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Worse, even those rates that have edged down still impose costs on borrowers that no one but a Mafia loan shark would have dared demand in most years past. Indeed, if there is one point on which economists of every shade of opinion agree, it is that the U.S. cannot enjoy a vigorous recovery from the present recession, or perhaps even much of a recovery at all, unless interest rates fall much more sharply than they have so far. "It would take a drop of five to six percentage points for industry to get up on its feet," estimates Richard Peterson, senior vice president and economist of Continental Illinois National Bank & Trust Co. of Chicago. A comparison with history is helpful. In 1978, the last year in which housing construction and auto sales could be said to have boomed, both the prime rate and interest rates on new mortgages averaged around 9%, little more than half their present levels. y no coincidence, 1978 was also the year before a towering (6 ft. in.), burly (240 Ibs.) banker named Paul Volcker became chairman of the Board of Governors of the Federal Reserve System. His appointment by President Jimmy Carter was almost universally hailed because Volcker promised to be a man who had a plan for controlling inflation, which was galloping along at a rate of 13.3% during the year in which he took office. Also, Volcker was seen quite rightly as a man with the toughness to carry out his plan. The essence of his strategy: deprive inflation of its monetary fuel.
Volcker alone did not push up interest rates, nor is he singlehandedly keeping them high now. But by law he and the six other governors of the board have the prime responsibility for creating money, a power that they exercise independently of the President. Since interest rates are essentially the price of renting money, Volcker has his hands on one side of the supply-demand balance that sets those rates.
The demand for money, in the form of lendable funds, is determined by many factors: the growth of the economy, the rate of inflation (consumers and businessmen need to borrow substantially more when prices are rising at a 10% rather than a 5% pace) and, of extreme importance, how much the Federal Government needs to borrow to cover ballooning budget deficits. The Federal Reserve has at its command various devices that can in effect create the money needed to meet this demand (see box). And had Volcker chosen to use them lavishly in the past few years, he might have kept interest rates from skyrocketing as much as they have. By the same token, if he chose to expand the nation's money supply more rapidly now, that probably would produce lower interest rates, at least temporarily. On the other hand, Volcker believes that boosting the supply of money would eventually lead to more inflation, increased demand for credit and, ultimately, higher interest rates than ever.
That is precisely what Volcker is seeking to avoid. In his view, previous Fed chairmen, though they tried sporadically to keep down the growth of the money supply, erred by devoting far more attention than they should have to smoothing out short-term fluctuations in interest rates. That policy led them most of the time to create too much money for the financial system to absorb, thereby intensifying an inflationary spiral that was already being fed