Fed up With the Fed

Public opinion of the Fed is that of being a vigilant watchdog of inflation. Always seen as watching economic indicators and ready to adjust the interest rates in order to "fight" inflation. This is of great irony, because it is the very same Fed that is increasing the money supply thereby causing a reduction in value and subsequent higher prices of goods and services.

The confusion stems from the definition of the word inflation. Properly defined, inflation relates to an increase in the money supply in the same way as a balloon is inflated with a volume of air. This has the effect of causing a rise in the prices of goods and services because the value of the unit of money has fallen.

The inflation of a money supply does not have a direct 1:1 effect on pricing of goods and services. For instance, a 10% increase in the money supply does not mean that prices across the board will uniformly increase by 10%. It has a much different effect.

To use an example, let us assume that the U.S. government decides to spend money on a new computer system for jets. Let us also assume that this money is newly created money - it wasn't collected through taxation or the issuing of government bonds (i.e. debt). This newly created money first goes to the people involved with the company that designs and manufactures these said computer systems. Accordingly, these people become wealthier and have more to spend. Let us assume that they buy cars and wine. Now the new money has gone to those people involved with the making of cars and wine. They in turn buy books and shoes. Now those people become wealthier. And so on...

Now what about the average person who doesn't work in these industries. All he sees is an increase in cars, wine, books and shoes. He now has less to spend on beer and pretzels. So now the beer and pretzel industry experiences a downturn. New entrepreneurs, seek business opportunities within the car, wine, book and shoe industries and avoid the making of beer and pretzels.

So what we have is an unequal increase in the pricing of certain goods and services. Some go up, while others actually go down. We also experience a transfer of capital investment from some industries to others.

Additionally, the Fed distorts the market through the manipulation of interest rates. Left to it own devices, the market would determine its own rate of interest based upon a consensus of the market participants. If economic conditions were seen as favourable, than new businesses would stand a good chance of succeeding and money lenders would compete with one another to lend out their capital to entrepreneurs. Conversely, if economic conditions were seen as unfavourable, money lenders would charge a higher rate of interest as they would see it as a greater risk to lend out capital. This theoretical, as it currently exists, interest rate is the market rate of interest.

Under the governance of the Fed, the interest rates are dictated by a council of twelve men in expensive suits. The rate of interest is determined and set in accordance with their decision. As it is in the interests of the government to have a boisterous economy, this set rate of interest is often set at a rate below the natural market rate of interest. As such, the entrepreneurs may see profitable ventures where in fact there are none.

For instance, let us assume that the market rate of interest is 10%. The Fed sets the rate so that banks will lend money to entrepreneurs at only 5%. An entrepreneur will conduct his calculations for the construction of a cheese factory. He needs to borrow one million dollars and forecasts a profit before interest payments on debt of $80,000 per year. Under a natural rate of interest, that being 10%, he would not go ahead with the business model, as it would be losing $20k per year. However, with the seemingly generous 5% rate of interests, his business model will provide a profit after paying the interest payments of $30k per year. As such, he decides to go ahead with the business.

At first blush this seems like a great idea since the cheese factory will produce a profit and provide employment. However, what is lost here is that given the current state of affairs within the marketplace there is insufficient demand for his product as revealed by the 10% market rate of interest that would reveal the business as unprofitable and thus it should never exist.

Things will seem to go along well enough as long as the Fed keeps the interest rate low. A multitude of business models such as this cheese factory comprise what is commonly known as a boom.

However, as history shows, the Fed cannot do this indefinitely, because inflation (in the sense of rising prices for goods and services) will erode the consumer base. The Fed responds by raising interest rates. Seemingly overnight, the cheese factory and all other businesses that really shouldn't exist become unprofitable and a bust occurs. Companies lay off employees (think Nortel, GM), there are an increased number of bankruptcies (think 360Networks, Worldcom) and corporate scandals are exposed (think Enron).

Austrian economists refer to these processes as malinvestment. This is the description of capital moving towards unprofitable businesses as a direct result of manipulation of the money supply and interest rates. Economists and pundits refer to it as "overinvestment" or "the economy is overheating".

Published on www.DollarDaze.org - May 19, 2006.