Sunday, January 24, 2010

The Fed's philosophy creates financial dragons

Published in The Tennessean, January 24, 2010

The Fed's philosophy creates financial dragons

by Richard J. Grant

George Santayana's admonition, "Those who cannot remember the past are condemned to repeat it," is much-quoted and sometimes taken to heart. But it does not imply its often-assumed corollary, "Those who remember the past are guaranteed not to repeat it."

The trouble with experience and the study of history is that neither presents us with self-evident life lessons. The lessons learned depend on the intellectual makeup of the observer. It depends on what we have within us to interpret the workings of the world.

Although history never repeats exactly, we do see the same kinds of mistakes recur. Despite having a "student of the Great Depression" on the Federal Reserve Board during the past 10 years, we still found ourselves being threatened with economic depression.

In his writings and speeches, we see that Ben Bernanke, now Fed chairman, believes the Fed "caused" the Great Depression by failing to stop the credit contraction in the banking system. This was consistent with his actions when he reacted to the recent financial crisis by injecting reserves into the banks to offset the contraction. This is what we expected the Fed to do, though the magnitude was unprecedented.

The blind spot in Federal Reserve philosophy is the failure to recognize the Fed's role in creating the problem in the first place. It is the habit of the Fed to see phenomena such as inflation and recession as if they are beasts of nature that suddenly leap out at us like dragons. The Fed sees itself as a knight standing ready to defend us from these beasts.

In a recent speech, Chairman Bernanke attempted to defend the Fed from accusations that the Fed itself had created the dragons. But he couldn't explain away the Fed's pushing down of interest rates in 2001, with the targeted federal-funds rate dropping from over 5 percent to less than 2 percent. From mid-2003 to mid-2004, the Fed held the federal-funds rate at a record low of 1 percent.

This also pushed down mortgage rates. The Fed does not reduce rates by decree. It does so by increasing the growth rate of the quantity of money. The Fed has a statutory monopoly in the creation of U.S. currency. It creates dollars out of nothing.

Creating new dollars by fiat does not create new wealth. But the new dollars are as good as any other dollars; and with more dollars in circulation, there are more available for loans even though people are not saving more. This is why interest rates fell.

But the situation doesn't last. As new dollars come into existence and are used for purchases, there is a tendency for the prices of all goods to be bid higher than they would have been. This is the source of price inflation, which means that the purchasing power of each dollar goes down.

When the value of each dollar falls, the total value of loanable funds also falls. This coincides with interest rates rising again, which is what happened from late-2004 through 2006.

Not all prices rise at the same time or at the same rate. Government incentives channeled money toward the purchase of homes. That is why house prices rose faster than most other prices. Many financial assets also became over-inflated.

Artificially low interest rates also made business projects to appear more profitable than they would have otherwise. This encouraged many businesses to expand their operations and to use more capital (and labor) than they would have.

The trouble with creating money to encourage loans is that it does not create new savings. Borrowers act as though capital is plentiful when it is not. They are still bidding for the same resources, which is why prices and interest rates must eventually be bid up. So ends the boom; and so begins the recession.

Excessive regulation reduces our adaptability. The Fed is currently holding the federal-funds rate near zero. Here we go again.

Richard J. Grant is a professor of finance and economics at Lipscomb University and a scholar at the Tennessee Center for Policy Research. His column appears on Sundays. E-mail:

Copyright © Richard J Grant 2010