Interest rates - History of Business in the U.S.
Definition: Rates of payments made for the use of money, expressed as percentages of the sums owed
Significance: Borrowing at interest is an important source of funds to finance business investment in machinery, buildings, inventories, and general operations. Banks and other financial businesses borrow and lend money as well as pay and receive interest.
Many debt claims, such as bonds and mortgages, are bought and sold among private investors and institutions at prices that vary with supply and demand. The supply of loans comes mainly from savings, while demand for loans, earlier dominated by business borrowing, now comes from households and government as well.
The higher the price of a marketable bond with a fixed-dollar interest payment and redemption value, the lower its yield to an investor who buys it at the higher price. Because many financial claims are close substitutes for each other, debt claims of similar risk and time to maturity tend to have the same yield. Interest rates tend to rise and fall together, although the differentials may change.
Interest rates will tend to be higher on high-risk financial claims. For example, home-mortgage interest rates are higher than corporate bond rates, which are higher than U.S. Treasury bond rates. An increase in the expected rate of inflation tends to lead to a rise in interest rates, as demonstrated by the great rise of the 1970’s.
Historically, interest rates have tended to rise and fall over the business cycle. During boom periods, business firms and households have been eager to borrow, driving interest rates up. During business downswings, profit prospects are less attractive, demand for loans falls, and interest rates decline.
Reliance on debt claims was very widespread in colonial America. Many people borrowed money to buy land. Merchants borrowed money to buy ships and to pay for their inventories of goods for sale. Colonists drew extensively on loans from British sources. A benchmark for interest rates was the national debt of the British government. Yields on British government securities averaged between 3 and 4 percent during much of the eighteenth century.
In the absence of banks in colonial America, some of the individual colony governments opened loan offices to supply credit. Examples include Massachusetts (1711-1714, loans at 5 percent), Pennsylvania (1722, at 5 percent, loans secured by land), and Virginia (1755, at 5 percent).
The American Revolution required heavy borrowing by the newly formed national government and by the states. The national government borrowed from bankers in Paris and Amsterdam at yields of between 4 and 6 percent, but much of the war was financed by issues of paper money. This generated severe inflation. Domestically, governments issued bonds payable in paper money, but because the contractual payments were not met, these fell in price far below par, generating effective yields as high as 40 percent. Financial conditions during the 1780’s were chaotic. However, the first banks and insurance companies were established during this period.
After adoption of the Constitution of 1787, the new government redid the funding for the chaotic mass of debt claims previously issued by state and national governments. New government securities were issued in several varieties, paying either 3 or 6 percent. All initially fell below par, reflecting the shaky finances of the new government. By the first decade of the new century, however, yields were once again only slightly over 6 percent. Congress gave high priority to paying interest and redemption as promised. U.S. government securities thus became, as they have been ever since, among the safest and most secure debt claims in the world.
The new nation soon developed banks in major cities. During 1812-1815, war with England drove interest rates up, with government securities yielding as much as 9 percent in 1814. The rise reflected heavy government borrowing to finance the war and the fear of inflation. Apostwar slump ended the inflation fear, depressed demand for private credit, and brought yields on federal securities down into the 4 to 5 percent range during the 1820’s.
As the population grew and the area under cultivation expanded, the number and activity of banks expanded. Much bank lending was done at 6 percent interest. Often state laws (usury laws) forbade charging higher rates. Savings banks paid about 5 percent on deposits from 1836 through 1867. They generally used these funds to buy mortgages or bonds.
As banks proliferated, the economy was subject to periodic episodes of banking panics and depressions. Bank efforts to borrow to cover panic withdrawals would lead to brief episodes of very high short-term interest rates. Such financial panics occurred in 1819, 1837-1841, and 1857. Interest rates on short-term commercial paper went as high as 36 percent in 1819, 1836, and 1839, and reached 24 percent in 1834 and 1857.
Railroad building commenced on a serious scale during the 1840’s and expanded rapidly during the 1850’s. Many railroad projects were financed by issuing bonds, often sold to British and other foreign investors. During the late 1850’s, such bonds were yielding between 6 and 7 percent on average.
The Civil War and Reconstruction
During the U.S. Civil War, both the North and the South resorted to bond issues and paper-money issues to finance their large military expenses. The North issued bonds for which interest and redemption were paid in gold. This protected bondholders against inflation and protected foreign investors against foreign-exchange depreciation of the dollar. Yields on such bonds averaged between 4.5 and 6 percent in 1862-1865.
After the war’s end in 1865, the country experienced a long period of gradually declining prices—deflation. High-grade railroad bonds yielded an average of 5.7 percent during the 1870’s, 4.0 percent during the 1880’s, and 3.5 percent during the 1890’s. Short-term rates on commercial paper fluctuated much more widely in response to business cycles, going as high as 16 percent in 1873 and 11 percent in 1893. Rates on savings deposits slid down from 6 percent during the 1860’s and 1870’s to 4 percent during the 1880’s and 1890’s.
