High interest rates are a blessing.
They deflate inflation. They reward savers. They punish those who spend more than they can earn. They return the economy to stability.
Use of credit is the linkage between business expansion and contraction. Use of credit is also the linkage between money supply and inflation. This is true because use of credit determines whether spending is faster or slower than output. This determines change in both the inflation rate and profit margin. Both demand for credit and interest rate levels are determined by this chain of relationships.
The differential between interest rates and inflation is the governor of inflation. The amount and direction of that difference is a predictor of future change.
If a lender is repaid with money that will buy less than the money he lent, then he has lost real value by lending. He has been punished for lending instead of spending. He has not even preserved the value of his capital unless the interest he received more than offsets inflation. His real interest rate has been negative.
Negative real interest rates are far more negative than they seem because interest income is taxed. Taxation of interest income is an automatic "inflation surtax" on the lender. The lender must pay a tax equal to his bracket times inflation times his loan just to preserve the value of the money he lent.
In the same fashion, borrowers are rewarded by inflation. They repay the loan with devalued dollars. They can often deduct their interest cost from their taxable income. Their real interest rates are far less than even the differential between nominal interest rates and inflation.
Since interest rates are set by supply and demand, the tax structure forces up interest rates by punishing lenders and rewarding borrowers.
What seem to be very high interest rates may in reality be low or negative after adjusting for inflation and tax effects. Negative interest rates subsidize those who borrow to spend faster than they earn. Sustained periods of subnormal or negative real interest rates produce a race between inflation and interest rates. Inflation must increase at an ever faster rate to keep real interest rates low enough though the demand for loans is compounding too.
There is no way that interest rates can be kept low compared with inflation without continually increasing the inflation rate. The reverse is also true.
The United States had steadily declining real interest rates for about 15 years. Real interest rates began a downward trend in the mid-1960s. Real interest became negative in 1972 and continued to become increasingly negative until 1981. The rate of inflation was erratic, but continually increased during this period. The rate of change in the inflation rate accelerated during this period also.
Then, at the end of 1980, a dramatic reversal of this long trend occurred. Real interest rates became positive instead of negative. They became positive by even more than the historic 1 to 3 percent real that has been typical during past periods of stability. Inflation will end if true positive interest rates somewhat above normal are continued for long.
Such a reversal can be punishing to some. Those who overspent with borrowed money at high interest will be losers. Inflation will not reduce the loss; neither will it offset the high interest rates of inflation.
Industries whose customers depend heavily on credit will be forced to take much of the cyclical swing from a period of overspending and borrowing to a period of underspending and saving.
Any change in the use of credit up or down can be profoundly disturbing to the stability and productivity of a complex economy. Any shift from a steady state requires time to adjust and produces temporary distortions. As a consequence, any change in money supply that produces a change in interest rates or the credit markets tends to slow down productivity. This is inevitable, since such changes make all normal management controls, plans or indices unreliable.
Monetary easing can hold down interest rates and produce temporary stimulus or even boom. But like a narcotic, such stimulus requires ever greater doses to obtain the same effect. The stimulus can be continued for a time by an ever increasing rate of inflation. But continually increasing inflation can produce disaster. At some point, the whole monetary system breaks down as it did in Germany in 1922-23. But real interest rates will be approximately the same at any steady state of inflation in the absence of war or national disaster.
The apparent high interest rates of 1981 are evidence of the national will to end inflation and restore stability to the economy.