One of my commenters, Dana (but not the Dana who posts here), responded to my assertion that the Fed has contributed to booms in the stock market and housing sector with the following comment:
Caused by the Fed in what way? If you are saying that the Fed has done so by working to keep interest rates low, I’d agree, at least in part, but the Fed really had little choice in this: the Fed was attempting to help economic growth following the downturns in 1991 and 2001, and there would have been no support at all for raising interest rates at those times. Since economic growth wasn’t as strong as people would have liked, especially following the 2001 recession, all of the pressure was for keeping rates low.
I started to write a response and realized that, with the amount of energy it was going to require, I might as well make it into a post. In June I argued that ending the Fed is a free market solution, and promised future posts on the Austrian theory of the business cycle and related concepts. Now is as good a time as any to continue the project.
The implicit assumption underlying Dana’s comment is twofold, and is held by most mainstream economists: that 1) the proper response to an economic downturn is to lower interest rates, and 2) the Federal Reserve should be entrusted with manipulating interest rates to make macroeconomic corrections in the economy.
I believe both assumptions are misguided. To explain why, I need to explain the Austrian theory of the business cycle.
The Austrian theory of the business cycle, developed by Ludwig von Mises and refined by F. A. Hayek, addresses the following question: why is it that there are times when all entrepreneurs seem to be making bad decisions, all at the same time? The free market, of course, assumes that many entrepreneurs will make bad business decisions — and when they do, their businesses should fail, to make way for better ones. But in this process, entrepreneurs with better foresight should succeed — in other words, the market selects for the very best entrepreneurs. So it seems odd, then, when in a recession or depression, great numbers of these people all make bad decisions, all at the same time. What explains that? Why would all the very best entrepreneurs all make bad decisions at once?
The answer lies in banks, especially central banks, engaging in artificial credit expansion and (worst of all) manipulation of interest rates.
Imagine a world with no Federal Reserve setting interest rates. In this hypothetical Shangri-La, the market would set interest rates. So: what would cause interest rates to go up and down? The conclusion is simple if you think of credit as a good, like any other good, subject to the laws of supply and demand. The more credit is available, the cheaper it will be — and the less credit is available, the more expensive it will be. If banks have a lot of money to lend, they will have to compete with one another to get people to borrow from them — and that means lower interest rates. If banks have very little money to lend, then demand will increase relative to supply, and borrowers will have to compete for that limited credit by offering higher interest rates. Easy enough so far, right?
Now, when do banks have a lot of money to lend? If you take the Federal Reserve out of the picture, the answer is: banks have a lot of money to lend when a lot of people are putting money in the bank. Consumers are usually in one of two modes: either they are spending a lot, or they are saving a lot. When they are saving a lot, two things happen: 1) banks have more money to lend, and interest rates naturally should go down, and 2) there is less demand for consumer products, because consumers are spending less.
Businesses, like consumers, go through natural cycles. Sometimes they are focused on long-term expansion — things that are not going to pay off today, but which will increase production capacity years into the future. This includes activities like research and development, or building factories. Conversely, sometimes businesses are concerned with providing more consumer goods right now, and put long-term expansion on the back burner.
At this point we need to take a small step back and provide a couple of necessary definitions. (Don’t worry: it’s very simple stuff.) Even the simplest good has an entire production structure behind it. For example, Milton Friedman popularized Leonard Read’s example of the lengthy production process involved in manufacturing a pencil in his series “Free to Choose”:
Look at this lead pencil. There’s not a single person in the world who could make this pencil. Remarkable statement? Not at all. The wood from which it is made, for all I know, comes from a tree that was cut down in the state of Washington. To cut down that tree, it took a saw. To make the saw, it took steel. To make steel, it took iron ore. This black center—we call it lead but it’s really graphite, compressed graphite—I’m not sure where it comes from, but I think it comes from some mines in South America. This red top up here, this eraser, a bit of rubber, probably comes from Malaya, where the rubber tree isn’t even native! It was imported from South America by some businessmen with the help of the British government. This brass ferrule? [Self-effacing laughter.] I haven’t the slightest idea where it came from. Or the yellow paint! Or the paint that made the black lines. Or the glue that holds it together. Literally thousands of people co-operated to make this pencil.
