There are only two ways to bring down interest rates: decrease the demand for credit or increase the supply of credit.
President Reagan has been struggling with record-shattering interest rates because his administration has been almost wholly occupied with the first of these two options. The Keynesian and monetarist "demand-side" economists have dominated thinking about the interest- rate dilemma. They focus on trying to reduce the demand for credit.
Budget director David Stockman, once a supply-sider, has been drawn into this demand-side exercise, hacking away at school-lunch programs, Medicaid and national defense in a desperate attempt to reduce the federal government's demand for credit.
The monetarists sprinkled through the administration likewise have no interest in the supply of credit. Indeed, they specifically argue that the Federal Reserve should pay no attention whatever to the price of credit, i.e., interest rates. They aim at control of the "money supply," as they define money. If there is less "money," people will be able to demand less in the way of wage and price increases.
For the monetarist solution to work, we are told, there must be a period of recession and unemployment in which "people" realize they can't ask for more, because there isn't enough "money" in the system.
Federal Reserve Chairman Paul Volcker is not a monetarist per se, but he is a big believer in recessions as a way of bringing down interest rates. He believes that inflation is caused by workers asking for more money and businessmen granting those demands. He thus will support any idea to induce a recession, a goal he has now achieved.
The supply-side economists put their focus on the supply of credit. If we could increase the supply of credit we could avoid using a recession as a way of lowering interest rates. If we could increase the supply of credit rapidly enough, we could even experience a rising demand for credit with falling interest rates.
The chief instrument to bring down interest rates, though, could not be fiscal policy. Supply- side economists (excepting a few supply-side fiscalists such as Treasury Undersecretary Norman Ture) have always asserted that monetary policy is the key to interest rates. Of course, they believe any assault on credit demand is doomed to failure. The recession only shrinks the economy and its tax base, setting the stage for higher interest rates next year.
The only way to break this spiral is by increasing the supply of credit, basically by making it so much more attractive to be a creditor that people will once again be happy to lend long at low interest rates.
How can this be done? The supply-siders say it can only be done with a gold standard.
Only by announcing that we are going to move toward the opening of the gold window that President Nixon closed in 1971 will people be encouraged to lend long again. Only by guaranteeing the dollar's value as a unit of account, in a specified weight of gold, can the current global liquidity crisis end without inflation. And it surely is a global crisis. It was Robert Mundell, the Canadian economist, who observed 10 years ago when the gold window was closed that it was the first time in 1,500 years that the world was without a single currency convertible into gold or silver. We are in a Greenback era, in which all governments can change the value of their currencies annually, monthly, weekly, daily, hourly.
In the past decade, the U.S. government has repeatedly defaulted on its debt to bondholders --by devaluing the dollar relative to real goods. Prospective lenders to either government or the private sector demand enormous premiums in the form of interest rates. Why should anyone lend to anyone else when the banking is done in dollars or other non-convertible currencies that constantly melt in real value?
It is, after all, not only government that defaults on debt when the monetary standard shrinks; all creditors lose. The more they lose, the less they lend. For this reason, there is almost nothing better that the government can do for its people than maintain a constant value of its unit of account, its currency. People make most of the important decisions of their lives around the value of the government official unit of account. When the government alters its value, or "floats" it, as Nixon did, everyone loses. The debtors may momentarily gain, but inflation poisons the community at large in which debtors live too.
When the dollar is convertible into gold, this is impossible. There are no windfall losses or windfall gains. Debtors pay what they promised; creditors receive what was pledged. As a result, there are no inflation premiums in the interest rate. Once again, people lend long at low interest rates.
If Reagan tomorrow announced a return to convertibility, the rest of the world would rush to join the system. No nation could afford to stay on the paper standard if it wished to continue conducting international banking services. Who would bank in floating Deutschemarks, yen, sterling, francs or lira if the dollar were as good as gold?
We abandoned convertibility, remember, not because we were in a credit crunch, but because Nixon was sold the Keynesian idea that a devalued U.S. dollar would make us more competitive with the Japanese. The monetarists persuaded Nixon to float the dollar altogether in 1973 so they could try another of history's periodic experiments with a paper standard.
Stockman believes convertibility would mean an initial period of illiquidity, a wave of bankruptcies. But that is what we are now experiencing. Gold ends the liquidity crisis that is endemic on a global scale because there is no international monetary standard of value. When the supply of credit expands, interest rates tumble and relieved debtors and creditors can happily refinance.
Before we get to that point, though, there must be a general awareness in Washington--in the White House and on Capitol Hill--that there is more than one way to bring down interest rates. Cutting the demand for credit, the method attempted thus far, is the wrong way. The "cure" is worse than the affliction in that it embraces poverty and unemployment as necessary side effects to lowering interest rates.
Expanding the supply of credit is the only positive solution. It can only be done by reestablishing the dollar's link with gold, reestablishing the value of the accounting unit in real terms. Until the president moves decisively toward this positive solution, he and his administration and the world economy will continue to suffer, and it will get worse.