The Case for Low Interest Rates

During the war, the Federal Reserve pegged interest rates to suit the U.S. Treasury. In the summer of 1944, Samuelson took up the argument that the interest rate should have been much lower.

In the summer of 1944, Samuelson wrote a paper that was eventually published in the American Economic Review.⁶¹ It was certainly correct that the present value of bank assets—the value they could be sold for in the market—would be reduced by a rise in interest rates, but this did not mean that they were made worse off. To the contrary, banks were made better off by such changes. His purpose was not to say that interest rates should be raised. To the contrary, he believed that interest rates should have been lower—the war was a 2 percent war, but it should have been a ι percent war, for this would have reduced its cost, and in a world of direct controls and inflationary gaps, interest rates had no effect on consumption or investment.

The central part of his argument was that the mistake lay in looking only at the value of bonds held, and not at the streams of revenue accruing to banks. He began by considering a university that had invested endow­ment funds in government securities, an example that would be familiar to his predominantly academic audience. If interest rates fell, the value of the bonds held would fall, but so long as the securities were held to maturity, the university would be no worse off, its income being unchanged. Of course, it would have been better to have delayed purchasing the bonds until their val­ues had fallen, but that was a completely different argument.

l. There is an inverse relationship between the rate of interest and the market price of fixed- coupon securities. For perpetuities, the yield on such a security, i, is AP/V where V is the value of the security and AP is the annual interest payment. This yields the relationship V=AP∕i. For fixed-term securities, the equivalent formula is more complicated, but V still falls when i rises.

equivalent to an annual subsidy to the banks of $600 million. The obvious problem caused by the loss in capital values was that if there were a sudden withdrawal of deposits, the bank would need to liquidate assets. However, Samuelson argued that, given the situation banks then faced, this was simply not going to happen.

Though Samuelson presented these conclusions as obvious—he described himself as “giving away the secret which all wise men know but which no wise man will tell,” defending them required his going into technical details.⁶² He produced data showing that banks held very little of the long­term debt that would be most affected by interest rate changes; he calculated the relationships between interest rates, security prices, and revenue streams; and he spoke with apparent authority on how the U.S. Treasury and the Federal Reserve would behave after the war. However, though demonstrat­ing, for the first time, his credentials in the field of finance, the underlying lesson involved an elementary point: high interest rates benefited creditors and harmed debtors.

In the middle of November, Samuelson was invited to take part in a “Debate in print” in Modern Industry over the question of whether the federal government should abandon its easy money policy.⁶³ His opponent was to be Christian Sonne, a merchant banker (president of Amsinck, Sonne & Co.), who had written a book about eliminating corporate taxes and was chairman of the Executive Committee of the National Planning Association.

When the article was published on January 15, 1945, alongside adver­tisements for industrial gloves, roller bearings, and silent hoist equipment, a box (see table 23.1 ) on the first page summarized the opposing arguments.⁶⁵ Samuelson’s was a simple point: that low interest rates stimulated business investment through making it more profitable. However, he needed to allay fears about what was happening to the federal debt, which he did by arguing that easy money was different from deficit spending, for it involved increas­ing the supply of capital, not keeping rates low by using government to push money into the economy. In any case, although the federal debt exceeded $200 billion, “the Government’s credit was never so good” and there was nothing to worry about. The government could lower interest rates and could

table 23.1 ADebate AboutEasyMoney

Note: This table summarizes the contents of the boxed feature in the Modern Industry article, in which their photographs and short biographies were also presented.

have made them even lower, had the U.S. Treasury so desired. High interest rates might control inflation in a postwar boom, but they would not stimu­late investment and could cause depression. Against Sonne's argument that the United States needed to attract funds from abroad, Samuelson reminded readers that the United States was the world's greatest creditor, and that it should follow Britain's example of keeping rates low, as the rest of the world wanted.

Samuelson had closed his article in the American Economic Review by asking to hear from “the wise men” about whether the government's policy of keep­ing interest rates at 2 percent had been “uninspired.”⁶⁶ This challenge was taken up by Seymour Harris, at Harvard, and George Coleman, an economist with the Mississippi Valley Trust Company. Harris, who claimed to be sup­plementing rather than criticizing Samuelson's “brilliant” article, defended government policy, arguing that the government had done a good job of pre­venting banks from profiting excessively from war financing, and that banks were less profitable than other enterprises.⁶⁷ Coleman, on the other hand, was more critical. He began by turning Samuelson's rhetoric about this being a secret shared by all “wise men” against him:

This plea [to hear from “wise men”] leaves anyone who might wish to comment on this article in the temerarious position of being accused of thinking himself to be a “wise man.” This difficult position becomes somewhat more tenable, however, when realizes that his evaluation of a “wise man” is subject to a substantial discount since he believes that barbers know more about banking practices than bankers do.⁶⁸

Samuelson, Coleman claimed, had made an error in his calculations—perhaps too small to worry an academic economist, but significant enough to make the difference between profit and loss in a bond transaction. Samuelson had also used the wrong basis for valuing assets and correcting this changed the capi­tal loss from raising interest rates from Samuelson’s 3 percent to 25 percent.

In responding to Harris and Coleman, Samuelson abandoned the patron­izing tone of his earlier articles, and rather than enter “a titanic battle between Mr. Coleman’s bank clerk and my economic sophomore,” he chose to talk about changes that had taken place in the government bond market since his article had been written. The most he conceded was that there was “some interest” in Coleman’s suggestions about how securities should be valued.⁷¹ Though the language was less arrogant, he did not soften his criticisms of bankers. Since 1942, the U.S. Treasury had, in effect, guaranteed a particular pattern of interest rates; the fact that banks did not shift to higher yielding bonds showed that they either did not believe this or that they did not under­stand it. Samuelson turned this account of how the Treasury had achieved such a firm grip on interest rates into a reiteration of his call for “another turn of the ‘cheap money’ screw.”⁷² He presented himself as someone intimately familiar with the institutional details of government financing and its impli­cations for banking and the economy.

These arguments about interest rates were one of his first forays into finance, a field in which he was to become a major contributor in the 1950s. The episode, like the reference to the emperor’s new clothes cited earlier, marks the emergence of a highly confident and ironic style that was to become a feature of Samuelson’s writing.