The process to deliver that pencil involves multiple stages. Those stages of production that are closer in time to the point of sale — such as the transportation of the pencils in trucks to the store — are called “lower-order” stages of production. The parts of production that are further removed from the point of sale — such as planting the trees that will eventually be chopped down for the wood, or mining the iron ore to make the steel to make the saws that cut down the trees — are “higher-order” stages. Investment in the higher-order stages will have the eventual benefit of making the production process more efficient, and making the product cost less . . . but it may take years for that investment to pay off. Conversely, investment in lower-order stages (the store needs more pencils! Hire more trucks to deliver them!) is unlikely to lower the cost of the good, but it will ensure delivery of a sufficient supply in the immediate future.
The key here is time preference. If it is important to deliver more consumer goods right now, a business will tend to invest more in the lower-order stages of production (hire more trucks now!). So investment in lower-order stages is good when consumer demand is high right now. Conversely, if consumer demand is low, it may be a good time for a business to engage in things like research and development, or investment in other higher-order stages of production — things that won’t pay off today, but that will ensure efficient production in the future.
Here’s the thing: long-term investments in higher-order stages of production typically require a business to borrow money. The longer the period of time it will take for the investment to pay off, the longer the period of the loan. The longer the period of the loan, the more important it is for the interest rate to be low — because long-term loans are very sensitive to interest rate changes. Businesses (and individuals too, of course) are far more likely to take out long-term loans when the interest rate is low, because the longer the loan, the more money they save. That means that borrowing for investment in higher-order stages of production typically happens when interest rates are low.
When interest rates are allowed to fluctuate with the free market, all this works in harmony. When consumer demand is low, people save more. The interest rate is lower, causing businesses to invest in higher-order stages of production. Times of low interest rates are a good time for businesses to make such investments, because the need to provide great numbers of consumer goods is not great when people aren’t buying them in great quantities.
By contrast, when demand for consumer goods increases, people are saving less. Interest rates rise, and businesses divert their profits into investment in lower-order stages of production, the better to deliver greater amounts of consumer goods to the public in a short time span.
Now consider what happens when a central bank artificially lowers interest rates. Businesses are incentivized to invest in higher-order stages of production. However, this action is not balanced by a lowering of consumer demand, and there is no increase in savings. Consequently, there is unexpected competition for the same resources. For example, when consumer demand is low, the trucking business takes resources away from delivering consumer goods, and moves them into delivering materials for, say, factory building. But when consumer demand is still high, trucks are in demand for delivery of consumer goods and for delivery of raw materials to build factories. The competition for resources drives up prices of inputs into production, and the long-term projects end up being more expensive than the businesses anticipated. Businesses start to fail, and a recession or depression hits.
The central observation here is that central planning never works in a complicated market economy. To some extent, people have internalized this lesson when it comes to prices of goods. At least a significant segment of the public understands that when the government sets prices, through price controls or otherwise, this introduces distortions into the market economy and makes it less efficient. But for whatever reason, we seem to have a tolerance for central planning when it comes to setting price controls for credit. Interest rates, after all, are nothing more than the price of credit. Why do we think it’s a good idea to allow a central authority to set that price, any more than we should tolerate central planning for any price in a free market?
To come back to Dana’s question, then: lowering interest rates when the economy is not doing well is a bad idea. Recessions/depressions are caused by malinvestment by businesses responding to manipulation of the price of credit. The proper response is to let the economy readjust, and keep government out of the way. This is what the U.S. did in 1920-1921, and that recession disappeared right away. Conversely, Hoover and then FDR monkeyed with the economy after the onset of the Great Depression, and with their actions they extended the misery unnecessarily for years.
Let’s put a stop to central planning. It didn’t work when Josef Stalin did it, and it doesn’t work any better when Janet Yellin does it.