“I think we have much more of a Fed problem than we have a problem with
anyone else”, said US President Donald J. Trump on 20 November 2018. While
the press, mainstream economists, and bankers cry wolf, the US President hits
the nail on its head: The Fed is the source of significant economic and
political trouble. By issuing US dollar out of thin air, it sets into motion
unsustainable booms, which sooner or later turn into bust.
What is more, the Fed, expanding the US dollar quantity through credit
expansion, nurtures the “deep state”: Providing it with the financial means
to buy voter consent; to increase its impact on all walks of peoples’ lives;
to make possible its aggressive military adventures on a world-wide scale;
and to keep alive and kicking its monetary system – that couldn’t survive
without an ever deeper state.
Viewed from this perspective, is it not good news that the Fed wants to
tighten its policy further? Well, the truth is that Fed interest rate changes
do not and cannot solve any problems caused by the Fed’s meddling with
interest rates in the first place. By its very nature, monetary policy
inevitably creates economic distortions – which appear in the build-up and
bursting of speculative frenzies and the notorious boom and bust cycles.
By reviewing how the Fed has been setting interest rates in the past, you
might get the impression that things have become ever more problematic. Just
consider Figure 1, which shows annual US nominal GDP growth and the Federal
Funds Rate in per cent. Eyeballing these two series suggests that the Fed has
set its interest rates more or less in line with nominal GDP growth.
The "Interest Rate Gap"
Mainstream economists would not find any fault with such an interest rate
setting. They would argue that the central bank should, in principle,
increase its interest rate if and when economic growth accelerates, and it
should lower borrowing costs once GDP expansion loses steam. (A formalized
version of this viewpoint has been made popular by the concept of “Taylor
interest rate rules.”)
The really interesting finding, however, comes out in Figure 2: It shows
the difference between annual nominal GDP growth and the Fed’s main interest
rate in percentage points. Moreover, as we can see, this time series has been
drifting upwards: from cycle to cycle, the Fed has allowed the gap between
nominal GDP growth and its main refinancing rate to widen. In other words: It
appears that the Fed’s policy has become increasingly expansionary.
In this context, we have to remind ourselves what artificial lowering
of the market interest rate — and this is what the gap between nominal
GDP growth and the Fed’s main refinancing rate represents — does to the
economy. For instance, it inflates asset prices. In the case of stocks,
expected future profits are discounted with a lower interest rate, thereby
increasing their present value and thus stock prices.
Pretty much the same happens with real estate prices. As asset prices go
up on the markets, their value as collateral in credit transactions also
rises. Borrowing on the part of asset holders becomes economically more
attractive. Lenders, encouraged by collateral gaining in value, ease their
lending standards. As a result, rising asset prices set into motion a
borrowing and lending spree.
Furthermore, artificially suppressed market interest rates encourage
consumption at the expense of savings. The economy is then living beyond its
means. Initially, output and employment increase. Sooner or later, however,
it becomes evident that the “boom” is unsustainable, and that it (other
things being equal) inevitably has to turn into “bust”.
To fend off the bust, the central bank prevents the artificially lowered
interest rate from rising. In fact, to keep the boom going, the central bank
has to push the market interest rate to ever lower levels. This is actually
what the Fed has been doing for decades: It has set into motion a boom
through pushing down market interest rates, and in times of crises, it has
lowered borrowing costs even further.
Once the economy recovered, the Fed has raised interest rates, but only
very hesitantly. This may explain why the gap between nominal GDP growth and
the Fed’s key interest rate has grown so substantially over time. With the
Federal Funds Rate currently standing in a band of between 2.00 and 2.25 per
cent, Figure 1 b would suggest that the Fed’s rate hiking spree might be
pretty close to an end.
What Should — and Can — Be Done
But as noted earlier, this would by no means bring the problems caused by
Fed monetary policy to an end. But what should and could be done? Let us
conclude this article with what Murray N. Rothbard has to say about the Fed,
the problems it creates, and how an economically sound solution would look
like:
The American economy has suffered from chronic inflation, and from
destructive booms and busts, because that inflation has been invariably generated
by the Fed itself. That role, in fact, is the very purpose of its existence:
to cartelize the private commercial banks, and to help them inflate money and
credit together, pumping in reserves to the banks, and bailing them out if
they get into trouble. When the Fed was imposed upon the public by the cartel
of big banks and their hired economists, they told us that the Fed was needed
to provide needed stability to the economic system. After the Fed was
founded, during the 1920s, the Establishment economists and bankers
proclaimed that the American economy was now in a marvelous New Era, an era
in which the Fed, employing its modern scientific tools, would stabilize the
monetary system and eliminate any future business cycles. The result: it is
undeniable that, ever since the Fed was visited upon us in 1914, our
inflations have been more intense, and our depressions far deeper, than ever
before.
There is only one way to eliminate chronic inflation, as well as the booms
and busts brought by that system of inflationary credit: and that is to
eliminate the counterfeiting that constitutes and creates that inflation. And
the only way to do that is to abolish legalized counterfeiting: that is, to
abolish the Federal Reserve System, and return to the gold standard, to a
monetary system where a market-produced metal, such as gold, serves as the
standard money, and not paper tickets printed by the Federal Reserve.”
