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March 1995
Volume 13, Number 3
How Clinton Destroyed the Bond Market
Ivan Pongracic
In 1994, bondholders lost hundreds of billions, thanks to
Clinton's monetary escapades. What
happened? It's a sad story of interest rates and their
manipulation by government planners.
In 1993 President Clinton began with a plan to jump-start the
economy. His view was simple: the
economy was already rebounding, so all it needed was lower
interest rates.
Short-term interest rates can fall for either authentic or
artificial reasons. When public
expectations change or when savings increase, the market drives
down interest rates as a signal
for more investment. The same can happen artificially as the
central bank expands credit and
inflates the money supply.
The difference between the authentic and artificial paths is
crucial. The central bank creates
distortions in the capital structure, including stocks and bonds,
while an increase in private
savings allows steady economic growth.
The Clinton administration, of course, chose a political
solution: it pushed the Fed to lower
short-term interest rates. The philosophy was this: people are
not spending enough because
money is too scarce and too dear, so we must make money cheaper
and more abundant by
lowering interest rates.
The official government economic philosophy is that interest
rates are the "price of money." That
view leads government to think that by lowering rates, it can
kill two birds with one stone.
Money becomes both cheaper and more abundant, since banks can
create more credit money only
if people and companies ask for money.
But the Clinton administration forgot that more abundant money
carries certain dangers. One is
higher prices. Known popularly as inflation, this lowers the
purchasing power of money, which
forces the Fed, sooner or later, to raise the interest rates back
to a higher level. The usual
consequence is an economic slowdown or even recession. A
by-product may be a lower
exchange rate internationally.
That's exactly what happened, but the result turned out to be
more catastrophic than the planners
believed possible. The dollar lost heavily against the yen, and a
little bit less against some other
currencies. Most important, the bond markets collapsed.
The second and more subtle effect of artificially driving down
interest rates is to introduce a
psychology of gambling. When interest rates tumbled, those who
live on CDs and other forms of
saving were tempted into higher-paying, riskier investments, and
they got clobbered.
But not only individual investors decided to gamble.
Institutional investors, not only pension and
mutual funds, but cities, counties, and other municipalities,
gambled on lower interest rates,
investing in derivatives and other high-risk instruments.
None of this, including the Orange County fiasco, was a
coincidence. It was an inevitable result
of economic ignorance and bad policy. And it's only the
beginning: banks have begun to feel the
pinch, federal deficits will rise sharply again, and business
bankruptcies will increase.
Monetary and interest-rate policies designed to overrule the
market are self-reversing. No
economy can survive with real interest rates below zero.
To proceed with the monetary expansion was impossible for yet
another reason. The Clinton
administration was capable of fooling the domestic public into
thinking that inflation was under
control. But international markets knew better, and drove the
dollar into the ground. Their verdict
on Clinton-Greenspan policies ultimately proved decisive.
Clinton started his presidency with a focus on economics. But
he and his advisers should have
read Mises and Rothbard, not listen to the politically tailored
advise of their favorite experts.
As the Austrian School proved long ago, the "interest rate" is
merely a shorthand phrase covering
the vast and intricate web of market relations and human choices
on the use of time and
resources. Play with it and you play with fire. As the Clinton
administration is doomed to find
out, markets, even those for loanable funds, outwit the planners
in the long run.
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Ivan Pongracic teaches Economics at Indiana Wesleyan University
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