The US Federal Reserve is playing with the idea of raising interest rates,
possibly as early as September this year. After a six-year period of
virtually zero interest rates, a ramping up of borrowing costs will certainly
have tremendous consequences. It will be like taking away the punch bowl on
which all the party fun rests.
Low Central Bank Rates have been Fueling Asset Price Inflation
The current situation has, of course, a history to it. Around the middle
of the 1990s, the Fed’s easy monetary policy — that of Chairman Alan
Greenspan — ushered in the “New Economy” boom. Generous credit and money
expansion resulted in a pumping up of asset prices, in particular stock
prices and their valuations.
A Brief History of Low Interest Rates
When this boom-bubble burst, the Fed slashed rates from 6.5 percent in
January 2001 to 1 percent in June 2003. It held borrowing costs at this level
until June 2004. This easy Fed policy not only halted the slowdown in bank
credit and money expansion, it sowed the seeds for an unprecedented credit
boom which took off as early as the middle of 2002.
When the Fed had put on the brakes by having pushed rates back up to 5.25
percent in June 2006, the credit boom was pretty much doomed. The ensuing
bust grew into the most severe financial and economic meltdown seen since the
late 1920s and early 1930s. It affected not only in the US, but the world economy
on a grand scale.
Thanks to Austrian-school insights, we can know the real source
of all this trouble. The root cause is central banks’ producing fake money
out of thin air. This induces, and necessarily so, a recurrence of boom and
bust, bringing great misery for many people and businesses and eventually
ruining the monetary and economic system.
Central banks — in cooperation with commercial banks — create additional
money through credit expansion, thereby artificially lowering the market
interest rates to below the level that would prevail if there was no credit
and money expansion “out of thin air.”
Such a boom will end in a bust if and when credit and money expansion
dries up and interest rates go up. In For A
New Liberty (1973), Murray N. Rothbard put this insight
succinctly:
Like the repeated doping of a horse, the boom is kept on its way and ahead
of its inevitable comeuppance by repeated and accelerating doses of the
stimulant of bank credit. It is only when bank credit expansion must finally
stop or sharply slow down, either because the banks are getting shaky or
because the public is getting restive at the continuing inflation, that
retribution finally catches up with the boom. As soon as credit expansion
stops, the piper must be paid, and the inevitable readjustments must liquidate
the unsound over-investments of the boom and redirect the economy more toward
consumer goods production. And, of course, the longer the boom is kept going,
the greater the malinvestments that must be liquidated, and the more
harrowing the readjustments that must be made.
To keep the credit induced boom going, more credit and more money,
provided at ever lower interest rates, are required. Somehow central bankers
around the world seem to know this economic insight, as their policies have
been desperately trying to encourage additional bank lending and money
creation.
Why Raise Rates Now?
Why then do the decision makers at the Fed want to increase rates? Perhaps
some think that a policy of de facto zero rates is no longer
warranted, as the US economy is showing signs of returning to positive and
sustainable growth, which the official statistics seem to suggest.
Others might fear that credit market investors will jump ship once they
convince themselves that US interest rates will stay at rock bottom forever.
Such an expectation could deal a heavy, if not deadly, blow to credit
markets, making the unbacked paper money system come crashing down.
In any case, if Fed members follow up their words with deeds, they might
soon learn that the ghosts they have been calling will indeed appear — and
possibly won’t go away. For instance, higher US rates will suck in capital
from around the word, pulling the rug out from under many emerging and
developed markets.
What is more, credit and liquidity conditions around the world will
tighten, giving credit-hungry governments, corporate banks, and consumers a
painful awakening after having been surfing the wave of easy credit for quite
some time.
China, which devalued the renminbi exchange rate against the US dollar by
a total of 3.5 percent on August 11 and 12, seems to have sent the message
that it doesn’t want to follow the Fed’s policy — and has by its devaluation
made the Fed’s hiking plan appear as an extravagant undertaking.
A normalization of interest rates, after years of excessively low interest
rates, is not possible without a likely crash in production and employment.
If the Fed goes ahead with its plan to raise rates, times will get tough in
the world’s economic and financial system.
To be on the safe side: It would be the right thing to do. The sooner the
artificial boom comes to an end, the sooner the recession-depression sets in,
which is the inevitable process of adjusting the economy and allowing an
economically sound recovery to begin.
