The Greatest Danger to the US Economy is the Fed

By: Gerard_Jackson

As I have said a number of times, the real economic problem that confronts the world today -- and that includes the US -- is lousy economics. Bernanke has made it clear that he follows fallacious line that it is the role of central banks to manipulate interest rates. We now have Charles Plosser, Philadelphia Fed President, stating that Bernanke's "aggressive rate cuts" will put the US on a growth trend of about 2.7 per cent by 2009. However, he claims that "if something can tip us into recession, the housing market is the biggest risk".

So why is Plosser comparatively sure about his growth figure? One reason could be the fact that the Fed's target rate is now below the 10-year bond rate. This means that the yield curve has turned positive. It needs to be understood that interest is the most important price in the economy. There is not a single factor of production that is free from its influence. It is the means by which the supply of capital is equalized with the demand for capital and then allocated through time, so to speak.

Like any other price, interest is a market phenomenon. Now if you were to suggest to Plosser or Bernanke that they should try to control the prices of houses, cars or televisions they would rightly laugh at you. Yet the very same learned men think they can control the price of time, which is what we call interest. In a pioneering work Knut Wicksell wrote in 1898 that

[i]t is important to notice that the long-term rate of interest (the bond rate of interest) must correspond somewhat closely to the short-term rate of interest (the bank rate of interest), or at any rate that a certain connection must be maintained between them. It is not possible for the long-term rate to stand much higher than the short-term rate, for otherwise entrepreneurs would run their businesses on bank credits -- this is usually feasible, at any rate by indirect means. Similarly it cannot stand lower than the short-term rate, for otherwise most capitalists would prefer to leave their money at the Bank . . . (Knut Wickell, Interest and Prices , Sentry Press New York, 1936, p. 75)*

Wicksell was absolutely right. He fully understood that forcing the rate of interest below its market rate sent out a false signal to consumers as well as producers. That this misbegotten meddling leads businessmen and consumers to make spending decisions that are unsustainable appear to be beyond the ken of central bankers. Misled by the artificially low rate of interest businessmen make unprofitable invest decisions because they think the supply of capital goods are being increased. Likewise consumers are also deceived with respect to such durable goods as houses and cars.

In the last couple of articles I explained how a cut in the rate of interest from 4 per cent to 3 per cent can result in a massive increase in the demand for credit. For example, if the maximum amount a couple could afford to borrow for a house was $300,000 at 4 per cent then by cutting the rate to 3 per cent the Fed would raise the couple's borrowing capacity to about $400,000. The same process applies to cars. This is because their heavy expenditure causes these consumer goods to share some of the characteristics of highly durable capital goods.

It should go without saying that for the interest rate cut to take effect potential borrowers should be sufficiently confident that the interest rate will remain low, at least for sometime. This returns us to Plosser's view that the "housing market is the biggest risk" the US economy is facing. But as we have just seen, changes in the demand for housing are directly linked to the Fed's manipulation of the interest rate. That Bernanke, Plosser and other Fed officials apparently cannot see this means that the biggest risk to the economy is the Fed itself.

Bernanke has been accused of continuing to implement Greenspan's "stop-and-go policies". What these critics have not grasped is that "stop-go", as it was called in 1950s Britain, are the result of monetary manipulation. Cutting interest rates stimulated credit expansion which in turn created balance-of-payments problems and "overheating", at which point the monetary brakes were applied. Critics are correct in noting that this policy disrupts long-term investment plans. Yet the same critics believe that using monetary policy to stabilise the price level will provide the necessary environment for business investments. They are blind to the fact such 'stabilisation' schemes are themselves inflationary.

The Fed seems to believe that with the right monetary management it can successfully maintain aggregate demand. As far as the Fed is concerned problems only emerge when aggregate demand exceeds supply. But this is to say no more than monetary demand has risen faster than output. Monetarists argue that keeping monetary demand equal to output will keep prices -- meaning consumer goods prices -- steady. Supply-siders emphasise the need for tax cuts to expand aggregate output, not realising that -- as the classical economists rightly put it -- supplies constitute demand. What has been lost to mainstream economics is the fact that this economic identity is severely disturbed by the kind of monetary policy well-intentioned monetarists and supply-siders promote. As always, the end result is recession.

*Wicksell was apparently unaware of the fact that Henry Thornton's An Enquiry into the Nature and Effects of the Paper Credit of Great Britain (1802) contained the same conclusions.

By Gerard Jackson
BrookesNews.Com

Gerard Jackson is Brookes' economics editor.

Copyright © 2008 Gerard Jackson

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