new in what Hayek was saying. Henry Thornton observed that when the rate of interest has been forced below its market level businesses will
obtain their loans too cheap. That which they obtain too cheap they demand in too great quantity. To trust to their moderation and forbearance under such circumstances, is to commit the safety of the bank to the discretion of those who, though both as merchants and as British subjects they may approve in the general of the proper limitation of bank paper, have, nevertheless, in this respect, an individual interest, which is at variance with that of the Bank of England. (Henry Thornton, An Enquiry into the Nature and Effects of the Paper Credit of Great Britain (1802), London: George Allen and Unwin, 1939, p. 255)
Henry Thornton's insights extended to the nature of the business cycle and the disproportionate changes in prices and the pattern of production caused by monetary expansion. (Unfortunately Thornton's book was badly structured and worded. The word 'prolix' doesn't begin to describe it). Without being aware of Thornton's work Wicksell also came to the conclusion that artificially lowering the rate of interest encourages businessmen
to extend their businesses in order to exploit to the maximum extent the favourable turn of events. And the number of people becoming entrepreneurs will be abnormally increased. As a consequence, the demand for services, raw materials, and goods in general will be increased, and the prices of commodities must rise. (Knut Wicksell, Interest and Prices, Sentry Press New York, 1936, p. 106).
(Having exposed the fallacy that forcing down the rates of interest promotes economic growth he fell prey to the extremely dangerous error that the when the natural rate of interest coincides with the money rate prices will be stabilised)*.
We can now deduce that the reason why interest rates would eventually rise, even in the absence of a price premium, is because the current rate signals there is more real capital available than actually exists. This leaves capitalists competing against each other for a much smaller pool of savings. It is this competition that eventually drives up rates near the end of the boom. This clearly shows that even if official interest rates were kept artificially low interest rates to businesses would still eventually rise.
The above reasoning leads to the conclusion that where the rate of interest has been driven down for a prolonged period the central bank will usually have to raise them significantly to halt the resulting inflationary boom. This is the main reason why interest rates rose to unprecedented levels near the end of the ‘80s boom. It was not until late 1989 that cash rates and the prime rate began to fall.
*In an address to the Australian Business Economists and the Economic Society Glenn Stevens — who is now Governor of the Reserve Bank of Australia — explained that in targeting the correct rate of interest they rely on Wicksell's "concept of the natural or neutral interest rate". This should frighten people because — to put it bluntly — Stevens does not know what he is talking about. (Recent Issues for the Conduct of Monetary Policy, 17 February 2004). Anyone who discusses Wicksell's "natural rate" must always bear in mind that it is based on the marginal productivity of capital as it would be in a barter economy. But it would be impossible for a uniform rate of interest to emerge in such an economy. Hence the concept is completely untenable. No wonder Australia is suffering from a severe monetary disorder.
Gerard Jackson is Brookesnews' economics editor
BrookesNews.Com
Monday 17 February 2008