The Free Market 13, no. 3 (March 1995)
In 1994, bondholders lost hundreds of billions, thanks to Clinton’s monetary escapades. What happened? It’s a sad story of interest rates and their manipulation by government planners.
In 1993 President Clinton began with a plan to jump-start the economy. His view was simple: the economy was already rebounding, so all it needed was lower interest rates.
Short-term interest rates can fall for either authentic or artificial reasons. When public expectations change or when savings increase, the market drives down interest rates as a signal for more investment. The same can happen artificially as the central bank expands credit and inflates the money supply.
The difference between the authentic and artificial paths is crucial. The central bank creates distortions in the capital structure, including stocks and bonds, while an increase in private savings allows steady economic growth.
The Clinton administration, of course, chose a political solution: it pushed the Fed to lower short-term interest rates. The philosophy was this: people are not spending enough because money is too scarce and too dear, so we must make money cheaper and more abundant by lowering interest rates.
The official government economic philosophy is that interest rates are the “price of money.” That view leads government to think that by lowering rates, it can kill two birds with one stone. Money becomes both cheaper and more abundant, since banks can create more credit money only if people and companies ask for money.
But the Clinton administration forgot that more abundant money carries certain dangers. One is higher prices. Known popularly as inflation, this lowers the purchasing power of money, which forces the Fed, sooner or later, to raise the interest rates back to a higher level. The usual consequence is an economic slowdown or even recession. A by-product may be a lower exchange rate internationally.
That’s exactly what happened, but the result turned out to be more catastrophic than the planners believed possible. The dollar lost heavily against the yen, and a little bit less against some other currencies. Most important, the bond markets collapsed.
The second and more subtle effect of artificially driving down interest rates is to introduce a psychology of gambling. When interest rates tumbled, those who live on CDs and other forms of saving were tempted into higher-paying, riskier investments, and they got clobbered.
But not only individual investors decided to gamble. Institutional investors, not only pension and mutual funds, but cities, counties, and other municipalities, gambled on lower interest rates, investing in derivatives and other high-risk instruments.
None of this, including the Orange County fiasco, was a coincidence. It was an inevitable result of economic ignorance and bad policy. And it’s only the beginning: banks have begun to feel the pinch, federal deficits will rise sharply again, and business bankruptcies will increase.
Monetary and interest-rate policies designed to overrule the market are self-reversing. No economy can survive with real interest rates below zero.
To proceed with the monetary expansion was impossible for yet another reason. The Clinton administration was capable of fooling the domestic public into thinking that inflation was under control. But international markets knew better, and drove the dollar into the ground. Their verdict on Clinton-Greenspan policies ultimately proved decisive.
Clinton started his presidency with a focus on economics. But he and his advisers should have read Mises and Rothbard, not listen to the politically tailored advise of their favorite experts.
As the Austrian School proved long ago, the “interest rate” is merely a shorthand phrase covering the vast and intricate web of market relations and human choices on the use of time and resources. Play with it and you play with fire. As the Clinton administration is doomed to find out, markets, even those for loanable funds, outwit the planners in the long run.