The Twentieth Century
During the 1890’s, Yale economist Irving Fisher advanced the later fashionable theory that interest rates would move point for point with changes in inflationary expectations. The grinding deflation following the Civil War led to low interest rates because lenders expected to benefit from the increased purchasing power of their interest and redemption payments. That deflation ended during the 1890’s, when gold production expanded. As Fisher predicted, the shift to an inflationary outlook caused interest rates to begin an upward trend.
Bank deposits, which constituted half the money supply in 1865, rose to 90 percent by 1916. The interest received by banks provided the revenues from which deposit-management costs were paid. In 1914, the Federal Reserve System, the central bank of the United States, came into operation, intended to protect the public from disastrous bank panics. The Federal Reserve (known as the Fed) was empowered to lend to banks, and its chief tool was to be the interest charged—the rediscount rate. The Federal Reserve was also authorized to buy and sell government securities. It soon discovered that its purchases tended to reduce interest rates, and sales tended to increase them.
Hardly had the Federal Reserve begun operations, when World War I broke out in Europe. The Federal Reserve Banks began lending to banks at a rediscount rate of 6 or 6.5 percent in late 1914, but lowered the rate to 4 percent or less from 1915 through 1917. After the United States entered World War I in April, 1917, federal expenditures rose rapidly and were financed largely by issuing bonds and other forms of debt. The Federal Reserve aided the Treasury by lending freely to banks to encourage them to buy government securities. The earliest war loans yielded about 3.5 percent to investors, and subsequent loans in 1918 yielded slightly over 4.5 percent. Short-term rates were generally higher—an unusual situation. Commercial paper rates averaged 5 percent in 1917 and 6 percent in 1918.
The easy-money policies of the Federal Reserve contributed to rapid expansion of bank reserves, bank credit, the money supply, and inflation. After the war ended in November, 1918, the Treasury no longer needed to borrow as much. In an effort to curb the inflationary process, the Federal Reserve rapidly raised rediscount rates until by June, 1920, all twelve Federal Reserve Banks were charging 6 or 7 percent for loans to banks. The result was a drastic reduction in Federal Reserve lending to banks and a corresponding upward shock to interest rates.
Inflation soon ceased, giving way to a painful economic depression in 1921-1922. This reduced the demand for loans, particularly by business, and brought lower interest rates. By mid-1922, commercial paper rates were down to 4.1 percent, with government bonds just slightly higher. For the remainder of the decade, long-term rates stabilized between 3 and 4 percent, while short-termrates fluctuated more widely with the business cycle.
The 1920’s brought a major transformation in consumer credit, as installment lending became common, particularly for automobile purchases. Because of the greater risks and transaction costs, these loans often involved interest rates substantially above those on corporate bonds or commercial paper.
Boom and Bust: 1927-1933
The late 1920’s witnessed an accelerating rise in the prices of corporate stocks. The prospect of stock price increases encouraged many investors to borrow money to speculate, driving up interest rates. Stock market ninety-day loans fell as low as 4.0 percent in late 1927, then moved steadily upward, passing 7 percent in 1928 and hitting 9 percent just before the market crashed in October, 1929. However, long-termbonds were not much affected. The economy’s descent (1929-1933) into the worst economic depression in history thoroughly disrupted the financial world.
A high rate of bank failures reduced the availability of bank loans. Investors sought security, liquidity, and the opportunity to benefit fromfalling prices of goods and services, stocks, and real estate. They eagerly demanded short-term low-risk debt claims, such as Treasury bills, on which yields fell below 1 percent from1931 until 1947. High-risk corporate bonds (BAA grade) were hard hit by corporate bankruptcies and loan defaults. As their prices fell dramatically, their yields rose from 6 percent in late 1929 to more than 11 percent in mid-1932.
The Federal Reserve Banks, most of which were lending to banks at 5 percent in 1929, reduced their discount rates at first—the New York rate went as low as 1.5 percent in 1931. However, they believed that higher interest rates were necessary to keep from losing a lot of gold during a panic episode in September of 1931 and raised rates to 3.5 percent, which precipitated a new wave of bank failures.
After the inauguration of President Franklin D. Roosevelt in March, 1933, drastic measures were taken to end financial panic. A variety of federal agencies were established to make loans directly or to insure or guarantee private loans. The Federal Housing Administration used its role in insuring home mortgages to promote long-term amortized mortgages. To protect banks against competition, the government forbade paying interest on demand deposits and imposed (low) ceiling rates on timedeposit interest rates. As the economy experienced a painfully slow recovery, interest rates remained low. High-grade corporate bonds, which had yielded more than 4 percent in 1930-1933, slid down to 2.7 percent in 1940.
