Viewpoint: Interest Rate Compassion

If you were watching the CBS Evening News one night in November then you might have seen Dan Rather introduce a segment on the economy by saying that sometimes the "human realities" get lost in all the economic aggregates, hiding from view the people who are "hurt" by government economic policies. Cut, then, to Mr. Manny Dembs, a homebuilder from Farmington Hills, Michigan, who was testifying before a Senate Democratic Task Force on Interest Rates, chaired by Sen. Donald Riegle of Michigan. Dembs launched into a lengthy diatribe that was very good theater—the reason, no doubt, it was transmitted by CBS-TV—but very bad economics.

Manny Dembs's argument was that high interest rates have hurt homebuilders, including himself, and high interest rates are caused by the Federal Reserve System. Ergo, Paul Volcker and his monetarist minions (Milton Friedman was singled out) are the enemy of the economy in general and of Mr. Dembs's homebuilding business in particular.

The first part of Dembs's argument is correct. High interest rates are not good for business in general. But it is not true that the Federal Reserve "sets" interest rates. Can we not get this into our heads? Interest rates are market phenomena, the price at which the supply and demand for credit are equalized. It is true, of course, that the Fed sets the discount rate, at which member banks may borrow reserves from the Fed, but this rate does not lead the train of interest; it follows in the rear, like the caboose.

Clearly what Mr. Dembs wanted the Fed to do was to expand the money supply. This is within the power of the Open Market Committee of the Fed, which can determine the degree to which the federal debt is "monetized" by buying back government bonds from holders (banks) on the open market. Since these bonds are bought back with electronic money created out of thin air, and since this electronic money becomes bank reserves with the potential to be multiplied later on as a result of bank lending, such debt-dissolving behavior is inflationary in its essence.

In short, it rather looks as though what Mr. Manny Dembs of Michigan wanted the Fed to do was to inflate the money supply so that interest rates would go down so that his homebuilding business would pick up. But why should the value of my savings, and everybody else's savings, be eroded so that some business owners may be bailed out?

That is one question—essentially a moral one. But there is another and more practical issue, which is still far from understood. Does expanding the money supply really drive down interest rates? The emerging monetary aggregates are now closely watched by participants in the money markets. An expansion of the money supply may indeed increase the available pool of credit, but lenders have also become more sophisticated and realize that such an expansion of the pool means that the real value of money will decline in the future. Lenders therefore take action to protect themselves against such a decline in value by demanding a higher interest rate. The "inflation premium" in interest rates will increase.

If this is true—and it seems to be more and more true every day (such changes in market behavior do not happen overnight)—then the Fed not only does not control interest rates, but any attempt it might make to force them down by monetizing the debt will be counterproductive. And if this is so, then we can all heave a sigh of relief, because it means the days of irresponsible Fed behavior must surely be over. Only if the Fed refuses to monetize the debt will interest rates come down.

Of course, we will all be delighted if interest rates do come down. That, at least, all parties may agree on. What, then, can the government do to bring them down? There is one solution, and I'm only sorry that Mr. Dembs didn't seem to realize that the principal culprits were sitting there right in front of him: members of Congress.

The best way of reducing interest rates would be for Congress to stop taxing away that portion of interest which in no sense is income—let alone "unearned income," as it has hitherto been known—but which merely protects the saver from inflation. Such a change in the tax laws could, I estimate, immediately lop three or four points off the interest rate.

At the moment it is just about impossible for a saver who is in any kind of a tax bracket at all (and most people who are in a position to save are in the 50 percent bracket) to protect his savings from the dual ravages of inflation and Uncle Sam. It has taken lenders some time to realize this point. And when they did, interest rates stayed up rather than come down, as they were supposed to do this summer (when commodity prices were dropping). Lenders were no longer being taken for a ride. They were demanding a real, aftertax return.

The CBS News segment conveyed to us the message that real people are getting hurt by an uncaring government. In fact, real people are being hurt by a compassionate government. It is not people like Mr. Dembs who are being hurt by monetarists like Paul Volcker; rather it is people like you and me (and Mr. Dembs) who are being hurt by senators like Donald Riegle: intensely caring, compassionate senators, who care so much that they are willing to tax away savers' inflation-protection, to justify doing so by calling it unearned income, and then to hand out this money—and $50 or $100 billion or so more than is collected, so great is their compassion—to other people who then find that they do not have to work for a living as a result.

It is indeed time for CBS News to point the finger of accusation, but it is softness, not hardness, in high places that is to blame.

Tom Bethell holds the DeWitt Wallace Chair in Communications at the American Enterprise Institute. He is a Washington editor of Harper's and the American Spectator.