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Volume 24, Number 9
The Mystery of Central Banking
By Robert Murphy
With the recent rate hike, the mainstream press obediently parrots the macroeconomic analysis offered by our friendly central planners at the Federal Reserve. The average citizen knows that he or she is not nearly smart enough to understand the complex interrelationships of various price indices, yield curves, consumer confidence, and so forth—that’s Greenspan’s job.
But the basic story, as told by our wise overseers, runs something like this: A high interest rate keeps prices down, but stifles business and prolongs unemployment. On the other hand, a low interest rate stimulates output and hiring but causes inflation. It is the job of the central bank to pick an interest rate j-u-u-u-st right, to achieve the optimal balance between these two extremes. (Indeed, I once read a financial analyst who actually used the term "Goldilocks" in describing Fed policy.) A good central banker knows when to cut rates to jump-start the economy out of a recession, but he also has the courage to "apply the brakes" by hiking rates when the economy begins to "overheat."
Standard Macro Models are Nonsense
As you may have inferred from my tone, I reject this popular analysis as utterly crude and pernicious. In a market economy, the interest rate is not merely a lever to stimulate or depress economic growth, and the connection between interest rates and inflation is far more subtle than the standard story suggests. The price of borrowing money has a "correct" value just as the price of a pair of shoes; the government cannot tinker with this value willy-nilly without causing drastic distortions.
Even putting aside theoretical objections (which we will analyze more fully below), the standard macroeconomic story has no historical support. The most obvious example is the Great Depression itself, which occurred a good 15 years after the Federal Reserve had been established to ostensibly dampen the vicissitudes of the wildcat free market.
In the 1970s, the US experienced "stagflation," i.e., simultaneous double-digit unemployment and inflation. This was impossible according to the prevailing Keynesian orthodoxy, the equivalent of an economy that was both stuck in a rut and overheating at the same time.
More recently, Japanese policymakers were stumped in the 1990s when they couldn’t improve their lackluster growth, despite nominal interest rates that were very close to or even literally zero percent. At that point, they had hit a wall; you can’t cut rates lower than zero, since lenders would do better to stick their funds under a mattress. (I saw a lecture by Paul Krugman in which he told us that his advice to the Japanese central bankers had been to credibly announce very high rates of future inflation, which would cause the real rate of interest in Japan to become negative.)
As these historical episodes illustrate, even the staunchest proponent of central banking would have to concede that it is more an art than a science. "Exogenous" parameters in macroeconomic models can always change, such that the "optimal" policy move turns out, in retrospect, to be dead wrong. But isn’t this true in all fields? Shouldn’t we just give the macroeconomists more time to accumulate statistics and generate even more sophisticated mathematical models?
No, we shouldn’t give the policy wonks another decade to tinker, because in this case it is the arrogant and ignorant mismanagement of the central bankers itself that is the major source of macroeconomic instability. As with other areas of government meddling in the economy, political "remedies" only serve to exacerbate (or indeed, often cause) the very problems they supposedly solve.
To appreciate the damage wrought by central banking, it may help to change the context in order to break free of habitual modes of thought. To that end, imagine that there is no Federal Reserve System, but rather a Federal Housing System. This organization is entrusted with a printing press, with which it can literally run off perfectly legal, crisp $100 bills. Every month, the Fed prints new greenbacks and distributes them to a select group of housing developers, giving the new money in proportion to how many houses a particular builder constructs in a given period. This privileged group then uses the newly printed money (in addition to other funds) to buy lumber, bricks, etc. and to hire workers to construct new houses, which are then sold to homeowners in the normal fashion.
What would be some of the major effects of this hypothetical arrangement? Well, the newly injected $100 bills would allow the builders to bid up the prices of lumber and other materials, siphoning these resources away from other uses, and causing more homes to be built than would otherwise have occurred. Especially on the heels of a bigger than expected injection of cash, there would be an apparent boom in the housing industry, as builders increased their orders for materials and hired more laborers to complete their projects. Because of the government subsidy, the housing industry would be more profitable than before, and competition among builders would eventually lead to a fall in housing prices for consumers.
Of course, running off new $100 bills from the Fed’s printing press would cause a rise in the price level, first in the prices of lumber, shingles, windows, etc., but eventually in the prices of all goods and services, as the extra cash worked its way throughout the entire economy. The people running the Federal Housing System would soon learn that if they injected too much cash too quickly, it would cause massive dislocations in other industries (which need lumber, laborers, etc. too) and would lead to unacceptably high rates of price inflation. Of course, it would be very painful and disruptive to stop the printing press altogether, since this would put many builders out of business and cause a spike in housing prices. After such policy reversals, entire neighborhoods of half-built houses would be abandoned, serving as stark reminders of wasted resources.
