The Malady of the Federal Reserve

Ben Bernanke and his pals at the Federal Reserve are meeting today to come up with their next plan for manipulating credit markets.  Tomorrow they’ll let us know their grand designs for monkeying with the money supply and interest rates.  Of course, you can count on more money at cheaper prices…it’s what they always do.

If only more money equaled more wealth.  Then we’d all be rich.  After all, the Federal Reserve’s added $2 trillion dollars to its balance sheet and pushed the federal funds rate to practically zero since mid-2008.

Unfortunately, more money does not automatically equal more wealth.  Sometimes more money equals less wealth.  In fact, the typical American family’s net worth fell 39 percent between 2007 and 2010.  What gives?

The fact of the matter is more money, by way of cheaper credit, does not equal more wealth.  It equals more debt.  More debt, especially when used for consumption, equals the exact opposite of more wealth; it equals less wealth.

Real wealth is accumulated through savings and capital investment.  Not credit based consumption.  Accumulating real wealth takes patience and discipline.  Moreover, it takes hard work.

Ignorant of Ignorance

The Federal Reserve prefers quick fixes and cheap tactics to policies of real wealth creation.  That’s why they’ve pushed interest rates below the rate of inflation.  They want more borrowing and spending.  They prefer this to higher interest rates, which encourage greater savings and a more cautious use of credit.

“To be ignorant of one’s ignorance is the malady of the ignorant,” said Amos Bronson Alcott, sometime in the 19th century.  Although Alcott made this remark long before the Federal Reserve came into existence, it’s likely he would have concluded the Federal Reserve suffers from the malady of the ignorant.

Here at the Economic Prism we know not what the rate of interest should nor shouldn’t be.  But we do know that the Federal Reserve, and its army of technicians, doesn’t know either.  This, regrettably, is more than the Federal Reserve knows.  For the Federal Reserve believes they know what rate of interest lenders should charge borrowers.  They also believe they know the optimal price of interest for the economy…they even have yield curve graphs to prove it.

The propensity of government to believe they can improve an economy through central planning and control is what Friedrich Hayek called The Fatal Conceit.  According to Hayek, economic decisions require price signals, in the form of a price charged for a commodity, for producers to increase supplies and/or consumers to reduce demand.  When these price signals are hindered through government policies, economic distortions appear.

Even with their five year plans, and army of technicians, Soviet planners couldn’t get the price of toothpaste right.  They’d set the price too low and the shelves would go empty.  Or they’d set the price too high and inventory would pile up.  They couldn’t keep up with the ever changing conditions of the economy.

Likewise, government edicts cannot command the price of Peruvian bananas or rents on New York City apartments.  But when decisions are left to producers and consumers, supply gluts and demand crunches quickly equilibrate at their market determined price.

The Malady of the Federal Reserve

So if Soviet central planners couldn’t figure out the price of toothpaste, where does the Federal Reserve get off thinking they can fix the price of the economy’s most fundamental element…its money?

Obviously they can’t.  This simple fact is evidenced by the destructiveness of their policies, particularly over the last decade.  Yet the Federal Reserve continues to suffer from the malady of the ignorant.  They continue to affect the price of all goods and services by tinkering with the price of money rather than lettering free individuals (i.e. lenders and borrowers) enter into private contracts to determine the price of money on a transaction by transaction basis.

On the agenda of today’s Fed gathering is whether they should continue their bond buying program or not.  This bond buying program has been called Operation Twist, and is currently set to expire at the end of the year.  If you recall, Operation Twist is a little different than straight quantitative easing…where the Fed borrows money into existence and uses it to buy long-term mortgage bonds and Treasuries.  Here’s a brief review…

Under Operation Twist, the Fed prints money to buy long-term bonds and then borrows the money back from investors for short, approximately 1-month periods.  By doing so the freshly printed money is pulled back out of the financial system, which restrains inflation expectations.  The Wall Street Journal’s referred to these money games as “sterilized” QE.  We call it “writing checks to each other.”

In theory, sterilized QE allows the Fed to lower long-term interest rates and encourage more credit based spending by households and businesses.  By artificially lowering the price of money the Fed believes they stimulate demand and boost economic growth.  Thus far, in the weakest recovery in the post-World War II era, the Fed’s scored a big fat goose egg for their efforts.

Naturally, the Fed’s actions are with the best of intentions.  Unfortunately, they don’t appreciate that government price-fixing always makes a big mess of things.  This is hard to believe, we know, for if you look around you can see the disorder of their handiwork just about everywhere.

For instance, certificates of deposit from Bank of America are currently yielding 0.25 percent over 12-months.  If you invest the $10,000 minimum, at the end of the year you’ll have made $25 bucks.  No doubt, only extreme government intervention into financial markets could pull off such a feat.

Sincerely,

MN Gordon
for Economic Prism

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