James Cumes
SvZ Net 2009
Studien von Zeitfragen

James Cumes

Gardiner CreditThe Indigent Rich and The Rate of Interest

Remarks by James Cumes on the occasion of a New Book
On Creditary Structures
by Geoffrey W. Gardiner, 4.5.2006

During the past thirty-seven years, most national economies and the global economy have been dominated by issues related to inflation, money supply and credit. The period has been marked by unstable currency, stock and real-estate markets, and burgeoning speculative as distinct from real economic enterprise. Within the complex of problems and quests for solutions, the rate of interest has been a central preoccupation for governments, banks, traders, economic and financial gurus and laymen alike.

It has established itself overwhelmingly as the principal instrument of economic and financial management. Therefore, an understanding of what it is and what it does is crucial to an understanding of what has happened in the past and what changes might be necessary if we are to achieve more stability and more confidence in our future economic and financial policies. As always, those economic and financial policies will have an array of direct and indirect effects on social, political and strategic situations with which they are inevitably linked.

The interest rate, we might reasonably suggest, is the price for hiring money or obtaining credit. It is the price you will pay for having a certain amount of liquid resources in your hands or under your control, for use in direct or indirect investment, for speculation or gambling, or for some form of consumption, whether essential food, clothing and shelter or entertainment, pleasure, relaxation or conspicuous waste.

It was the hike in interest rates by the Fed in July 1969 that, in alliance with some simultaneous fiscal measures, marked the transition from the stable post-World-War-Two economy to the increasingly free-wheeling and mismanaged instabilities afterwards. The action of the Fed in July 1969 inadvertently precipitated stagflation and the array of problems that followed. Although, simultaneously, the Nixon administration imposed fiscal restraints, it was the interest-rate rise that had the most significant impact and, even more importantly, it was the interest rate that became the most common and most potent instrument of economic and financial management subsequently. The fiscal factor, though not neglected, especially under Presidents Reagan and Bush the younger, tended largely to hover in the background. By contrast, rumoured changes in interest rates, speculation about such changes or declarations of intention or actual decisions by central banks increasingly became headline news. Front-page press headlines such as those of 19 and 21 November 2005 reporting "ECB making a risky bet" or "Trichet signals that ECB will raise rates" have become routine and typical of popular as well as financial news coverage, in the United States, the European Union, Japan and other countries around the world.

Within a year of the hike in interest rates in July 1969, American industrial production declined by some 7% and unemployment jumped by a million. The unexpected feature however was that the cut in production and the leap in unemployment were accompanied by an increase in inflation, giving us what was then seen as a new phenomenon. Appropriately it was given a new name: stagflation.

This was of course not what those who hiked interest rates had intended. The intention had been quite the opposite: to reduce inflation and/or to ease inflationary pressures then and in the future. That was the conventional wisdom of the time: higher interest rates "fight inflation."

There was very little expression of any contrary opinion. An interest rate hike would relieve inflationary pressures. In the other direction, an interest-rate cut would tend to expand demand in relation to supply and quench any tendency towards deflation in the economy. So the orthodox economists and policymakers believed. So indeed, with few exceptions, they still believe.

Indigent Rich

Indigent RichThere was only one published expression of dissent at the time. That was in 1971 in The Indigent Rich. "What is in fact needed to restore equilibrium at the upper, inflationary level of the modern, Keynesian economy is not more unemployment but less unemployment, not less production but more production."

"The Indigent Rich" was followed, in 1974, by "Inflation: A Study in Stability", in which I said, carefully at one point -

“Certainly, the rise in the interest rate will have some effect on the economy. Indeed, it will probably have a major effect. The greater the interest-rate rise, the greater - probably - the impact. In certain circumstances - although this needs closer investigation - the movement in interest rates might be the most thrusting element in increasing prices, wages and incomes and the major destabilising element in the modern economy.

As the productive economy is largely based on various forms of credit, the rate of interest might be the most potent single force in changes in the balance between production and consumption and thus in changes in prices and, partly by derivation, in wages.”