After the Federal Housing System had been in place for some time, the private sector would become better at anticipating its actions. Analysts would devote their entire careers to parsing the casual remarks by Fed leaders, and would run statistical tests on the data used by the Fed to determine how much cash to print in the upcoming months. (For example, perhaps the Fed would look at new homes per capita, or the rate of housing growth compared to inflation, in order to determine its "target price" for new homes.) As people came to expect the monthly injections of cash, the Federal Housing System would become less and less able to influence events. In order to boost employment, for example, the Fed would have to inject ever higher amounts of cash, in order to catch the ever savvier home builders by surprise and make their projects more profitable than they had originally reckoned.
Naturally, certain groups would have a vested interest in either high or low rates of money injection. Young couples, for example, would clamor for the Fed to print out more cash and push down the price of a new house. Older couples who held no mortgage, on the other hand, would write Letters to the Editor urging restraint on the part of the Fed, since they would want their older homes to retain their market value. In this environment, it would be up to the technocratic economists to advise the Fed on a fair and sensible amount of money injection to the housing industry, which would best balance the desires of everyone.
The Real World
I hope most readers will agree that the hypothetical Federal Housing System would be a horrible idea. In the long run, it would be far better for everyone involved—even new home buyers—to eliminate the extra source of uncertainty and political manipulation in the housing industry by abolishing the FHS. Freely established market prices would foster the best use of scarce resources to satisfy consumer desires, whether for housing, fancy dinners, or automobiles.
But if the reader has agreed with me thus far, then he or she must also endorse the abolition of the Federal Reserve System. Despite the mysticism of central banking, and the awe with which we mere mortals behold Alan Greenspan, there is no major difference between central banking in the US, and the hypothetical scenario I invented above.
After the Federal Reserve sets a "target interest rate," it achieves its goal by (among other things) literally creating money out of thin air. The process is obscured through intermediate steps (such as "open market purchases" of securities), but ultimately the Federal Reserve creates new deposits for major banks out of an accounting vacuum, and then allows its privileged clients to use these new deposits as the collateral with which the client banks issue new credit to borrowers. Because borrowers will seek a larger quantity of credit only at lower interest rates, the Fed can indirectly influence the various market rates of interest by controlling the amount of credit that its client banks can ultimately loan.
All of the effects described above (for the Federal Housing System) occur under the Federal Reserve System, except that in the latter case the damage is more widespread, since the credit markets affect virtually all industries. Rather than printing up new cash and handing it out to large home builders, in effect the Federal Reserve prints up new cash and hands it out to privileged lenders. The hypothetical Fed stimulated housing construction, but the real Fed stimulates all industries that engage in long-term projects.
As explained by the Austrian theory of the business cycle, the interest rate serves to coordinate the intertemporal structure of capital goods. To put it simply, a high interest rate is a signal to producers that consumers are "impatient" and place a premium on production processes that involve a relatively short gestation period. A low interest rate, on the other hand, is a green light to producers to invest in processes that tie up resources for a longer period. (Notice that a process in which resource costs are rolled over for, say, 10 years will be more sensitive to the interest rate than a process in which resource costs are recouped by the final sale after, say, two years.)
Depending on factors such as technology, the supplies of various capital goods, and the willingness of consumers to postpone immediate consumption in order to enjoy higher consumption in the future, the Austrians believe that there is a "correct" market rate of interest at any given time (for loans with a specified level of risk). But a central bank interferes with the market’s natural tendency to achieve these correct rates. In order to keep voters happy, the central bank habitually pushes rates lower than they ought to be, which causes the familiar boom period in which stock prices soar and unemployment falls. But this artificial expansion is unsustainable, and inevitably leads to a bust period, in which many of the production processes must be curtailed or abandoned altogether, and workers in these lines must be laid off.
A short article such as this one cannot of course explain the subtle features of Austrian business cycle theory; the interested reader should consult Mises’s discussion in Human Action. However, I hope that my analogy of the Federal Housing System has alerted the reader to the problems of our current arrangement. We will never rid ourselves of the boom-bust cycle until we remove our monetary and banking institutions from political manipulation, and return them to private individuals operating in a voluntary market. In light of the more sophisticated Austrian analysis, the standard macro theories regarding Fed policy and interest rates are hopelessly naïve and destructive.
Robert Murphy is an adjunct scholar of the Mises Institute. He teaches economics at Hillsdale College (firstname.lastname@example.org).