There are growing expectations that the current cycle of rising interest rates will result in a deflationary recession. While a credit crisis is increasingly likely to evolve in the coming months, it is a highly inflationary situation. A combination of higher interest rates and catastrophic falls in the purchasing power of fiat currencies will continue to plague welfare-driven states in the wake of a credit crunch. The standard post-crisis solution of monetary and fiscal reflation will not be available. This article examines the ultimate consequences of the West’s abandonment of sound money, free markets and wealth creation in favor of increasing state intervention and wealth destruction.

Introduction

Since 1981, interest rates have been in a secular decline, falling from 20% to zero in US dollars. They are now on the rise, but the general assumption is the current low-interest rate environment will broadly continue. This view is complacent and likely to be expensively wrong, being founded on the erroneous view that significant levels of price inflation have been banished.

For the last forty years or so, monetary expansion has taken over from savings as the means of funding business expansion. This accords with the wish expressed by Keynes in his General Theory for the euthanasia of the rentier (or saver) and for entrepreneurial capital to be provided through the agency of the state.^[i] Not only have declining interest rates deterred personal savings and encouraged the proliferation of consumer debt, but pension funds, seen as a personal savings backstop, have been undermined by the reduction of compounding interest. Therefore, we can say that during the time of our headline chart, the state has taken over the role from free markets of setting interest rates and distributing capital.

The chart above of the 10-year US Treasury bond tells us that there is now a break in this trend (shown by the dotted line). It appears there is a significant reversal of falling bond yields, threatening the state’s control of interest rates and capital allocation. Lines on charts are notoriously misleading at times, but they also indicate a very low-interest-rate level is enough to create a credit crisis. That is one issue, another is the general assumption that interest rates can remain permanently low.

The origin of the hope that interest rates will remain low is in large part psychological. For millennia, high-interest rates have been seen as usury or unfair charges imposed by greedy money-lenders on defenseless borrowers. This was certainly Keynes’s view, and it persists with his followers today.^[ii]Instead, low-interest rates are seen as both an inducement to spend rather than save and to favor the entrepreneur investing in production over the saver.

Keynes’s view appeared to be that savers, or rentiers as he called them, were the idle rich, not employed but living off usury. To him, it was morally wrong that “functionless investors” should benefit from the scarcity of capital, hence his desire for the euthanasia of the rentier. To take this line of argument, he had to navigate round the sheet-anchor of classical economics, Say’s law. He did this by describing it in such a way that it was open to question. These were his words:

“Thus, Say’s law, that the aggregate demand price of output as a whole is equal to its aggregate supply price for all volumes of output is the equivalent to the proposition that there is no obstacle to full employment.”^[iii]

That is nearly all he had to say on the principle which previously had been the greatest obstacle in economic theory to government intervention. He does not define it but interprets Say’s law sympathetically to his intentions, and misdirects the reader by alleging that Say’s law was a denial of the high levels of unemployment that persisted in the decade when he wrote these words. And if the greatest living English economist at the time implies that the evidence of mass unemployment shows Say’s law cannot be true, it from that moment dies like Monty Python’s parrot, becoming an ex-law.

Say did not write down a precise definition of what subsequently was associated with him as an iron rule, but he set out very clearly his understanding of how human exchange operated. He demonstrated that we work in order to buy the things we need, and our savings are the source of finance for production. This means that all consumer demand is the consequence of and follows the production of supply. Says was describing the division of labor, which is the way humanity maximizes relevant output and improves its lot. Say also made it clear that the role of money is only temporary to facilitate the process. 

It is a system born from the market, where people freely negotiate their business. It particularly benefited Britain during the industrial revolution, improving the lives of ordinary people, creating wealth and economic progress. There was never any need to replace savers with the state as the provider of capital as Keynes described. Nor for that matter, to replace the peoples’ money, which was gold and silver, with the state’s money. If there was disruption of production, it always came from the government and its licensed banks, which created credit out of thin air through fractional reserve banking. Diluting money by expanding both it and associated credit is a fraud on existing owners of money.

This is Keynes’s inflationary financing, relying on the fact that no one can tell the difference between existing currency and the introduction into circulation of yet more. Obviously, if you expand the quantity of money, other things being equal you have more money chasing the same quantity of goods, so prices will rise. That is the message from Say. The Keynesians answer to this is the demonstrably false proposition, that higher prices encourage consumer demand. However, there is one circumstance where this is true, and that is when the average person shifts his ownership preferences away from money towards goods and services. But this is playing with fire, because such a move can undermine a currency’s purchasing power with surprising rapidity, building into an unstoppable momentum.

There are therefore two variables that alter a currency’s purchasing power: the quantity in circulation and the public’s judgment of its future value. Central banks tend to pay attention to the quantity. The qualitative element cannot be calculated by a mathematical approach, so is generally ignored. Furthermore, mathematical economists tend to overlook sectoral shifts, whereby currency and credit flow between financial and non-financial applications. It is the non-financial economy, the part that produces goods and services that they monitor, assuming financial activities and the asset inflation they stimulate are merely a by-product.

There is a further dimension we cannot ignore. Since the interest rate spike in the early-1980s, savings have migrated from earning interest in seeking equity participation. The simplistic economic model of consumers saving and businesses borrowing has disintegrated, with consumers increasingly taking an entrepreneurial risk and funding their personal consumption with credit. Companies with low credit ratings have been happy to print equity rather than go to the bond markets, encouraged further by the freedom from having to pay any dividends. 

The result of these changes has been to skew the economy in favor of asset inflation, which has replaced interest on bank deposits and bonds held to redemption as wealth-creator for the ordinary saver. Asset inflation is excluded from inflation statistics, which means it can be increased at will. But asset inflation reflects the passage of expanded money and credit into the financial sector, from whence it always leaks into the real world of production.