Sunday, March 04, 2012

The Fed and The Power To Redirect and Redistribute Wealth

by Richard J. Grant

A butterfly flapping its wings in a rain forest is nothing compared to a central banker flapping his lips.

Federal Reserve Chairman Ben Bernanke recently told a congressional committee that, although he wouldn't rule out another round of quantitative easing, he did not foresee another round in the near future. With this statement, the dollar rose compared to other assets, as reflected in a sudden 5 percent drop in the price of gold. The silver price also plunged, as did stock prices and Treasury securities.

Other than the good news – that the Fed won't be inflating the money supply as much as it has been recently – it highlights the economic impact of one of many government-created agencies. The Federal Reserve Board, through its statutory power to create currency, does not create wealth but has the power to redirect and redistribute wealth.

When it inflates the money supply to hold down interest rates, it ensures that those who sell bonds get a higher price (at the expense of buyers) and that those who buy and hold bonds receive lower income streams than they would have. Investment choices and patterns are different than they would have been under a different monetary regime. Interest rates no longer reflect the preferences and decentralized market knowledge of millions of market participants. Instead, interest rates are manipulated by a small group of government-appointed individuals according to their much narrower judgment and preferences.

The exercise of such powers usually results in some kind of seemingly unconnected crisis or reversal. This is why periods of deliberately low interest rates are eventually followed by periods of deliberate and systematic increases in the Fed's targeted interest rates. During the period of artificially low interest rates and expanding money supply, credit seems cheap and resources are directed into investments and uses where they might not otherwise have gone. It looks and feels like a boom of prosperity, but it is also a time when businesses are misled by low interest rates to invest as though capital is less scarce than it really is.

What can't go on forever must stop. Expansion of the money supply eventually causes prices to be higher than they would have been. When inflation goes above the Fed's preferred level, as it is now, they must slow or stop the expansion of money supply. Interest rates will rise commensurately. Families and businesses that can't handle the higher rates might have to postpone future plans or reverse previous decisions.

If such reversals are widespread, we call that a recession. We recognize that something is wrong; we change our plans; and while we reorganize, people and resources are often unemployed. All this unfolds because some central planners thought that they could improve on the market.

Other government agencies, such as Fannie Mae and Freddie Mac, use their power to shift risk onto taxpayers through government guarantees of mortgage-backed securities. This lowers the perceived costs of homeownership. They don't really create new wealth; they merely change the patterns of mortgage lending and property ownership. Resources that would have gone into more-productive uses are enticed toward apparently less-risky mortgages.

Still other government agencies interfere in banks’ decisions about creditworthiness and which markets they will serve. Any one of these can create problems for someone, but all of them together multiply the likelihood of financial crises and industrial fluctuations.

Richard J. Grant is a Professor of Finance and Economics at Lipscomb University and a Senior Fellow at the Beacon Center of Tennessee. His column appears on Sundays.

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Copyright © Richard J Grant 2012