Growth, Money and Interest Rates Jude Wanniski May 16, 1997

Supply-Side Economics Lesson No. 23

Memo: To Website Students
From: Jude Wanniski
Re: Growth, Money and Interest Rates

The question this week is from Michael Zilkowski of Saskatoon, Saskatchewan: "If the economy continues to expand and the demand for money rises, do interest rates have to rise also?"

This is not going to be an easy question to answer, but it is pertinent to the debate that is going on in Washington, having to do with Federal Reserve Chairman Alan Greenspan's concern that the economy might grow so fast that will cause inflation. This leads Greenspan to worry that the rising stock market reflects "irrational exuberance" about future economic growth and leads him to raise the one interest rate the Federal Reserve controls directly — with the express aim of slowing down the exuberance in the market, growth in the economy and the inflation that is supposed to follow. This is in line with Zilkowski's question. In his most recent speech, Greenspan added a new concern, which he had not expressed prior to the Fed's interest-rate increase six weeks ago. That is, he worried about "excess credit creation."

Now, eminent economists have written entire tomes attempting to answer the basic question. Das Kapital by Karl Marx devotes a chunk of its space to these mysteries. Ludwig von Mises, the great Austrian economist, devoted an entire book, Theory of Money and Credit, to the subject, as did his Austrian confreres, Friedreich von Hayek, whose book Prices and Production assembles lectures on the subject he gave at the London School of Economics in 1932. From another angle. Milton Friedman has spent a good part of his career on the topic of money and credit. John Maynard Keynes expostulated on this subject as well. In my attempts to find out what they had to say, I can't say I was ever overwhelmed by any. Robert Mundell lent me a copy of his book on monetary theory, only 200 copies of which were printed 30 years ago, and I learned a few important things from it. The most important was in letting me see paper money as non interest-bearing debt of government, just as monetary gold earns no interest. I also learned a lot from von Mises Human Action, as it discussed inflation and deflation and the role of the entrepreneur in the production process. All of these works have plenty of loose ends, which suggests to me that the definitive book has yet to be written. I will suggest that the definitive book on money and credit will profit from my 1977 thesis that the stock market crash of 1929 was caused by the Smoot-Hawley Tariff Act of 1930.

Why? Because all the great books mentioned above proceeded from the assumption that the cataclysmic crash and the Great Depression that followed was largely a monetary phenomenon. That is, even von Mises and von Hayek went along with the conventional wisdom of the monetarists and the Keynesians that the Federal Reserve and the private banking system combined to screw things up, resulting in the puncturing of the Wall Street bubble. Proceeding from that assumption, every one of these great minds were misled at least in some way, large or small, in their understanding of the connections between growth, money and interest rates. Reuven Brenner, who was guest lecturer at Supply-Side University two weeks ago, seems closest to me in seeing the interaction of the ideas of Frank Knight, Robert Mundell and Ludwig von Mises, who are the men whose ideas most helped me put together my understanding of economics.

Having said all this, in getting back to the original question, my answer has to be no, I do not believe interest rates need rise in an expanding economy. The argument that interest rates must rise when there is an economic expansion is based on the simple law of supply and demand, which says there is always a price that clears the market — where supply exactly equals demand. If there is an expansion of demand for credit while there is an increase in the supply of credit greater than the increase in demand, economic growth will occur against a background of falling interest rates. The presumption that interest rates will rise in an expansion follows the assumption that the borrower of capital is more interested in borrowing than the lender of capital is in lending. This does occur at times, and when it does economic expansion will occur against a background of rising interest rates. Interest rates must also rise when economic expansion has reached a point where the supply of fresh capital has been depleted and cannot be replenished with superior monetary and fiscal policies. Then, interest rates must rise to allocate marginal capital.

Start from a point of equilibrium in order to follow one scenario or another. That is, all the capital that wishes to be employed is employed, the price of capital having cleared the market, and all the labor that wishes to be employed is employed, the price of labor having cleared the market. The lenders have loaned all the resources they wish to lend and the borrowers have borrowed all they wish to borrow. If in this condition there is an event that causes the expected return on the investment of capital to enjoy an increase, lenders of capital will be more willing to lend or invest, and will increase their lending at no increase in interest rates or no decline in the price of equity. The supplier of capital will lead the parade. Borrowers of capital who, at the margin, had all the capital they desired, would stand aside with this new infusion of capital. This would allow those who wished to borrow, but could not find takers for their stocks and bonds, to suddenly find suppliers willing to take it in exchange for real goods, or claims on real goods, i.e., money. In other words, I will buy your bond or your stock with money and you will use the money to pay the factors of production in your enterprise. Where did I get my money? I got it by deciding to sell some of my unused time, energy or talent for money in order to buy your stocks or bonds, and in the broad marketplace, you are using the money to buy an equal amount of my time, energy or talent in order to pay the factors of production in your enterprise.

