This article appeared on the Op-ed page of the Wall Street Journal December 14, 1981.

This fight represents a low of wasted ink. It reminds me of the scene from the movie in which Frankie Avalon and Annette Funicello are frantically trying to brush those pesky ants from their picnic blanket, when a creature emerges from the surf in the background. Remember how we screamed ourselves hoarse trying to warn them? "Look out, Frankie!" "Turn around, Annette!" They just wouldn’t listen.

In my view the obsession with both Wall Streeters and supply-siders with analyzing credit flows has led both to forget who the real star is in the interest rate story.

Major changes in U.S. interest rates are usually caused by changes in the way the public wants to hold its net worth. The point of this article is that the drop in inflation in the last 18 months is forcing households to restructure their wealth in a way that will force reductions in interest rates n 1982, no matter what the level of savings or budget deficits in the next year.

Flow-of-Funds Focus on Savings

Both sides of the debate use a flow-of-funds framework to forecast interest rates. This framework views a financial market as a kind of farmers’ market, where households bring their savings (credit supplies) and governments and corporations bring their borrowing needs (credit demands). Interest rates are the price that equates credit demands and credit supplies. This is the source of the current fixation on deficits and savings.

Wall Streeters fear that mega-deficits will piggyback the growing calendar of corporate debt issues to explode credit demands. Savings won’t be able to increase fast enough to meet these needs. After a brief dip, due to the recession, short-term interest rates will climb to new highs by late 1982. Long-term rates won’t budge from current levels because institutional portfolio managers translate large budget deficits into fear over rising future inflation.

Supply-siders believe the tax cut will increase the after-tax real rate of return on investment income, inducing households to increase savings. These increased savings, they argue, will provide more than enough credit to satisfy government and corporate appetites for funds, letting interest rates fall during 1982. And savings will continue to grow, so exploding interest rates shouldn’t be a big problem through the ’84 elections.

The debate, then, has largely degenerated into a doctrinal dispute over the degree to which private savings will be stimulated by Mr. Reagan’s tax cuts. To both groups, the key question is by how much and how quickly personal savings will respond to changes in the after-tax real rate of return.

Forced to choose between the Wall Street and supply-side views, I would go with the supply-siders. There is ample evidence that households do respond to change in relative prices – witness the phenomenal growth of the money market funds (from $11 billion in 1978 to $150 billion in 1981). Moreover the evidence, though not conclusive, bears some resemblance to the supply-side view. Since Mr. Reagan took office, real after-tax rates of return have stepped up households’ savings (i.e., they have stopped spending money). Since mid-August, interest rates have fallen sharply.

In adopting the flow-of-funds framework of interest rate forecasting, both sides neglect the fact that, in addition to owning stocks, bonds, bank accounts, money market certificates and other financial assets, households also owns condominiums, land, used cars, gold and countless other tangible assets. This stock of existing goods, or tangible assets, has been produced and stockpiled over many years, and in a real sense represents the nation’s collected real wealth.

The stock of tangible assets in the U.S. is enormous. At today’s prices the total stock of houses, cars, collectibles and other tangibles is worth about $7 trillion. That’s more than twice the total value of the goods and services the U.S. economy will produce this year.

I believe that failing to recognize the existence of the stocks of tangible assets renders flow-of-funds analysis almost worthless for forecasting interest rates.

To private investors, tangible assets are substitutes, or alternatives, to financial assets. They ask: Should I buy a condominium or should I put my money into a T-bill account? Should I sell some of y shares of stocks to buy gold coins?

To consumers, tangible assets are substitutes for buying currently produced goods and services. Should I buy a new car or is my current car good enough for one more year? Since the amounts in question are so huge -- $7 trillion – even a moderate sift in the way households want to hold assets can have a huge effect on both credit markets and durable goods sales.

The key to understanding the influence of tangible assets on interest rates is the concept of "asset market equilibrium." An individual is free to hold his wealth in any combination of assets he chooses. One person with a net worth of $40,000, for example, may choose to hold $20,000 in gold coins and $20,000 in currency. Another person, with the same net worth, may choose to hold a $100,000 house, financed with an $80,000 mortgage loan, $12,000 in furniture, automobile and personal effects, and an $8,000 savings account.

Asset market equilibrium describes the state in which each and every asset holder in the economy has gone through his own process of portfolio selection, and now is holding the combination of assets which, at current market prices, he finds most desirable.