At a later point, this was spelled out in more detail -

“We need to re-appraise the role of the rate of interest in the modern economy. Its significance has always been a matter of some mystery. It can be - or has seemed to be - a simple agency for equilibrating the demand for and the supply of money. Or it can be, as Keynes saw it, a price for overcoming liquidity preference: 'the rate of interest at any time, being the reward for parting with liquidity, is a measure of the unwillingness of

those who possess money to part with their liquid control over it.' The rate of interest can be a means of reversing trends in the trade cycle and of mitigating its effects. It can be a stimulus to the flow of short-term funds internationally and thus a destabilising element in the balance of payments. Through its domestic and international effects it can, ultimately, destroy the stability of a high-employment economy and undermine the international monetary system.

If it doesn't do all of these things, it can perhaps do some of them. But several things can certainly be said about it:

The rate of interest has a significant role in the modern economy. Its role in the economy now is different from that which it had twenty-five years ago, because the economy in which it operates is different.

A rise in the rate of interest will have a depressing effect on those parts of consumer spending (such as purchase of houses) which, because they involve large outlays, are therefore dependent on credit.

But other consumer spending will remain high and might even be increased inter alia, by the transfer of expenditure from the interest-dependent objects.

On balance, therefore, a rise in the rate of interest is likely to have a relatively small net effect on consumption but it is likely to have a relatively large net effect on production and could cause unemployment or move employment away from production to, for example, consumer marketing.

Through its effect on production and employment, a rise in the rate of interest will therefore tend to intensify inflation and a fall in the rate will tend to reduce it.

More directly, the rate of interest will have an effect on production costs, especially on those industries that are heavily dependent on borrowed funds and this impact on costs will again intensify inflation if the movement in the interest rate is upwards and reduce inflation if the rate moves downwards.”

A Letter to the Financial Times

That was written in 1974. Apart from my subsequent writings, attitudes towards the rate of interest and its impact on the economy remained unchallenged until the Financial Times of London carried a five-column headline above a letter written by Geoffrey Gardiner in 1988. The headline read: "High interest rates are no more a cure for inflation than bloodletting was for fever."

The Gardiner letter outlined some of the history of thinking about the impact of the rate of interest. Then and later, he noted that the early British economists all took the view that high interest rates cause high prices. Around 1621, Sir Thomas Culpeper and his son both campaigned for lower interest rates so that English merchants could compete with the Dutch who rejoiced in lower rates.

The idea that high rates of interest will reduce prices seems to have originated in 1832 when a committee of the British Parliament looked at the monetary and banking system of the day and produced a report known as the "Minutes of the Secrecy Committee", which now resides in the archives of the Bank of England.

It was the Governor of the Bank of England at the time, J. Horsley Palmer, who, in answer to No. 678 of more than 5,300 questions posed by such people as "Mr Rothschild" and "Mr Baring", gave an answer for which he offered little empirical or other supporting evidence. He said that, if one made money more expensive, by which he presumably meant higher interest rates, lending would fall and so would prices. That was in 1832. The Palmer doctrine, if it deserves such a respectful title, has prevailed ever since, right up to the present day.

The hike in interest rates that was crucial for our era was that made in July 1969. In 1971 and 1972, the new Chairman of the Fed, Burns, did in fact lower interest rates for a time and is credited with having helped Nixon's re-election in 1972 by his "accommodative" handling of monetary policy. The cut in interest rates was said to have been intended to offset Nixon's price and wage controls. Consequently - and ironically - Burns has since been roundly condemned for cutting interest rates and thus igniting the inflation that plagued the American economy during the rest of the seventies and into the eighties. Those who still condemn him have no clearer idea - even now - of what the relationship is between the interest rate and inflation than the Chairman himself did more than thirty years ago. All of them have lived and still live contentedly with J. Horsley Palmer's fuzzy conviction of 1832.

That isn't quite the whole story; but it is necessary to go back nearly fifty years before the events of the early 1970s to discover any significant discussion of the possibility that an increase in interest rates was, in fact, linked with an increase in consumer prices, that is, with an increase in inflation as popularly understood.

