Why the Fed will never succeed

Submitted by Alasdair Macleod – FinanceAndEconomics.org

The Fed will never succeed in its attempt to manage inflation and unemployment by varying interest rates, because it and its economists do not accept the relationship between, on one side, the money it creates and the bank credit its commercial banks issue out of thin air, and on the other the disruption unsound money causes in the economy. This has been going on since the Fed was created, which makes the question as to whether the Fed was right to raise interest rates recently irrelevant.

Furthermore, it’s not just the American people who are affected the Fed’s monetary management, because the Fed’s actions affect nearly everyone on the planet. The Fed does not even admit to having this wider responsibility, except to the extent that it might have an impact on the US economy.

That the Fed thinks it is only responsible to the American people for its actions when they affect all nations is an abrogation of its duty as issuer of the reserve currency to the rest of the world, and it is therefore not surprising that the new kids on the block, such as China, Russia and their Asian friends, are laying plans to gain independence from the dollar-dominated system. The absence of comment from other central banks in the advanced nations on this important subject should also worry us, because they appear to be acting as mute supporters for the Fed’s group-think.

This is the context in which we need to clarify the effects of the Fed’s monetary policy. The fundamental question is actually far broader than whether or not the Fed should be raising rates: rather, should the Fed be managing interest rates at all? Before we can answer this question, we have to understand the relationship between credit and the business cycle.

There are two types of economic activity, one that correctly anticipates consumer demand and is successful, and one that fails to do so. In free markets the failures are closed down quickly, and the scarce economic resources tied up in them are redeployed towards more successful activities. A sound-money economy quickly eliminates business errors, so this self-cleansing action ensures there is no build-up of malinvestments and the associated debt that goes with it.

When there is stimulus from monetary inflation, it is inevitable that the strict discipline of genuine profitability that should guide all commercial enterprises takes a back seat. Easy money and interest rates lowered to stimulate demand distort perceptions of risk, over-values financial assets, and encourages businesses to take on projects that are not genuinely profitable. Furthermore, the owners of failing businesses find it possible to run up more debts, rather than face commercial reality. The result is a growing accumulation of malinvestments whose liquidation is deferred into the future.

Besides the disruption to healthy business development, monetary inflation also transfers wealth from the owners of the existing money stock into the hands of the initial beneficiaries of extra money and credit. The transfer of wealth is predominantly from savers and wage earners in the non-financial part of the economy, reducing their ability to spend. The beneficiaries of this wealth transfer are the banks and their favoured borrowers, for whom the credit has been created. How it is that destroying widespread ownership of wealth is meant to provide meaningful, lasting improvement to an economy is a mystery never properly explained.

Monetary inflation not only encourages malinvestment, but by destroying the purchasing power of savings it encourages consumers to turn from being savers into borrowers. They have learned that money no longer retains its value. The madness of weak-money policies becomes even more clear when one contrasts empirical evidence of the post-war success of Germany’s economy, which was rebuilt on the accumulation of savings, compared with the failure of the other European economies that tried unsuccessfully to inflate their way to prosperity.

Eventually, the tendency for monetary inflation to undermine the purchasing power of a currency leads to a shift in consumer preferences away from holding cash and bank deposits in favour of accumulating physical goods. This is actually the effect that central banks try to achieve, in the mistaken belief they can control the outcome. However, only a small change in this balance of preferences is enough to trigger a dramatic downward shift in the currency’s purchasing power, raising the rate of price inflation to far higher levels than previously thought likely by the monetary planners. It is the threat, or even the actuality of this development, that always forces the central bank to raise interest rates to the point where the balance of preferences between money and goods is restored. Inevitably, this triggers a crisis where malinvestments and their associated debt threaten to come dramatically unstuck.

One would have thought it blindingly obvious that the boom and the bust are two sides of the same coin. In other words, if the artificial boom had not been created by monetary stimulus, the crisis of a bust could not occur either.