The Fed's Potent Power
The Fed's Manipulation of the Money Supply Distorts Interest Rates and Thus Economic Activity
JANUARY 01, 2007 by DONALD BOUDREAUX
Filed Under : Inflation
The Federal Reserve holds the fate of the U.S. economy in its hands. Or that’s the conclusion many observers draw when they watch investors react wildly to the most minute details of the Fed’s policy statements.
This conclusion is at once exaggerated and accurate.
It’s exaggerated because, at bottom, the Fed controls only the supply of dollars. All the entrepreneurial creativity, the risk-taking, and the human effort that generate our prosperity are in the hands of each of us. If we consume without saving and laze about, or if other government agencies tax and regulate us imprudently, the economy will decline, regardless of how wisely the Fed behaves.
But the Fed’s control of the money supply nevertheless is an extraordinarily potent power. By manipulating the money supply the Fed can distort one of the economy’s most vital prices: interest rates. These rates coordinate economic activity over time.
Suppose we choose to save more. This change in our preferences would mean that we are willing to consume fewer things today in exchange for more things tomorrow. From each of our perspectives, this savings involves actions such as putting more money into savings accounts or buying more shares of corporate stock. From the economy’s perspective, however, additional savings releases some resources from the need to produce goods for consumption today. These resources become available for use in producing more capital goods and services—more factories, machines, and R&D.
Regardless of perspective, an increase in savings reduces real interest rates. These lower rates help to “tell” investors to produce fewer consumption goods and more capital goods. Of course, each investor sees only the lower cost of borrowing. But this lower cost means that some investments that previously were unprofitable are now profitable. Profit-seeking investors rush resources into these now-worthwhile projects.
Now we can see the potential problem with the Fed’s control of the money supply. Because savings, lending, and borrowing are done in dollars, when the Fed pumps out too many dollars it appears to banks as if saving has risen. Banks have more funds on hand to lend. Competing for business, banks then naturally lower interest rates, prompting investors to borrow more in order to produce more capital goods and services.
But increasing the money supply does not really increase people’s willingness to save. The lower interest rates caused by money-supply growth are an economic lie. They trick investors into thinking that income earners have become more willing to supply resources over time to support investment projects. The genuine interest rate—the one matching people’s willingness to save with investors’ willingness to invest—has not fallen.
After the Fed’s initial wave of new money works its way through the economy—sparking, by the way, some price inflation—banks find that people in fact are still saving at the same lower rate as before the Fed injected the new money. Banks will thus raise interest rates back to previous levels that accurately reflect people’s willingness to save.
The Fed’s economic lie, though, has genuinely sour consequences. If an investor builds a new factory, he expects to be able to acquire the materials and labor he’ll need over the course of decades to operate the factory profitably. Trouble is, because he was lured to build this factory only by artificially low interest rates, once rates are restored to their truthful, higher levels, the factory owner will find that he can’t operate profitably with the additional cost of borrowing. (Remember, the factory was thought to be profitable only because the Fed lowered interest rates artificially.) As soon as the owner realizes this fact, he cuts his losses by liquidating part or all of his interest in this project. Workers lose jobs.
The Fed—although thankfully not under the direct control of Congress or the president—is a government institution influenced by political considerations. If such job losses are widespread, the Fed might succumb to pressure to “solve” the problem by injecting even more money into the economy and thus keeping interest rates artificially low for a longer time. This tactical lie might mislead investors for a while longer (perhaps until after the next election). But the Fed can’t lie forever. Investors eventually catch on that the amount of resources that income earners want to devote to investment is less than the amount required to sustain current levels of investment. At this point, continued injections of money by the Fed lead only to inflation without sparking an even temporary economic boom. Recall the 1970s stagflation.
Milton Friedman’s famous solution to this problem was to oblige the Fed to follow a “monetary rule”—that is, to increase the money supply by no more than the annual growth rate of the economy.
Compared to a Fed intent on using monetary policy to manipulate economic activity, Friedman’s monetary rule would be an improvement. But a far greater improvement would be to get government out of the money-supply business. Let private banks issue money in competition with one another.
It Can Work
When people today hear this proposal their first reaction is disbelief. “That can’t work!” they say. But this assertion is belied by history. As Lawrence White, George Selgin, Kurt Schuler, and some other scholars have shown, “free banking”—which is what competitive note issue is called—has been tried several times throughout history, typically with much success. (Larry White’s 1984 Cambridge University Press book Free Banking in Britain and George Selgin’s 1985 Cato Institute essay “The Case for Free Banking” remain among the best introductions to this important topic.)
Banks’ desire to win customers keeps them from over-issuing their notes. No one wants to hold, or to accept in payment, currencies whose value is less secure than other available currencies. This same desire propels banks to find ways to reduce their customers’ costs of deciphering prices expressed in different currencies.
This competition, along with ridding money-supply decisions of political influences, is the best way to ensure that prices—including interest rates—reveal as accurately as possible people’s demands, supplies, and preferences for future consumption over current consumption. Economic decisions will be even better with money supplied competitively rather than politically.