I would have thought that two back to back boom/bust cycles would have our Federal Reserve governors rethinking their dogma, but that does not seem to be the case. A federal funds rate of 1% created the housing bubble which is still rendering our banking system insolvent, throwing large numbers of people onto the unemployment rolls, and generally producing the most significant economic recession since the Great Depression.
So what is the Fed’s prescription for our current ailments? Well, with this recession much more serious than the 2002 experience, the Fed has now dropped the federal funds rate to a record low of between 0% and .25%. Will these low interest rates help the economy recover from this deep recession? Will they cure our current difficulties and generate healthy new growth?
Based on my reading of economic principles, the answer is no. In fact, I believe our Federal Reserve is setting us up for more economic heartburn. Consider this quote from Marc Faber, an exceptionally astute, international economic commentator:
"This is where I have the greatest problem with US economic policy makers. I don’t think they have ever recognised that the excessive, credit-driven expansion of the US economy was unsustainable in the long run and that, sooner or later, the current crisis was inevitable. But not only that! … US economic policy makers are attempting to restore economic growth through essentially the same policies; … In fact, I would argue that the large fiscal deficits and easy monetary policies will make sustainable, healthy economic growth next to impossible."
Marc Faber, The Gloom, Boom & Doom Report, July 9, 2009
In Are Low Interest Rates Beneficial, I explained why a naturally falling interest rate is indicative of a healthy, progressing economy. Let’s now explore the nature of an artificially depressed interest rate, and why it harms us.
To Reduce Interest Rates, a Central Bank Floods the Economy with New Money
A central bank cannot just declare a lower interest rate. If our Fed, for example, could just forcibly reduce interest rates on loans to below market levels, we would find more people wanting to borrow and fewer people wanting to make loans — we would have a credit shortage. This is an inexorable economic law that not even the Federal Reserve can ignore: a maximum price on a good causes a shortage of that good.
Whenever the Fed wants to lower interest rates, therefore, it must prevent a credit shortage by creating as much new money as the markets demand. Creating new money for this purpose was impossible when money was gold, but now … as the Federal Reserve Chairman Ben Bernanke himself said in 2002: "… the U.S. government has a technology, called a printing press … that allows it to produce as many U.S. dollars as it wishes at essentially no cost."
To drive bank lending rates lower, the Fed revs up its "printing press" via a credit expansion (as I explained in The Trouble with Credit Expansions). The Fed’s purpose since inception has been to run a profitable banking cartel, and it has pursued that goal by creating an environment exceptionally hospitable to credit expansions. Economics Professor George Reisman, for example, commented in a recent blog post on the Fed’s "… long-standing, deliberate policy … of reducing and even altogether eliminating reserve requirements." I presented arguments for this interpretation of the Fed in my earlier post , The Trouble with our Banking System.
To initiate or accelerate a credit expansion, therefore, the Fed only needs to move the federal funds target rate to below-market levels — assuming, of course, that the banking system is solvent and people want to borrow. With a Fed Funds rate well below free market levels, banks have exceptionally easy and inexpensive access to bank reserves, allowing them to meet all credit demands. The Fed ensured that bank rates remained low by holding its Fed Funds Target Rate at 1% for an entire year, and then raising it ever so gently over another two years. One intellectually sound measure of the money pouring into the US economy over this period is the Austrian Money Supply chart provided by mises.org, here.
Below Market Interest Rates Mean Unbounded Credit
Credit availability increases with either a naturally or an artificially falling interest rate, but there is an enormous difference between the two situations. On a free market, with a naturally falling interest rate, new investment spending is limited to the increase in savings, which is equal to the reduction in consumption spending. With the central bank holding interest rates below free market levels, however, the economy may experience virtually unlimited borrowing and spending — for as long as the central bankers keep reserves growing, and as long as the banks continue to find creditworthy borrowers.
Unlike a free market environment, the only constraint on a credit expansion is judgment: the judgments of borrowers and lenders. Federal Reserve officials could potentially exercise judgment, of course, but former Fed Chairman Alan Greenspan has repeatedly told us that Fed officials are unable to detect bubbles before they burst. In my opinion, this self proclaimed failing has more to do with the Fed’s unacknowledged role as banking cartel leader, than a lack of judgment (see The Trouble with Our Banking System).
Many commentators in 2009 are suggesting that federal government regulators could have prevented the boom’s excesses, but it’s frankly silly to think that federal government employees would have gone against the desires of the Bush Administration, the Federal Legislature, and the Federal Reserve — all of whom actively promoted the credit expansion boom. See my previous post Capitalism Did Not Fail Us for more on this point. Besides, how does it make sense to hire an army of regulators to look over bankers’ shoulders when a higher, market determined, interest rate would automatically achieve a better, more consistent result?
Unbounded Credit Causes Malinvestments
When borrowers spend their new money, they increase market prices for the goods or assets they acquire, relative to what those prices would have been. When a lot of credit-driven buying is focused on the same good, such as houses, many people see the rapidly rising prices as an important market signal. In that event, people tend to borrow more money to participate in the apparent trend, further distorting relative prices. If the central bank keeps rates low even after such a dynamic develops, price distortions have sometimes reached fantastic extremes and triggered widespread economically dysfunctional behavior. Toward the end of the recent housing boom, for example, many house purchase decisions were entirely disconnected from personal income considerations — and some business projects were launched without any realistic profit expectation.