It was in January 1923, in an article in the Bankers Magazine, that A. H. Gibson put forward the notion that a rise in interest rates was to be associated, not with a reduction but with an increase in inflation. Like The Indigent Rich of 1971 and Inflation of 1974, Gardiner's letter of 1988 in The Financial Times had had no apparent impact on thinking about embedded policies and attitudes towards the rate of interest. In 1993, therefore, he wrote a book, "Towards True Monetarism" in which, after twenty -four years of monetary policy based firmly on the conviction that an interest-rate hike reduced inflation, he said (following quotes are from pages 42-44 and 116 in the book) -

"The suggestion that, contrary to standard doctrine, there is a historical correlation between rising prices and rising interest rates, the latter being caused by the former, and that lower interest rates lead to lower prices, appears to have been first publicised by A.H. Gibson in an article in the January 1923 issue of the Bankers Magazine. Gibson's revelation is not mentioned in the popular textbooks. In 1930, after five years work, Lord Keynes published his Treatise on Money in two volumes. It is a work with failings, some of which he appears to have later acknowledged, but in the second volume Keynes makes up a little for its faults, not only by publishing Gibson's discovery, but also by expanding the evidence for it. On page 178 of the second volume Keynes makes this fascinating comment on Gibson's theory,

'The Gibson paradox - as we may fairly call it - is one of the most completely established empirical facts within the whole field of quantitative economics though theoretical economists have mostly ignored it.'"

Keynes' statement that empirical facts "completely established" the Gibson paradox was, of course, further validated by what happened after July 1969: inflation increased and did so to a quite unexpected and remarkable extent. Part of this result may fairly be attributed to the welfare programs introduced by President Johnson in the 1960s, as part of his Great Society. In what was clearly something of a softener to those who would suffer most from the restraint policies of his administration and the Fed, Nixon acted to maintain personal incomes. Specifically, he sent a message to Congress on 8 July 1969 in support of legislation to extend unemployment insurance which he described as "an economic stabiliser."

Cold War defence spending and the hot Vietnam War also intensified inflationary pressures, as did the oil-price shock in 1973. However, although there were these additional factors in the American situation in 1969 and later, they did no more than intensify the effect that the interest-rate rise had on inflation. In other words, stagflation was caused by interest-rate hikes and intensified by such other factors as the welfare stabilisers and defence spending.

In this connection, Gardiner wrote -

"Expanding Gibson's own figures Keynes prints a comparison of the yield on Consols with the wholesale price index for the period 1791 to 1928. The two sets of data march in step. It is more than likely that the data could be extended up to the present day with the same high correlation that Keynes revealed except for the unusual wartime period, 1939 to 1946; but even during five of those seven years, throughout which Bank Rate was two per cent, the rate of price increases was remarkably low by the standard of the 1980s. As the level of interest rates between 1940 and 1946 was influenced by Keynes, he must have kept in mind Gibson's Paradox. He cannot be accused of ignoring it himself."

The United States had a similar experience. On 27 November 1985, Lord Beswick told the British House of Lords that a Congressional Sub-committee reported on 21 September 1961 that "the period from late 1939 to 1951 was as violent and catastrophic as any in the entire history of the United States. At the beginning of this period millions were still unemployed from the great depression. A short time later we were shooting away 250 million dollars every day on the battlefield ... Then came the Korean conflict. Yet during this entire period of economic stress and turmoil the interest rate on long term Government bonds never exceeded 2 and a half per cent. And those bonds never sold below par". Lord Beswick said that the report added the comment "The Fed can restrain higher interest rates when it wants to".

There is one point in Gibson's doctrine that needs clarification. He says that rising prices "cause" rising interest rates, rather than that rising interest rates "cause" inflation. On this point, Gardiner writes that –

"It is long-term interest rates which the Gibson Paradox correlates with prices. The correlation, which is very high, is not quite so strong for short-term rates of interest, but, according to Keynes, it is still highly significant. One interesting thing about Gibson's data is that it clearly shows that the rise in interest rates follows the rise in prices, not the other way around. This is surprising, as one would expect rising interest rates to push up prices. The much higher interest rates of more recent times certainly pushed up both costs and prices."