What happens if people desire more condominiums than exist? Individuals bidding for that scarce supply would drive the price higher, and the attempted sale of bonds or other securities to fund the condo purchases would tend to force securities prices down. These price changes tend to lower the yield on condos as an investment and raise the yield on bonds, causing people to reconsider their initial choices. Ultimately, both condo and security prices settle at levels which, again, make people content to hold the existing stock of assets.

This is not a new idea. James Tobin just received the Nobel Prize in economics for developing the notion of portfolio balance. Mr. Tobin’s idea was that the prices (interest rates) of financial assets will go to whatever level will make investors just content to hold the available stock of those assets. All we have done is to add tangible assets – land and so forth – to the portfolio management problem faced by every household.

This addition radically changes the nature of financial analysis and interest rate forecasting. It breaks the link between savings and credit supplies that plays such an important role in the flow-of-funds framework.

A household that owns at least some tangible assets can supply credit in two distinct ways: 1) by increasing savings, i.e., buying securities, with money out of its current income, or 2) by selling some portion of its tangible asset holdings to buy bonds, stocks or T-bills. The results are the same, increased credit supplies and lower interest rates.

Thus, a general increase in the public’s desire to hold financial assets – a desire to exchange tangible assets for financial assets – should be seen as an increase in credit supplies. Since the public’s holdings of both tangible assets ($7 trillion) and financial assets ($7.3 trillion) are extremely large, a relatively minor change in their desired stocks of assets can overwhelm savings and budget deficits in its effect on interest rates.

In short, we should treat households as managers of portfolios of real and financial assets. Their decisions about which assets to hold and in what proportions to hold them will be based on the same criteria as the decisions of the professional money managers; namely, expected yield comparisons. The choice between tangible and financial assets forces households to compare the expected yields on financial assets -- roughly, interest rates – with the expected yield on owning tangible assets. Often, the yield in tangible assets will include both a stream of services – e.g., you get to live in your house – as well as the potential for any increase in resale value of the asset – because housing prices go up – during the time it’s held. At this stage inflation enters the picture for determining interest rates.

A sharp increase in inflation, for example, means an increase in the yield on real assets relative to paper assets. Like any portfolio manager, the people who run households are attracted to the high return on real assets and try to increase their holdings of houses and durable goods, using money obtained by selling securities. The result, upward pressure on prices for houses and durable goods, and downward pressure on prices for bonds and other securities, i.e., rising interest rates.

The following graph shows how people changed their holdings of tangible assets as the inflation rate varied during the 1970’s.

At the end of 1972, for example, the inflation rate was below 5%, and about 41% of private sector assets were tangible assets: this implies that financial assets made up about 59% of the assets of households and businesses.

Within two years the inflation rate rose to nearly 10%. This increased the yield of tangible assets relative to financial assets, so people tried to cash in their stocks, bonds and bank accounts for money they used to buy houses, gold and antiques. The result: a 6% shift of private assets out of the financial markets and into tangible assets. That 6%, roughly a $400 billion shift, caused a major drying-up of credit supplies. Is it any wonder that interest rates soared in 1974? Rising interest rates and rising prices for gold and real estate are not simply related events; they reflect the same shift in household decisions about the safest way to hold onto their accumulated wealth. And the thing that sets off these decisions is inflation.

Turn the above analysis on its head and you’ll have the right analysis for 1982. In the last 18 months, U.S. inflation has slowed dramatically, undermining tangible asset yields. Residential real estate prices across the country are falling. At the same time, T-bill rates and other yields on financial assets have been at historic peaks. This has opened a gap between paper and real asset yields that, to some of the more aggressive inflation hedgers, looks like the Grand Canyon. As some households make the inevitable shift away from tangibles and back into higher-yielding paper, credit supplies will grow and interest rates must fall.

We expect 1982 inflation to fall to 6%. This means a continued lackluster performance for real asset yields. I am not saying that everyone who is reading this will rush out and sell his house or buy a bond, or that everyone in the U.S. will begin to think like a currency arbitrageur. But the available evidence suggests that each percentage point drop in the inflation rate should send about $100 billion of the tangible assets that people hold back into the financial markets as increased credit supplies.

Since the inflation rate for 1982 (6%) should be about four percentage points lower than the 1981 figure, this suggests we’ll see an increase in credit supplies of $400 to $500 billion for 1982 without counting on a nickel of increased savings. If the administration’s tax cut stimulates private savings by a significant amount, the case for lower interest rates is stronger still. To my knowledge, no one has yet announced that the deficit will hit one-half trillion dollars for 1982. If it does not, interest rates must fall.