New School Politics

Bernake Buckles, Bolsters Money Stock

Ryan | 27 08 2007

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After about a week of standing firm and not pump priming amidst the credit crunch as well as pleas from many investors to do so, Fed Chairman Ben Bernake injected the market with extra “liquidity” through Open Market Operations and a cut in the Discount Rate. Here is what the WSJ editorialized about the decision:

Financial markets were roiled again yesterday, with the Federal Reserve and other central banks stepping in to bolster liquidity in the wake of the subprime credit seizure. Serving as lender of last resort in these conditions is the proper function of central banks. But going further–with an emergency rate cut, as some in the market seem to be anticipating or hoping for–carries the risk of introducing even greater moral hazard into the financial system.

It’s worth recalling in this connection that the root cause of this credit correction was the Federal Reserve’s willingness to keep money too easy for too long. The federal funds rate was probably negative in real terms for close to two years between 2003 and 2005. This led to a misallocation of capital into real estate and certain mortgage instruments that is currently being worked off. For the Fed to take its eye off the price-stability ball now in response to short-term market gyrations would only compound the original policy mistake.

I couldn’t agree more. The recent boom in the housing as well as stock markets can, to a significant extent, be explained by the Fed induced monetary expansion which inevitably created a great demand for borrowing money. Now, borrowing money is natural economic phenomena, however, it must be understood that the borrowing cannot just occur, but rather it need be supported by proportionate amount of savings. Thus, for the economy as a whole, the demanded amount of loanable funds need be compensated by an equilibrated amount of savings, otherwise there will be a shortage of funds. In this way–like in any other market–supply and demand work together to find the correct price level.

(Back to the story) What appears to be happening currently is that the Federal Reserve kept the effective price of borrowing money too low and alas’ the market is realizing that there is actually a shortage of loanable funds. As I have pointed out before there is just not a sufficient amount of savings in our economy to justify low level of interest rates that we have been experiencing and we experience still today. The effect of the situation is an ”overinvestment” by businesses and individuals in lines of production that are essentially too expensive and too risky to be financed by the actual supply of savings–which is lower than the low interest rates led us to believe.

The peril of Fed policies are currently being experienced now. The current “credit crunch” is the reallocation of funds which includes the liquidation of many investments; it is also the source of the downward tumble of the markets. Nevertheless, the credit crunch is necessary and vital for the economy. Although at first glance it may appear to be the root of the problem, it is indeed the remedy to our economic imbalance. The deflationary pressure is nothing more than the market readjusting its price level towards equilibrium so that the relation between savings and investment do not continue to yield the same insolvencies.

The late economist Murray Rothbard explains the theory of this phenomenon very well:

In sum, businessmen were misled by bank credit inflation to invest too much
in higher-order capital goods, which could only be prosperously sustained
through lower time preferences and greater savings and investment; as soon
as the inflation permeates to the mass of the people, the old
consumption-investment proportion is reestablished, and business
investments in the higher orders are seen to have been wasteful.[8]
Businessmen were led to this error by the credit expansion and its
tampering with the free-market rate of interest.

He continues by explaining the significance of the ”boom” as well as the “bust” periods:

The “boom,” then, is actually a period of wasteful misinvestment. It is the
time when errors are made, due to bank credit’s tampering with the free
market. The “crisis” arrives when the consumers come to reestablish their
desired proportions. The “depression” is actually the process by which the
economy adjusts to the wastes and errors of the boom, and reestablishes
efficient service of consumer desires. The adjustment process consists in
rapid liquidation of the wasteful investments…In short, and this is a highly
important point to grasp, the depression is the “recovery” process, and the
end of the depression heralds the return to normal, and to optimum
efficiency. The depression, then, far from being an evil scourge, is the
necessary and beneficial return of the economy to normal after the
distortions imposed by the boom. The boom, then, requires a “bust.”

Of course, it would be very difficult for Rothbard to describe the present turbulence in 2007 since he died in 1995. The excerpt is from his book America’s Great Depression in which applies the Austrian theory that monetary policy is the prime cause of fluxuations in the business cycle to explain the cause of the Great Depression. Certainly, the peril of fiat money as experienced in the 1930s is far greater than what is happening today but the fact remains that when a governmental body is the dictator of an economy’s credit imbalances are likely to proceed.

It is a mistake that Bernake’s Fed is now moving to loosen credit at the same time that the market is moving in the opposite direction. In the grand scheme of things, they have not acted very radically so far, but their actions nevertheless will have consequences. The central bank should not cut the interest rate when they meet next on September 18 as many inversters hope they will. Perhaps the residual of the Fed induced bubble as well as the Feds inflationary crisis management will be small, however I assume that our credit problems are not yet solved and that we could witness a minor economic downturn within the next two years.