On Existing Policy

To help the economy grow, our economic policies encourage the use of credit. When growth gets out of hand, our policies fight inflation by raising interest rates. Higher rates tend to choke off growth. With less growth comes less inflation. Also as growth declines, the demand for credit falls and interest rates come down. Then the cycle repeats: Again we encourage the use of credit, until the next time inflation threatens.... These policies would be fine, except for one thing: They work like an old-fashioned water pump, increasing our reliance on credit with every push of the handle.

Our policies don't counterbalance each other. Anti-inflation policy does not undo pro-growth policy. An increase of interest rates does not undo an increase in credit use. When the Federal Reserve raises interest rates, it may for a time discourage additions to credit use. But it does not cause credit use to fall to its previous level.

Our policies result in credit use that never tends to fall. The policies do not give us an up-down-up-down pattern of credit use. The pattern is up-flat-up-flat, like a flight of stairs. The effect of policy is to produce an ever-increasing reliance on credit.

Perverse Effects
Fifty years ago, growth was largely based on credit, but existing economic activity was largely based on cash. An increase of interest rates tended to reduce growth (by making borrowing more costly) without having much effect on the existing level of economic activity. It was a good way to fight inflation.

Today, not only growth but also much of existing economic activity depends heavily on credit. An increase of interest rates today doesn't just make growth more expensive. The increase affects nearly all economic activity. Because of our increased reliance on credit, our economic policies no longer work the way they used to work.

Formerly, only expansion was made more costly by an interest-rate increase. Today, nearly all economic activity is made more costly by a rate increase. An interest rate increase today makes it more expensive to maintain the existing level of economic activity. Raising interest rates used to be a good way to fight inflation; but now it drives costs up. Our heavy reliance on credit has changed policy's effect on inflation.

Heavy reliance on credit has also changed policy's effect on growth. Interest rate increases have become less effective at slowing growth. Bigger rate increases are necessary to achieve growth-reduction targets. Why don't the smaller rate increases slow growth? Perhaps because the increased interest rates don't only affect growth anymore. The higher interest rates also increase the cost of maintaining the existing level of economic activity. Instead of making growth in particular a costly option, the policy pushes up costs and prices in general.

Only when rising interest costs have squeezed the vigor out of the economy do we see any downward pressure on inflation. And then it is not only growth, but economic activity in general that is curtailed. Formerly, anti-inflation policy reduced the rate of growth. Now it creates recession. It is this change--a change brought about by our increased reliance on credit--that policy-makers seem not to have noticed. An increase of interest rates, intended to reduce inflation, no longer simply slows the rate of growth. These days it creates recession--and adds to inflation besides.

Because of our heavy reliance on credit, anti-inflation policy increases costs rather than holding prices down. And because of our heavy reliance on credit, anti-inflation policy creates recession instead of slowing growth. Our anti-inflation policy has become ineffective because of the heavy reliance on credit. Yet it is economic policy that created the heavy reliance on credit:

  • Our policies encourage saving, to make more credit available.
  • Our policies allow tax deductions for interest expense, which is like offering a discount to borrowers.
  • We have no policy that encourages the repayment of debt.
The more we rely on credit, the worse our policies work. The worse our policies work, the more policymakers do to encourage the reliance on credit. It is a vicious cycle. The only way out is to question the assumption that excessive credit use is beneficial.

If excessive credit use creates problems, then excessive credit use is a problem, and economic policy should be designed to prevent it. However, our existing policies do not limit the excesses of credit use. Our policies encourage those excesses in a misguided effort to enhance growth. If blame is to be assigned, the finger must point at policy.

If it is true that our economic problems arise from the excessive reliance on credit, then the course for policy is clear: It is necessary to reduce the reliance on credit.

  • We must distinguish between old debt and new uses of credit. We must encourage the new uses of credit, which promote growth, but discourage the practice of carrying old debts, which do not promote growth.
  • We must reduce the reliance on credit in the private sector by paying off debt faster than we do at present, while promoting growth through new uses of credit.
  • We must reduce the ratio of credit-money to base-money through concerted action: tax incentives for accelerated repayment of debt; a higher reserve requirement; easy monetary policy; and an increase in the monetary base.
  • We must continue to encourage new uses of credit, something we do already.
  • We also need to solve the problem that results from credit use--the accumulation of debt. We don't yet do that. When things get out of hand, the Federal Reserve discourages new uses of credit. That's wrong. We must continue to encourage the new uses of credit, because those are the uses that promote growth. But we must begin to encourage borrowers to reduce their accumulations of old debt.

Accumulated debt is the sum of old debt and new. If we need to reduce the accumulation, there are two ways to go. We can discourage new additions to the accumulation but do nothing about old debt. That is what we do at present. Or, we can continue to encourage the new additions (which promote economic growth) and start to whittle away at old accumulated debt. This is what I propose to do.

When you borrow money and spend it, that's a new use of credit that stimulates the economy. You put credit to use. The way it seems is, the money's gone, and we're left with a debt. What really happens is, we put credit to use and it stays in use until we repay the loan. I propose tax incentives that will help us pay off our debts a little faster than we do now. That's the whole plan.

(c) 1999 by Arthur Shipman