A fortnight ago, the Federal Reserve raised its base rate for the 17th time in two years, to 5.25 percent. The purpose of the hike was to fight inflation, classically defined as too much money chasing too few goods. Higher interest rates are thought to suppress the demand for credit, and with it, the specter of too much liquidity baying after goods, services and transactions.
Reaction to the Fed move was less than positive. “Idiotic,” “delusional” and “senseless” were some of the words thrown out by people I spoke with or read. Whether the critics are right or wrong, there’s one aspect of the Fed’s inflation-fighting strategy that seems to me to beg an important if not a vital question.
Here it is: (1) The U.S. economy, especially the consumer sector, is fuelled by credit as much as by energy and information technology; I doubt there’s a single price component in the C.P.I., or the core index, or whatever else the juju folks at the Federal Reserve look at in their inflation-detecting deliberations, that doesn’t to some extent reflect the use of borrowed money on the cost side. (2) If the Fed raises the price of money month after month after month, don’t these increases eventually feed into the upward pressure on the indicial price of goods and services? Inflation can be cost-pushed as well as demand-pulled, depending on which stage of production and consumption you’re looking at.
One therefore asks: Mightn’t the Fed be doing its bit to contribute to the very inflationary trend that the Fed is raising rates to fight? In other words, is the Fed fighting inflation with inflation? Can this work? As the King of Siam exclaimed, Is a puzzlement! Will Mr. Bernanke please explain?
There’s not a business or household in America that doesn’t to some extent or at some point rely on borrowed money, mainly adjustable-rate credit, whether we’re talking about a family’s home-equity loan or a company’s bank line to finance inventory or an individual’s credit card. The cost of credit—to buy goods, build facilities, train and hire people—is a key component of the price at the pump, the wellhead, the loading dock, the cash register. It isn’t just the price of crude or direct refining and transportation costs that are reflected in a gallon of gas; financing costs are in there too—money borrowed to build refineries, lay pipelines, buy tanker trucks or take over other oil companies. Push up the cost of the cost-of-money component with 17 raises of 25 basis points or better and the money cost of 20 gallons at the pump will escalate without any help from OPEC or the commodity speculators. That’s inflationary.
In the late 1970’s, Paul Volcker was given the go-ahead by Jimmy Carter (although I’ll bet nine out of 10 would tell you it was Ronald Reagan) to squeeze inflation out of the economy. This Mr. Volcker accomplished by raising rates into the middle to upper double digits. Household purchasing power and leveraged transactions were stopped in their tracks, a spiky recession ensued, inflation went poof—but so did thousands upon thousands of decent small businesses whose existing operations were premised on what seemed a reasonable range of money costs, and so did God knows how many households whose budgets were blown up.
I speak with some feeling on this point: I owned one of those small businesses. We had financed the enterprise with 8 percent money; we figured we could hang in there even if the interest on our loan went to 12 percent, but when Mr. Volcker pushed the rate to the point where our bank demanded 19 percent, we were dead. I suppose this is what the followers of Joseph Schumpeter (now there’s a name you seldom hear nowadays) would laud as “creative destruction.” We didn’t find it so, nor did our bank, the employees who were let go, our suppliers or the small towns in which our facilities were located.
What these Fed increases also ensure is that consumer indebtedness isn’t paid down. Many if not most households living on Visa or MasterCard have a monthly budget of $X for debt service. As do many small businesses. When the interest rate on credit-card installment balances rises to 25 or 30 percent—the level that Citibank is telling its customers a missed payment will now take them to—a cardholder’s chance of getting out of the hole has gone from minimal to zilch. Funds that might have been earmarked to pay down principal are now diverted to interest. This simply ensures that borrowers stay in debt longer at rates of return pleasant to the lenders—which is a fine recipe for intensifying the wealth disparity that’s already sufficiently egregious in this country.
Is that really what we want? The point of borrowing money is to pay it back. Indeed, I think you can make the case that debt repayment is a form of productivity. And productivity—getting more economic output per unit of economic input, whether the latter is a B.T.U., an hour of labor, a dollar of investment—is generally viewed as the only humane cure for inflation. This was how Alan Greenspan justified flooding the economy with zero-interest dollars. More bang for more bucks. Read Bob Woodward’s Maestro (2000); productivity was Mr. Greenspan’s rosary as he sat there, pedal to the monetary metal.
The bottom line seems to be that the Fed’s interest-rate policy chokes off new borrowing while making borrowing in place more expensive. That strikes me as offering the worst of both worlds.
I think the solution is moral rather than mechanical. I think that what drives inflation is fiscal and financial waste, the throwing away of resources, or their misdirection. I think this spendthrift government—legislative and executive—is the true inflationary engine. But Wall Street does its share. The expectation of raising prices is every bit as much a core principle of leveraged “private equity” investment as is cost reduction.
Once upon a time, I clearly recall the Fed addressing Wall Street’s contribution to inflation by jawboning down the demand for money. The Street and the banks were told in no uncertain terms to put the fun and games on the back burner until the situation straightened out. No leveraged buyouts or takeovers, stock and investment plays, stuff like that: I believe the rubric used at the time was “nonproductive loans.” In today’s world, this would mean that the powers over which the Fed wields persuasive dominion, the Street and the banks (and thus, by extension, the hedge funds and private-equity players), would be asked to cool it for a bit. The object would be to slow down the game without spoiling it. Given the levels of take-home pay on the Street these days, one wouldn’t think a brief hiatus would hurt all that much. The object would be to try to reserve the nation’s and the system’s credit resources for plant and equipment, broadly speaking, and for the re-liquefaction of the consumer, rather than to finance the leveraged movement of pieces of paper.
Does any of this make sense? Probably not. Nowadays, nothing seems to.
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