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Economics in One Lesson
each other in the same way that the supply of and demand for any
commodity are brought into equilibrium. For we may define “savings”
and “investment” as constituting respectively the supply of and
demand for new capital. And just as the supply of and demand for any
other commodity are equalized by price, so the supply of and demand
for capital are equalized by interest rates. The interest rate is merely
the special name for the price of loaned capital. It is a price like any
other.
This whole subject has been so appallingly confused in recent
years by complicated sophistries and disastrous governmental policies
based upon them that one almost despairs of getting back to common
sense and sanity about it. There is a psychopathic fear of “excessive”
interest rates. It is argued that if interest rates are too high it will not
be profitable for industry to borrow and invest in new plants and
machines. This argument has been so effective that governments
everywhere in recent decades have pursued artificial “cheap money”
policies. But the argument, in its concern with increasing the demand
for capital, overlooks the effect of these policies on the supply of cap-
ital. It is one more example of the fallacy of looking at the effects of
a policy only on one group and forgetting the effects on another.
If interest rates are artificially kept too low in relation to risks,
funds will neither be saved nor lent. The cheap-money proponents
believe that saving goes on automatically, regardless of the interest
rate, because the sated rich have nothing else that they can do with
their money. They do not stop to tell us at precisely what personal
income level a man saves a fixed minimum amount regardless of the
rate of interest or the risk at which he can lend it. The fact is that,
though the volume of saving of the very rich is doubtless affected
much less proportionately than that of the moderately well-off by
changes in the interest rate, practically everyone’s saving is affected in
some degree. To argue, on the basis of an extreme example, that the
volume of real savings would not be reduced by a substantial reduc-
tion in the interest rate, is like arguing that the total production of
sugar would not be reduced by a substantial fall of its price because
the efficient, low-cost producers would still raise as much as before.
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The Assault on Saving
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The argument overlooks the marginal saver, and even, indeed, the
great majority of savers.
The effect of keeping interest rates artificially low, in fact, is even-
tually the same as that of keeping any other price below the natural
market. It increases demand and reduces supply. It increases the
demand for capital and reduces the supply of real capital. It brings
about a scarcity. It creates economic distortions. It is true, no doubt,
that an artificial reduction in the interest rate encourages increased
borrowing. It tends, in fact, to encourage highly speculative ventures
that cannot continue except under the artificial conditions that gave
them birth. On the supply side, the artificial reduction of interest rates
discourages normal thrift and saving. It brings about a comparative
shortage of real capital.
The money rate can, indeed, be kept artificially low only by contin-
uous new injections of currency or bank credit in place of real sav-
ings. This can create the illusion of more capital just as the addition
of water can create the illusion of more milk. But it is a policy of con-
tinuous inflation. It is obviously a process involving cumulative dan-
ger. The money rate will rise and a crisis will develop if the inflation
is reversed, or merely brought to a halt, or even continued at a dimin-
ished rate. Cheap money policies, in short, eventually bring about far
more violent oscillations in business than those they are designed to
remedy or prevent. If no effort is made to tamper with money rates
through inflationary governmental policies, increased savings create
their own demand by lowering interest rates in a natural manner. The
greater supply of savings seeking investment forces savers to accept
lower rates. But lower rates also mean that more enterprises can afford
to borrow because their prospective profit on the new machines or
plants they buy with the proceeds seems likely to exceed what they
have to pay for the borrowed funds.
4
We come now to the last fallacy about saving with which I intend
to deal. This is the frequent assumption that there is a fixed limit to
the amount of new capital that can be absorbed, or even that the limit
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