Current Fed Policy: An Exercise in Keynesian Folly
In his The General Theory of Employment Interest and Money, John M. Keynes criticized, without citing or mentioning him explicitly, Hayek’s (Austrian) primary policy recommendation: the best way to avoid a bust is prevention. Hayek knew that avoiding the credit-created boom prevents the associated malinvestments and over-consumption while boom-bust cycles will be avoided through prevention or significant reductions in credit creation.1 Keynes, however, thought differently:
Thus the remedy for the boom is not a higher rate of interest but a lower rate of interest! For that may enable the so-called boom to last. The right remedy for the trade cycle is not to be found in abolishing booms and thus keeping us permanently in a semi-slump; but in abolishing slumps and thus keeping us permanently in a quasi-boom.
A good interpretation of the Bernanke Fed monetary central planning since the end of the “Great Recession” with its near zero-interest rate policy coupled with multiple rounds of quantitative easing (QE) driven by apoplithorismosphobia, is that the Fed has been attempting to follow Keynes’s advice.2 The way to avoid a new slump is to keep interest rates low for as far as the eye can see as a way to overcome a lack of “animal sprits” and thus sustain a quasi-boom. As long as inflation is low, no harm, no foul. In fact, as the thinking goes, a little more inflation might be beneficial.
Comments by Peter Schiff in Reaction to the Federal Reserve Policy Statement “following the Fed’s announced limited tapering of QE III support this interpretation of Fed intentions.” Schiff points out, “There can be little doubt that today’s Fed announcement is an epic attempt at rhetorical audacity. The message they hope to convey is that they are tightening monetary policy by loosening it.” He then points out, “There is little evidence to suggest that the trends are self-sustainable. But seemingly strong data had made the arguments in favor of continued QE increasingly untenable. As they could no longer stay the course the Fed had to do something. Ultimately they decided to play it both ways.” Schiff then explains what is unstated, but between the lines — continued ease is the Fed’s intent:
But these “Open Mouth Operations” likely represent the full inventory of the Fed’s policy options. I suspect that when the economic data begins to disappoint, the Fed will quickly reverse course and increase the size of its monthly purchases. In fact, today’s Fed statement was careful to avoid any commitments to additional tapering in the future. It merely said that further changes in the amount of purchases will be dependent on the data. This means that QE could go in either direction.
If yields move much higher I feel that the Fed will have to intervene to bring them back down. In other words, the Fed will find it much harder to exit QE than it was to enter.
Austrians long ago showed the folly in such policies. Hayek’s lead essay in Profits, Interest and Investment (1939) provides an early Austrian response to Keynes’s nonsense.3 In what is one of Hayek’s most difficult articles, Hayek explicitly argues that such a policy will ultimately not only fail to achieve its stated objective, but will lead to significant long-run harm to the economy. The policy might temporarily appear to increase employment, but the effect is an illusion.4 Credit creation and artificially low interest rates, even if applied to an economy with currently unused resources still misdirects production leading to boom-bust episodes and higher future unemployment. Adrián O. Ravier updates these arguments in his two excellent QJAE articles, “Rethinking Capital-Based Macroeconomics” and “Dynamic Monetary Theory and the Phillips Curve with a Positive Slope”. In the first, Ravier provides
an explanation of why expansionary monetary policies fail in the longer term to solve the unemployment problems associated with recessions. This extension provides a fresh perspective on the debates between Hayek and Keynes in the 1930s and over “quantitative easing” today.
In the second article, Ravier shows:
While it is true that after the boom and bust the economy returns to the natural rate of unemployment, the crucial point is that the “natural rate” at the end of the cycle is quite different from the one evident at the start. This requires an “Austrian” Phillips curve with a positive slope.
During an artificial boom, employment may initially decline. However after a return to “normalcy,” unemployment may actually be higher than what would have been the norm before the policy-induced boom.
Joe Salerno cautions that besides the long run risks discussed above, an artificial low interest rate environment based on deflation fears may actually be preventing a healthy recovery.5 Salerno points out:
For recovery to begin again, there needs to be a steep rise in the “real,” or inflation-adjusted, interest rate observed in financial markets. High interest rates do not stifle the recovery but are the sure sign that the readjustment of relative prices required to realign the production structure with economic reality is proceeding apace. The mislabeled “secondary deflation,” whether or not it is accompanied by an incidental monetary contraction, is thus an integral part of the adjustment process. It is the prerequisite for the renewal of entrepreneurial boldness and the restoration of confidence in monetary calculation. Decisions by banks and capitalist-entrepreneurs to temporarily hold rather than lend or invest a portion of accumulated savings in employing the factors of production and the corresponding rise of the loan and natural rates above some estimated “true” time preference rate does not impede but speeds up the recovery. This implies, of course, that any political attempt to arrest or reverse the decline in factor and asset prices through monetary manipulations or fiscal stimulus programs will retard or derail the recession-adjustment process.
Current Fed policy is a policy of illusion, or better yet, of delusion.
- 1. For a more detailed discussion of Keynes and the Austrian see the my “ Capital-Based Macroeconomics: Austrians, Keynes, and Keynesians” which is an un-gated draft version of a forthcoming chapter in P. J. Boettke & C. J. Coyne (Eds.), Oxford Handbook of Austrian Economics. Oxford: Oxford University Press.
- 2. See also "The Federal Reserve: From Central Banking to Central Planning," by John H. Cochrane
- 3. see "Hayek's Critique of The General Theory", by David Sanz Bas.
- 4. See Unemployment and Monetary Policy: Government as Generator of the “Business Cycle." San Francisco: Cato Institute. PDF on request.
- 5. A Reformulation of Austrian Business Cycle Theory in Light of the Financial Crisis, p. 38.