Comparative Interest Rates in the United States, 1930-2007
Sources: Susan B. Carter, ed., Historical Statistics of the United States (New York: Cambridge University Press, 2006); Economic Report of the President (Washington, D.C.: U.S. G.P.O., various editions); Board of Governors of the Federal Reserve System, Annual Statistical Digest (Washington, D.C.: author, various years), Banking and Monetary Statistics, 1914-1941, and Banking and Monetary Statistics, 1941-1970 (Washington, D.C.: author, 1943, 1976 respectively)
World War II and After
After the outbreak of World War II in December, 1941, the U.S. government rapidly escalated military spending. TheTreasury was eager to keep interest rates low in the face of its need to borrow heavily. The Federal Reserve Banks kept discount rates low and adopted a policy of “pegging” the prices of marketable government bonds, buying them if their prices appeared to be falling. The pegging policy kept government bond yields at or below 2.5 percent, despite extensive borrowing.
The public was willing to save a lot of money despite interest rates of 2 percent on savings deposits and 2.9 percent on the newly created (and widely popular) U.S. savings bonds. Many people feared that Depression conditions would return and wanted to accumulate funds for that feared rainy day.
The low-interest policy of the Treasury and Federal Reserve resulted in a large increase in the money supply and increasing inflationary pressure.Wishing to take a more aggressive anti-inflation stance, the Federal Reserve broke off its support of government bond prices in 1951, allowing interest rates to rise. The postwar boom brought a strong demand for loans, and all interest rates migrated upward. Long-termgovernment bond yields passed 3 percent in 1956 and reached 4 percent in 1959. After a slight pause, their increase resumed under pressure from inflation during the early 1960’s. The Federal Reserve Banks raised discount rates from the neighborhood of 3 percent in 1961-1962 to nearly 6 percent in 1969-1970. However, they did not slow the rate of monetary growth, and inflation continued to rise. Interest rates on AAA (top-grade) corporate bonds rose from4.4 percent in 1960 to 8 percent in 1970.
From the late 1960’s, credit cards came to play a major role in household borrowing. Explicit interest was charged if the borrower failed to pay the balance in full each month; rates were typically around 17 percent. As household incomes rose, people devoted more of their income to housing and durable goods, expenditures often involving credit. The sum of household mortgage debt and consumer credit rose from 31 percent of personal income in 1950 to 65 percent in 1960 and 117 percent in 2006. Households paid more interest, but they also received more. The rapid expansion of retirement plans in particular contributed to a rising share of interest in people’s incomes. Personal interest income was only 4 percent of personal income in 1950 but rose to 10 percent by 2006.
The sharp run-up in international petroleum prices in 1973 accelerated inflation and raised inflation expectations. Interest rates reached peacetime record high levels. From 1974 through 1978, AAA bond yields were between 8 and 9 percent. Restrictive actions by the Federal Reserve sent them into double digits, peaking at 14 percent in 1981. Newly developed money-market mutual funds allowed households to share in receiving high interest. In 1986, most ceiling rates on deposit interest rates were removed. After 1979, the Federal Reserve’s actions in slowing money growth brought down the inflation rate, and interest rates gradually returned to more nearly normal levels. In January, 1997, the Treasury began to issue Treasury Inflation Protection Securities (TIPS). The interest and redemption payments were adjusted up or down to compensate investors for changes in the price level.
By the end of the millennium, actual inflation rates and expected inflation rates had reached low levels, and interest rates were correspondingly low, although they continued to rise in cycle booms and decline in slumps. Increasing globalization caused bond prices and long-term interest rates in the United States to be strongly affected by conditions in the international capital markets.
Interest rates were central to the subprime mortgage crisis that surfaced in 2007. Eager to reap large transactions fees, financial institutions developed “securitization,” packaging numerous home-mortgage loans together and using them as collateral for bond issues. Many loans were made to borrowers with poor credit ratings and provided for interest rates to rise substantially after an initial period. When home prices ceased rising, many of the loans fell into default.
Paul B. Trescott
- Fisher, Irving. The Theory of Interest. New York: Macmillan, 1930. This classic work by one of America’s greatest economists presents extensive history as well as theory.
- Friedman, Milton, and Anna J. Schwartz. A Monetary History of the United States, 1867-1960. Princeton, N.J.: Princeton University Press, 1963. Numerous references to interest rates are interwoven into American financial history.
- Homer, Sydney, and Richard Sylla. A History of Interest Rates. 4th ed. New York: John Wiley & Sons, 2005. The definitive historical resource, with information regarding many countries and a time span of many centuries.
- Kaufman, Henry. Interest Rates, the Markets, and the New Financial World. New York: Times Books, 1986. One of Wall Street’s legendary gurus mingles autobiography with sage commentary on the evolution of financial markets.
- Mishkin, Frederic S. The Economics of Money, Banking, and Financial Markets. 7th ed. New York: Addison Wesley, 2004. This college-level text deals extensively with both the theory and history of interest rates.