Ludwig von Mises Institute

The Mises Institute monthly, free with membership

August 1995
Volume 13, Number 8

The economy is again teetering on the brink of recession, and everyone's calling on the Fed to do something--anything!--to prevent another economic slump. But while the Fed has mastered the art of messing up the economy, it doesn't have the ability to stop the bad consequences of its own manipulative actions.

According to the typical business page, the Fed fully controls the economy through every phase of the boom-bust cycle. It raises and lowers interest rates, "fine tunes" the economy, ensures "optimal growth," prevents inflation, brings about "soft landings," and "cools off" production when the economy is "overheated."

This view of the Fed is as silly as the old Keynesian notion that taxing and spending can direct economic life. The Fed cannot master the economy. If it could, money creation could take us onward and upward into the light, under Greenspan's guiding hand.

In fact, a whole host of variables are out of the Fed's control. It cannot set exchange rates of the dollar, nor interest rates, nor capital values, nor the rate of price inflation. Politically, a central bank exists for one purpose: to keep interest rates low, inflate the money supply, and, thereby, generate economic booms, and reduce the burden of government debt.

The only rate of interest the Fed can actually set is the discount rate. That's the rate charged to financial institutions when they borrow from the Fed. If the Fed wants interest rates to fall, it can lower its discount rate; banks will then borrow more from the Fed and have a greater supply of loanable funds. It is the greater supply of loanable funds that lowers rates of interest. But the Fed can only influence, not set, these rates.

In a market system, literally no one has the power to set prices; even businesses do not set the prices of their own goods. Prices are set by the interplay of buying and selling on the market. Demand and supply, in turn, are determined by the evaluations people make of each good or service.

The interest rate on the market is determined by the value people place on present wealth over future wealth. Those who desire present funds more intensely will be able to acquire them, from those who desire present funds less intensely, in exchange for returning them plus a premium at an agreed to future date. Demand and supply set the premium (or interest rate) according to the balance among borrowers and lenders.

Now, Fed intervention can manipulate the interest rate, indirectly, by affecting the supply of loanable funds. Its open-market operations increase the overall supply of loanable funds as the Fed pays banks for securities with newly created money. This tends to push the interest rate down. This power, as small as it appears, is a boon for the Fed, the Treasury, and their privileged banks--if not the public that suffers from its consequences.

On the demand side of the market, the Treasury builds up loanable funds by marketing its securities. Without the Fed supplying loanable funds, the rate of interest on Treasury securities would be higher than it is (other things being equal). The Fed "monetizes" the debt, that is, it exchanges debt for newly created money, and then holds that portion of the debt off the market.

Banks benefit from these operations by brokering debt monetization. They buy Treasury securities, hold them to earn interest, then sell them to the Fed, which always stands ready to buy Treasury debt. Banks get a portion of their assets insured by the Fed, plus they receive a brokerage fee and capital appreciation of the securities when the rate of interest is pushed down by Fed actions.

To clear up confusion on how this process works, let's consider an analogy. Suppose that an automobile manufacturers consortium takes over the Fed and redirects open-market operations from banks to automobile firms.

The Fed, under control of the car cartel, uses newly created money to purchase cars, particularly those produced by the government's Car Department, whose autos "compete" with private producers for consumer patronage. Government cars are sold in large lots at auction, so they are most often purchased by auto dealers, not consumers. The dealers then broker the cars to consumers.

Fed inflation of the money stock would bid up the price of cars, to the benefit of producers including, and especially, the government. Auto dealers would benefit by having the Fed stand ready to buy their cars, especially government ones, at market prices or above. The Fed holds all the cars it purchases off the market, thereby preventing that part of the stock of cars from depressing the market price.

In this case, the Fed has market control. Why, then, can it not permanently support the price of cars and bring perpetual profits to car manufacturers and dealers? Because the car manufacturers respond to higher prices by producing more cars at a high rate of profit; this increases demand for factors (labor, machinery, parts, etc.), bids up their prices, and pushes the profit rate back to a normal level.

Fed inflation also causes the dollar to fall as the newly created money is spent more widely through the economy. Auto manufacturers, recipients of the newly created money first, pay owners of factors of production who produced the cars. They spend money on other goods and services, bidding up their prices and setting in motion a similar process in other markets. Eventually, the prices of goods and services in general are bid up. This reduces the "real" price of autos even though their "nominal" price stays the same.

Now we can see why the Fed, when starting a business cycle by expanding money and credit, looks like the master of the market. Open market purchases of government securities bid up their prices and lower interest rates. Fed intervention supports the market for government debt, allowing the Treasury to add to the national debt at lower rates of interest.

The additional bank credit at lower rates of interest entices entrepreneurs to borrow and spend freely on new capital projects. Consumer durables, houses and autos in particular, become more affordable. Debt-financed expenditures fuel a boom in housing and auto production.

As the boom is set in motion, the Fed appears to reign supreme: unemployment falls, profits increase, capital values rise, the stock market booms, price inflation is modest, and the dollar is strong. But the policy contains the seeds of its own destruction. As the newly created money is paid to workers who produce the boom-generated capital and consumer goods, they do not return all of it to banks in their savings accounts. They spend it on consumer goods, which drives up their prices.

As the purchasing power of money declines, lenders reduce their supply of loanable funds (to avoid being paid back in cheaper dollars) and borrowers increase their demand (to be able to pay back in cheaper dollars). The reduction of credit supply, and the increase in credit demand, conspire to raise interest rates. That causes the boom to reverse.

If the Fed tries to push the rate down by inflating more rapidly and purchasing bonds more intensely, then the dollar deflates in value all the more quickly. If the Fed ceases open market operations, the supply of loanable funds will be reduced. In either event, the rate of interest will increase and thus, counteract the Fed-desired consequences of its inflation policy.

In every inflationary cycle, the market eventually exacts revenge. The Fed, in contradiction to its main purpose for existing, is forced to surrender to the increasing rate of interest. That's when the Fed changes its posture. It begins to "engineer" a "soft landing" by "increasing" interest rates to "cool off" an "overheated" economy. Actually, the Fed is meekly reacting to market forces. These forces push up the rate of interest because of previous inflationary Fed policy.

The once-supreme Fed begins to twist to and fro. Instead of successfully manipulating and controlling the market, it is reduced to cajoling and reacting indirectly to counteract the changes brought forth by the market. None of this back-and-forth policy has anything to do with the market economy, in which there are no natural cycles of boom and bust.

The best way to rid ourselves of Fed arrogance and Fed-created business cycles is to rid ourselves of the Fed. That way, the market could determine the rate of interest, as it does prices, to the benefit of everyone. We could then go about our economic lives free of recessions and depressions, and of government attempts to manipulate the market for its own benefit.

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Jeffrey Herbener teaches Economics at Grove City College

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