It now seems certain that the Fed will embark upon a new, second round of money expansion, called Quantitative Easing, or QE2 for short. During QE1 the Fed expanded its balance sheet by roughly $1.7 trillion by purchasing assets, mostly government bonds, in order to lower interest rates and spur economic recovery. At least this was the Fed’s goal. It did lower the interest rate for short term rates to as close to zero as can be expected; now it will target longer term rates by offering a higher price for these instruments, thusly, driving down their interest rate. The Fed fears deflation, which it defines as a general decrease in prices, and is on record as desiring to instill at least a two-percent inflation rate, which it defines as a general increase in prices. The Fed policy makers believe that a two-percent inflation rate is what is necessary for the American economy to achieve full employment, which is one of the Fed’s overall policy goals. The other policy goal is stable prices. In typical government Newspeak the Fed boldfacedly asserts that a two-percent increase in prices is the same as stable prices. I guess it all depends upon one’s definition of “stable”.
There is little doubt that the Fed will be just as successful in driving down long-term rates as it has been in driving down short-term rates, but neither of these actions will help the economy. On the contrary, these actions will harm the economy. What the Fed should pursue exclusively is a stable supply of money, which is not the same as stable prices. The Fed should cease its sales and purchases of assets. Furthermore, it should end its interference into any money markets, such as the Federal Funds market for overnight sales and purchases of bank reserves. In other words, the Fed should stand aside as an active participant in the nation’s economy and act solely as a protector of the supply of money.
In the interest of space and the reader’s patience, I will explain very briefly why a stable money supply is desirable.
Money is a universally accepted medium of indirect exchange, meaning that people hold money only in order to expend it at some later time for a good or services that they really desire. (It is not true that people have an unlimited desire for money; they have an unlimited desire for the things that money will purchase.) As such, the relative demand for goods and services is expressed in terms of money, the universally accepted medium of exchange. But the exchange ratio between money and all individual goods is constantly in flux. Some goods become cheaper as their supply expands and/or demand for them drops. The opposite is true when a good’s money price rises. In an expanding economy, there is a general tendency for most goods to fall in terms of money, as long as the supply of money is held stable. There is no adverse economic consequence to such a situation; that is, in an environment of generally falling prices businesses will make money, pay back loans, and expand operations. It is not true that falling prices are a mark of a failing economy.
In order to keep prices from falling in a generally expanding economy that produces more goods and services, the supply of money must increase. This happened in the 1920’s and led to the 1929 stock market crash. As Murray N. Rothbard explains in America’s Great Depression, the 1920’s were a period of rapid productivity increases due to such factors as the expansion of the nation’s electrical grid and the introduction of the assembly line. But the barely decade-old Fed--which was under the sway of Irving Fisher, a very influential economist who held that price stability was important--increased the money supply throughout the decade to offset the tendency of prices to fall.
This interference in monetary affairs sent false price signals to entrepreneurs that more resources were available for long-term investment than really was the case. The structure of production was altered in such a way that not all enterprises could be completed profitably. The nation was not saving as much as the lower interest rate would suggest. The Fed had enticed businessmen to begin investments that were contrary to the wishes of the consumer as expressed by his real spending patterns. He wasn’t saving enough. Eventually the reality of the situation became apparent and the stock market crashed. But rather than allow the economy to shed the malinvestment, the government undertook a decade’s long experiment in even more intervention in a futile attempt to rekindle the false boom. Only the exigencies of World War II convinced government to end the worst of the Hoover/New Deal policies in order to ramp up war production.
So, we see that it was fiat money expansion that caused the stock market to crash at the end of the 1920’s. The general price level had indeed remained stable throughout the Roaring Twenties, but we now know that it should have fallen. A generally falling price level would have prevented the malinvestment of business, for interest rates would have reflected the true state of the cost of savings for long term capital investment. The structure of production would not have been skewed, which later required its wholesale liquidation.
Today’s Fed is contemplating inflicting an even worse situation on the nation—a positive inflation rate. By driving down long term rates it hopes to entice businessmen to alter the structure of production in favor of longer-term investments. At the same time it is trying to spur consumer spending. These are completely contradictory goals and cannot both be achieved. If the consumer spends more, he saves less. In a free market, this will drive up interest rates to reflect the consumer’s preference for goods in the immediate term rather than in the long term. If the consumer saved more, the additional supply of funds would drive down the interest rate and make longer term capital investment feasible. We cannot have it both ways. Furthermore, the Fed does not know the proper level of interest rates, because it cannot possibly know the consumer’s propensity to spend and save…nor need it know. If the Fed does its only job properly, which is keeping the money supply stable, the aggregate actions of all consumers will determine the interest rates for all maturities.
In conclusion, the Fed should not pursue any interest rate strategy. Rather, it should keep the money supply stable so that the market will allocate savings to establish the structure of production in accordance with the desires of the consumer. But current Fed policy is a replay of its own failed strategy of the 1920’s and ‘30’s, except it is a policy on steroids. The result will be more malinvestment, more bankruptcies, more unemployment, and general impoverishment of the nation.