The Interest Rate Fallacy: 49 Years Before Friedman

A delicious way to settle the
Vienna vs Chicago dispute

The interest rate fallacy means that it is a fallacy to look only to the state of interest rates as an indicator of whether or not the central bank (CB) has embarked upon an easy monetary policy. Because after a certain time period, CB can affect interest rates indirectly via inflationary expectations. For example if CB embarks upon an expansionary monetary policy and agents fully anticipate a rise in prices as consecuence of that, then the easy monetary policy will rise interest rate rather than lower it because of the inflation premium included in nominal rates. Conversely a tight monetary policy will lower interest rates if a “deflation premium” is added into nominal interest due to deflationary expectations. In this circumstances if you look only at the interest rates, you just don't know if the CB is on an easy or tight monetary policy. After a certain time period the direction of interest depends on inflationary expectations of people. The quantity of money and credit is a much better indicator. 

This discovery is usually credited to Milton Friedman, however Mises almost 50 years before him said a similar thing:

Mises (1949): "[A]t the very beginning of a credit expansion no positive price premium arises. A price premium cannot appear until the additional supply of money (in the broader sense) has already begun to affect the prices of commodities and services... The gross market rate would have to rise on account of the positive price premium which, with the progress of the expansionist process, would have to rise continually... Arithmetically, the gross rates of interest are rising above their height on the eve of the expansion."

Friedman (1998): "Initially, higher monetary growth would reduce short-term interest rates even further. As the economy revives, however, interest rates would start to rise. That is the standard pattern and explains why it is so misleading to judge monetary policy by interest rates."

Mises (1949): "It is the continuous increase in the supply of the fiduciary media that produces, feeds, and accelerates the boom. The state of the gross market rates of interest is only an outgrowth of this increase. If one wants to know whether or not there is credit expansion, one must look at the state of the supply of fiduciary media, not at the arithmetical state of interest rates."

Friedman (1998): "The Fed pointed to low interest rates as evidence that it was following an easy money policy and never mentioned the quantity of money. The governor of the Bank of Japan, in a speech on June 27, 1997, referred to the "drastic monetary measures" that the bank took in 1995 as evidence of "the easy stance of monetary policy." He too did not mention the quantity of money."

There we have both Mises and Friedman saying that if you want to see whether or not the CB is expanding credit, then you must look at the money supply rather than the nominal rate of interest.  

In Lecture 5 of Buck Hill Falls in 1955, Mises made this excellent clarification of ABCT: 

"The first thing I want to mention in this regard is that people say: "You ascribe the emergence of the boom to a lower rate of interest, to the fact that the rate of interest is lower than it should be. But if you look at the history of the business cycles over the last hundred years, you will discover that one of the characteristics of the boom periods is that there is an increase in interest rates. Therefore, your first assumption is wrong."

Now this objection is due to the fact that people talk about a higher or lower rate of interest simply from the arithmetical point of view. This objection was very carefully criticized by Wicksell. People say that 5% interest is higher and 4% is lower. True! But arithmetic has nothing to do with the problem. The question is whether the rate of interest charged by the banks is above or below the "equilibrium" rate or, as Wicksell said, the "natural rate of interest."… At the beginning of the boom, there was a certain basic, "originary," rate of interest. However, in adopting an easy money policy, the banks made loans below this originary rate of interest, creating additional money precisely for the purpose of lending. Then prices started going up… With an additional quantity of money in circulation, there is a tendency for prices, and also interest rates, to rise. If a borrower expects prices to rise, he values goods and money in the present relatively higher than he does goods and money in the future. When evaluating present goods as against future goods, people take into consideration the anticipated higher prices of future goods. As a result, they are willing to pay a premium to have things now, to pay a higher rate of interest, to obtain things sooner rather than later. Thus, there is added to the pure, originary, rate of interest, a "price premium."… Therefore, in a boom period the market rate of interest must necessarily go up and up, as it contains now not only the originary or pure interest rate but the price premium besides. The interest rate may go up and up in a boom and yet it may still remain below the rate it should have attained under these conditions. A higher money rate of interest doesn't mean that the real, the pure or originary, rate of interest is higher. Nor does it mean that the policy of easy money has been abandoned. Nor that the banks are trying not to expand too much; they may just be trying not to increase too much the spread between the lower rate they are charging and the market rate they would have charged if they were not expanding credit. Therefore, a higher interest rate in the course of the boom doesn't mean that the real interest rate is higher."

And this is the point. Even if you see interest rates rising during the boom, that doesn't mean that banks abandoned the credit expansion. As I already explained here (short explanation) and here (full explanation), the development of the malinvestment boom is perfectly compatible with a rising interest rates. The lowering of the rate of interest is a relative one, relative to the rate of interest that would have prevailed without credit expansion. This lowering can manifest itself on an arithmetical lowering or maybe by keeping the rate constant or by increasing it (less than it would have increased). Even if the rates of interest are increasing, the boom can continue as long as there is credit expansion. That injection of credit makes the rate be below what would have been without the injection. That's why, for example, the 2002-2007 boom continued in the US even when interest rate (FEDFUNDS) started to rise in 2004, because there was still some availabilty of credit (an increasing YoY rate of growth of M2 to give an example).