From an entrepreneur’s perspective, an artificially lowered borrowing rate creates apparent profit opportunities throughout the economy — because the prevailing natural rate of return is initially available almost everywhere. As with a naturally lower rate, the artificially lowered interest rate makes durable goods and capital goods look undervalued. Artificially low rates, therefore, promote widespread investments in capital goods and durable goods producers — just as the naturally lower rate does.
If time preferences remain unchanged during a credit expansion, consumption spending actually increases even as investment spending increases — an oxymoron made possible only by the flood of new money. With consumption spending increasing, returns to retail and other late stage businesses improve, instead of falling as they do when interest rates fall naturally. The artificially lowered interest rate, therefore, actually prevents late stage businesses from releasing resources needed to make capital goods investments viable.
Because no sector is releasing resources, businesses throughout the economy find themselves bidding against each other for a share of the finite factors of production. Many credit-funded entrepreneurs, therefore, find they need to borrow more funds to pay higher than anticipated factor costs. As factor prices continue to rise, more and more credit is sought. With borrowing rates remaining low, the free market signals that would have alerted entrepreneurs to the fundamental problem are suppressed.
The illusion of booming business continues as long as the credit supply grows rapidly enough to meet all demands. As we saw during our recent booms, that can be a long time. Eventually, however, the credit growth must slow and then the malinvestments begin to appear.
Unbounded Credit Causes Excessive Leverage
The viability of a leveraged investment depends, of course, on borrowing money at a lower rate than the investment is expected to pay. As explained in The Interest Rate — What is It?, free market forces tend to drive all laissez-faire interest returns toward one uniform rate (adjusted for risks). Capitalists pursuing the highest available rates of return move capital toward high returns and away from low returns, reducing the differences in the process. On a free market, therefore, opportunities to enhance investment returns with leverage are limited, fleeting, risky — and therefore self-regulating.
An artificially lowered interest rate, however, completely changes the nature of leverage. Whenever the central bank holds the borrowing rate well below the natural rate of return, the stage is set for easy "wealth" acquisition. With assurances of a continuing interest rate spread, the total return from an investment is limited only by the amount of leverage employed — and one doesn’t need to be a gifted entrepreneur to achieve high returns. A person who borrows enough money at low rates can invest the proceeds in almost any business or financial instrument and make extravagant returns — assuming no sudden change in interest rates or credit availability.
In a laissez-faire economy the profit motive is critically important and beneficial to everybody. When capitalist/entrepreneurs pursue higher returns, they are directing both their energy and capital toward meeting the most urgent consumer needs. A credit expansion boom, however, perverts the profit motive by driving the entrepreneurs and capitalists toward higher leverage.
During a credit expansion, capitalists naturally tend to leverage existing businesses and move more capital toward financial services where high leverage can be employed most effectively. It’s no wonder, then, that we witnessed a financial sector expansion during the bubbles. Companies like General Electric and General Motors expanded their financial divisions to the point where they delivered a large share of the parent company’s profits. We also saw tremendous growth in investment banking and the hedge fund industry, where significant leverage was often used to push fixed income investment returns to much higher levels.
It is clear that artificially depressed interest rates enabled and even directly caused most of the excesses which so many people are now blaming on "capitalism." In truth, however, the Federal Reserve is a central planning institution — it is a creature of government and an anathema to capitalism.
Artificially Lowered Interest Rates Cause an Inevitable Bust
To meet all demands during a credit expansion, banks must grant more and more credit every year. This credit expansion treadmill, however, can’t continue to accelerate forever. Eventually the central bank must raise interest rates, or risk an out-of-control inflation which could threaten the currency’s survival. Every credit expansion boom, therefore, reaches the point where the pace of credit creation slows, and that point inevitably signals the beginning of the bust.
Some projects are terminated because another increment of credit is unavailable, and some projects are shut down simply because profitable completion is obviously not feasible. Much of the demand entrepreneurs try to meet during a boom is itself dependent on the accelerating flow of credit, and rising interest rates tend to slow that growth — even as supply is expanding. Ultimately, however, there are simply insufficient real resources in the economy to allow all projects to be profitably completed.
The end result is capital consumption, conspicuously visible in the unfinished business projects, and in the idle factories, ships, freight cars, trucks, and other capital equipment. Following a boom, therefore, we have a distorted structure of production and a clear need to let the markets reallocate resources to those sectors which have consumer demand supported by real income — not credit.
But what happens when the Fed doesn’t permit the markets to reallocate resources and rationalize the economy? What if the Fed, instead, simply drops interest rates to even lower levels and pumps new money into the banking system’s balance sheet? Well, … we are about to find out.
 For example: Mish Shedlock: Trucks Sit Idle; Rail Traffic Horrific, and January ends with grim news on stocks, jobs, shipping (scroll down the page for this one).