THE PRIME interest rate crept up another quarter of a point in the New York financial market this week. That's an interesting example of the way interest rates move in the present economy, with its very large international flows of money and with its floating exchange rates. It's also an illustration of the dangers of thinking -- as the recent Democratic Party convention seemed to think -- that a government can put interest rates wherever it chooses. As the system now operates, a government does not have much discretion in managing interest rates, and mistakes are dramatically expensive.
The current lift in the banks' rates is a reaction to the probability that the recession will be short. The Federal Reserve Board seems to be restraining the growth of the money supply a little, to prevent an inflationary surge after the recession ends. That tightening raises the interest that banks pay when they borrow. The higher prime rate merely indicates that they are passing the cost on to their customers.
What if the Federal Reserve refused to tighten money?Borrowers and lenders alike would read it as evidence that American monetary authorities were prepared to tolerate a higher level of inflation next year than had seemed in prospect as recently as six weeks ago. Some of the lenders would then begin moving their money out of the United States to avoid that rising inflation.
The affect would be a decline in the dollar's international exchange rate. A declining dollar makes American imports cost more, which aggravates inflation further. At that point, the process becomes circular.It's the formula for a dollar crisis. That forces the government to intervene with whatever devices -- sharply higher interests, credit controls, budget cuts -- might be necessary to restore stability.
Real interest rates, most of the time, tend to be roughly equal throughout the world. A real interest rate is interest, in any given country, correted for the expected inflation there. Expected by whom? By the borrowers and lenders, not by the government. If the prime rate is 11.5 percent a year, as it now is, and an investor expects inflation next year at 10 percent, the real prime rate -- for that investor -- is 1.5 percent. It's a highly subjective calculation, which helps explain why rates react immediately to anything that seems to change the outlook. If any investor suddenly decided that inflation in this country was going higher, he might switch his money to Switzerland.Interest rates there are low, but the inflation is still lower.
There was a time when the United States dominated the world economy to a degree that allowed it to ignore the rest of the world in monetary matters. That time ended at least 15 years ago, but the memory lingers in a peculiarly hazardous kind of nostalgias. The expansion of international trade and investment has brought gret benefits to the American standard of living. But it's useful to remember that it also imposes genuine constraints on economic choices.