In The Way the World Works, I noted that between 1815 and 1851, the United Kingdom experienced the most explosive economic growth that civilization had ever experienced. It did so having begun the stretch with a national debt that had grown to monumental proportions during 22 years of war with Napoleon. Throughout the expansion, interest rates steadily declined until they leveled off at about 2% where they remained for the rest of the 19th century. In the United States, the most explosive growth occurred in the decade from 1879 on, with interest rates also in the 2% range.

How can this happen? It can happen because growth is the result of risk-taking. Not all risks produce growth, but if there is enough risk-taking, growth will occur. If the risks required for growth are reduced, more growth will occur. If the rewards to successful risk are increased, more growth will occur. The concept of "excess credit creation" means that someone who wants to extend credit to someone who wants to accept credit under conditions they both agree upon are doing something excessive. Von Mises believes it is possible for excess credit creation to occur, but only briefly if it occurs under a gold standard. That is, the credits that are extended can only extend so far before the absence of liquidity causes the inflationary boom to be corrected by a deflationary bust. I e-mailed the query to Prof. Reuven Brenner McGill at his home in Montreal; here was his quick response:

"If I recall -- and I do not have von Mises at home -- his excess credit creation view was the following: that there are times of, yes, what Greenspan called, excessive optimism, when banks give money to projects of lesser and lesser quality, many of which will fail. Unless there are unexpected spectacular successes to absorb the money advanced to the defaulting firms, there will be inflation. For, the money is there, but nothing was after all sold by the defaulting firms. It is similar to a situation when more money was printed, chasing, after all, fewer goods and services than expected. I never quite bought this view, because if you have the stock markets and bankers" self correcting institutions in place, this cannot be significant. Of course the story is different in places where the government creates credit for the State Owned Enterprises, which produce things nobody wants to buy. Then you have excessive credit creation - but that's the governments' and central banks' fault, not the market's. If banks are supported by the Fed (implicitly) -- as with the S&L's, you may have a similar problem."

Von Mises, if he were still alive, would no doubt agree with Prof. Brenner, that if gold were anchoring the system, preventing excess liquidity from building up, "excess credit creation" could not be significant. Gold "self-corrects" because it signals the central bank, when its dollar price rises, that there is more liquidity than non-inflationary commerce requires. The banks get stuck with the losses for their imprudence, in lending to projects of lesser and lesser quality, or the stock market knocks down the value of equity issued to support projects of lesser quality. Without gold as an anchor, the central bank can err in the direction of too much liquidity leading to inflation, or too little liquidity leading to deflation. If the market sees either occurring on a sustained basis, it automatically has to factor in higher risk to all enterprise, which puts up interest rates. As a result, marginal enterprise that otherwise might have been financed, is not. Growth slows. In the current world, Greenspan's dithering about what he and his colleagues have in mind for the future tells the markets that the Fed really doesn't know what it is doing. Every time he has spoken in the last several months, he has changed his theory of growth and inflation. This is why interest rates are so high, almost 7%, even though gold at $350 is about where it was when Greenspan took office as Fed chairman a decade ago.

In Zilkowsky's question, remember he asked if the economy expands and the demand for money continues to rise, do interest rates have to rise also. The phrase "demand for money" is something I had a hard time understanding. At first I thought of a bank robber "demanding money." But Art Laffer reminded me that my method of demanding money was to offer my supply of labor to the market. I could also "demand money" by offering goods I had produced to the market. You demand bread and I demand wine, you supply wine and I supply bread, so we make a deal. For most of the history of the world, gold (or silver) had been the proxies for all goods offered to the market. There are several uses of "money," one being a medium of exchange, another being a store of value, which means people "demand money" for different reasons. The most important function of money, though, does not involve supply or demand at all. The highest purpose it serves is as a unit of account. A "dollar" is fundamentally a concept, not a thing. People don't demand concepts with their labor or goods. They demand things. But a unit of account is critical for the world of commerce. It's how everyone on earth who is exchanging labor or capital for goods or services or fiduciary media keeps track of the values involved in these transactions or contracts. A unit of account without integrity, means every one of the billions of transactions made every day are costlier than they need to be. The easiest way for President Clinton to lower transaction costs around the planet would fall, be to end Greenspan's dithering and fix the dollar/gold rate to re-establish an honest accounting unit. [After you go through this lesson, you may want to revisit Lesson 13, "A Gold Polaris." of February 26.]

As the economy expands, there is an increase in the demand for money not in the sense that the economy needs more accounting units. One is enough. It is because expansion requires more circulating media. The Federal Reserve can only know this demand is consistent with an honest unit of account if demand shows up as a fall in the price of gold. If gold falls from $350 to $349, we know, and Greenspan and his colleagues should know, that the world would like a little bit more liquidity — in the form of non interest-bearing debt of the U.S. Government. Either cash or bank reserves.

So if economic expansion is occurring coincident with an increase in the demand for money, interest rates do not have to rise, and they could even fall, if the market understands that the U.S. government is going to maintain an honest accounting unit indefinitely.

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