The Fed Can Do Real Damage Without Even Trying

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The Fed Can Do Real Damage Without Even Trying

  • Bull in a china shop

December 17, 2015

The last financial crisis and recession drove many to the writings of Austrian economists and the Mises Institute. In fact, I’m in that cohort. And every time the Fed makes headlines, I see this crowd getting larger.

Sub-Groups Within the Anti-Fed Party

Even with this December 2015 episode, with the media abuzz over a 0.25 rate increase, many are questioning the Fed’s authority and ability to steer the macroeconomy toward calm waters and away from the storms. The anti-Fed crowd, however, has many sub-groups and some of them are especially distinct from the objective Austrian position that manipulated credit markets cause the boom-bust cycle.

  1. A few suggest that there’s no rudder attached to the Fed’s helm, and that “the economy is going to go where it’s going to go”.
  2. Others go to another extreme and assume the ship’s captain is corrupt, that the Fed is a part of or at the center of an evil conspiracy to destroy the economy and enrich themselves at the expense of everybody else.
  3. Still more argue the opposite of Austrians, as Robert P. Murphy pointed out in his article, Did “Tight” Fed Policy Cause the Financial Crisis? These “market monetarists” confuse the policies that affect the timing of the cycle for the causes of the cycle.

There may be small elements of truth to all three of these anti-Fed camps. The Fed certainly postures themselves as being in control of a lot more than they really can control, but their policy decisions and announcements definitely do have real and far-reaching effects. And, as an arm of the large and powerful institution we know as the US government, we can’t completely rule out the possibility of a few mischievous intentions creeping into FOMC meetings. Also, those in the market monetarist camp at least blame the right people for causing the business cycle, even if they are misguided on the important things.

The Fed Can’t Calculate the “Correct” Interest Rate

All of these positions miss the point that, whatever the Fed imagines they can control and whatever their real intentions are, a central authority cannot optimally set prices that are in line with people’s preferences. Unhampered markets are the only way that prices can reflect people’s real preferences.

This is why Peter Klein’s satirical piece, Underwear Prices to Remain Near Zero, is right on point. If it’s absurd to say:

[Federal Underwear Reserve Board] officials are struggling to decide whether the economy can tolerate higher underwear prices, as economic growth continues to wobble along rather than power ahead on a clear upward path. (A steady supply of new and clean underwear is a primary determinant of the labor-force participation rate, which in turn drives economic growth.)

…then it is also absurd for the FOMC to announce, as they did in October:

To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that the current 0 to 1/4 percent target range for the federal funds rate remains appropriate. In determining whether it will be appropriate to raise the target range at its next meeting, the Committee will assess progress–both realized and expected–toward its objectives of maximum employment and 2 percent inflation.

Rand Paul made a similar point when responding to the recent 0.25 rate hike. He even invoked the socialist calculation debate–if central authorities can’t even come up with the “right” price of bread, like in the Soviet Union, how can we trust a central authority to come up with just the “right” interest rate?

This lesson is even more important than the price of bread or underwear, because interest rates affect entrepreneurs’ decision to engage in various production projects and everybody’s decision to save.

But, the Fed Can Cause an Unsustainable Boom

When the central bank expands credit beyond what an unhampered credit market would allow, capital is diverted to lines of production that cannot be completed with the current set of resources in the economy. Consumption increases at the same time, as people decrease their saving at the lower interest rates.

This boom can’t sustain itself because no new resources have been added to the economy. In fact, the economy’s set of resources is diminished through capital consumption and misallocated due to farcical information from credit markets. The numbers tell a different story—consumption, wages, incomes, stock prices, and employment are all up, even though damage is being done throughout the economy.

The increasing scarcity of resources drives up the cost of production, turning any expected profits into realized losses. Mass liquidation follows as producers try to recoup their losses now that hindsight reveals their past errors. The previous upswing in the numbers is reversed as wages, employment, and stock prices fall.

Interest rates based on people’s real time preferences don’t have these effects. There’s no cluster of errors because there’s no fountain of bad information. Unhampered credit markets allow for sustainable trading of present and future money, instead of mountains of debt and malinvested capital.

Note: The views expressed on Mises.org are not necessarily those of the Mises Institute.

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