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Interest Rates, Funny Money, and Economic Malaise
Interest Rates, Funny Money, and Economic Malaise
Since the 2007–8 financial crisis, more and more economists have entertained the idea that there might be some connection between artificially low interest rates and business cycles. By “artificially low” I mean interest rates that are pushed below their natural levels by expansionary monetary policy. The relationship between monetary policy and interest rates is tricky; beyond the immediate short run, it is hard to say whether liquidity effects (which tend to push down rates) or rising income effects (which tend to push up rates) dominate. But in the short run, to the extent that expansionary monetary policy is a surprise, there should be a fall in market interest rates that is not justified by economic fundamentals — namely, real saved resources available for investment projects.
The way the business cycle unfolds looks like this: The monetary authority injects new money into capital markets in an attempt to give the economy a shot in the arm. Investors see artificially low rates and increase their investments in projects that will pay out in the future. But households are not saving any more real resources. In fact, households will probably respond to low interest rates in the same way: the costs of reallocating purchasing power from future you to present you have fallen, so you are more likely to borrow to equalize your intertemporal marginal utility of consumption. With both consumers and investors using up more real resources in ways that are fundamentally at odds with each other’s plans, something’s got to give. The comovement of consumption and investment beyond the economy’s production possibility frontier is ultimately unsustainable. When everyone wakes up to the fact that the low interest rates were the result of funny money, rather than real economic forces, the bubble bursts.
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The Federal Reserve: A Failure of the Rule of Law
The Federal Reserve: A Failure of the Rule of Law
“Money is power.” We’ve all heard this aphorism many times before. Too often it’s a lazy shorthand dismissal of the finding of mainstream economics, which show that the pursuit and possession of money often entails innocuous or even beneficial consequences for society. Dr. Johnson was right after all: “There are few ways in which a man can be more innocently employed than in getting money.”
But there are some contexts in which the saying is apt. An obvious case is the Federal Reserve. The Fed has a monopoly on the creation of base money, the fundamental asset underlying the banking and financial system. And over decades, with each instance of financial turbulence, the Fed has become less constrained in how, when, and why it creates base money. Since the Great Recession, the Fed has been able to bestow purchasing power, liquidity, and solvency on just about any financial organization it pleases. If that isn’t power, there’s no such thing.
The Federal Reserve System was created in 1913. It was intended to be a formalization of the interbank clearing system that then existed in the National Banking System. It was not intended to be a central bank. Even in the early 20th century, economists and politicians had some idea of what central banks did and how they behaved, and the existence of such an institution was widely regarded as inherently un-American, in the sense that it could not be reconciled with a self-governing society. That’s why so many proponents of the Federal Reserve System bent over backward to insist they were not advocating the creation of a central bank. And at the time, their repudiations were reasonable; there was no reason the Federal Reserve System had to acquire the powers it did.
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