There is little doubt that Gibson would have found "the modern theory of the relationship of interest rates and inflation rather curious" - and curiously naïve and unconsidered. "He would have considered that low interest rates on gilts encourage the application of savings to real investment in the hope of a better return. Real investment (plant, machinery, and other productive assets) if effective, should reduce real prices because it should lower production costs. Gibson's reason for the fall in the prices of basic commodities at the time he was writing was the big investment made in food and raw material producing countries in the period 1907-1913.. In the later decades of the twentieth century it has perhaps been more correct to say that the cost of energy, and especially oil, is the ultimate regulator of costs (if indeed there is one)."

Apart from Gardiner's distinguished work, the link between the rate of interest and inflation was described, as far back as 1974, in "Inflation: A Study in Stability", as follows:

"The effects of interest rates are complex. But certain it is that a rise in the interest rate means a necessary narrowing of that range of enterprise that will be profitable without a further escalation of prices. The deterrence that this provides to maintaining or increasing production will itself cause an increase in prices through pressure of sustained demand on static or reduced supply. If an increase in interest rates is combined with some price-fixing or price-justification arrangements, the effect on production, and ultimately on the price level, will be all the greater.

"Higher interest rates will also cause a diversion of investible funds from direct investment in production (including that through stock exchanges) into mortgage and consumer lending. Why should an investor take the risks of enterprise when he can get ten per cent or more clear on a safe mortgage or about as much on finance -company notes? There will thus be increased pressure from the consumer demand side just at the time that there is a weakening of incentive on the supply side to meet it.

"That brings us to the need to apply policies to restrain, or restrain the growth of, consumer demand at the same time as incentives are provided to increase production."

The stagflation of the 1970s, which affected many countries apart from the United States and which provided formidable empirical data to support the Gibson Paradox, should have inspired a close examination of the impact of interest rates on inflation but, curiously, it did not. Not only did conventional wisdom remain unmoved but the policies of using hikes in interest rates to fight inflation became more deeply entrenched. At the end of the 1970s and the early 1980s, the practice was to raise interest rates to fight inflation and then, if inflation persisted or moved even higher, to move interest rates even higher too, so that the misconceptions about the interest rate caused the impact on the economy and the society to escalate from damaging to disastrous.

There was a tendency to regard this imposition of suffering on a wide variety of people in the economy, as unavoidable and almost a "moral" requirement - a discipline of sackcloth and ashes that would purge the economy of its sins. Again, this applied to other countries as well as the United States. When a renewed bout of inflation occurred in Australia in the late 1980s, the Australian Government applied its usual policies of hikes in interest rates. That caused a sharp recession. The impact on employment and income, especially of lower-wage people, was even more severe than usual and caused real and widespread distress. The then Treasurer and later Prime Minister Paul Keating tried to assuage the stricken by saying that it was "the recession we had to have." No doubt he believed that his imposition of monetary and credit discipline would mean a stronger economy and better times for its people in the years ahead. However, he showed no understanding that the interest-rate increases that had provoked the recession would stimulate further inflation or, as did indeed happen, shift inflation from domestic price rises to even larger deficits in the balances of trade and payments. There was no sign either that the government glimpsed in any way that their policies were draining the secular strength of their own economy by gutting Australian industry and adding further to the dramatic growth of the highly competitive economies of south-east Asia.

Gardiner sums up the position as he sees it, as follows:

"Price variations which arise from natural variations in costs of production, such as the variation brought about by investment in more efficient machinery, are quite a different thing from what we now know as inflation and deflation. Inflation, which has been the main bugbear of the second half of the twentieth century, is not necessarily a natural phenomenon. It may have little to do with underlying costs. Instead it may have as one of its main causes excess demand arising from the unregulated creation of credit. One can see a dilemma: even if it were true that high interest rates discourage the creation of credit, it would still be true also that they discourage the investment which might reduce real costs of production, and expand the economy. Surely the latter objective is more important than the former? If, however, the monetary economists are wrong, and high interest rates cause both inflationary and real price rises, and they also lower the rate of investment, one threatens the economy with a triple jeopardy whenever one raises interest rates in pursuance of an erroneous theory."


This prompts us to draw what are crucial distinctions between (1) asset-price inflation, (2) consumer-price inflation and (3) fixed -capital investment. Movements in the rate of interest will have a crucially different effect on each of them.

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