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With the rate of inflation rising, the prices of
corporate stocks retreating, and economic activity slowing, Federal Reserve
Chairman Ben S. Bernanke and his fellow governors
face an onerous decision. If they should continue to raise interest rates in
order to check inflation, they may burden the economy and precipitate a
recession. But if they should choose not to act at all, or even reduce their
rates in order to stimulate economic activity, they may allow inflation to
accelerate. The core inflation rate, which excludes energy and food, already
approaches 3 percent a year. It may continue its upward march.
At stake is the Fed's credibility as an inflation
fighter and economic regulator, at least as perceived by most Americans. This
writer views the Fed in an entirely different light. He sees a federal agency
that has gradually gained control over the American money and credit system. Since
its inauguration in 1914, it has reduced the U.S. dollar by some 95 percent
of its purchasing power and is diluting it more every day. And the economy
has suffered from chronic cyclical instability. Another recession is on the
horizon.
Most Americans believe that recessions are phenomena
inherent in market economies and that government has the power and obligation
to correct the evil. They want the Federal Reserve to provide the funds and
the U.S. Treasury to adopt "contra-cyclical measures," such as
public works and other full-employment programs. They do not want government
to raise taxes or borrow the necessary funds in the open market, which would
not increase the aggregate amount of spending. Under the influence of
Keynesian and Neo-Keynesian thought, they view deficit spending as a way out
of recession and depression. Unfortunately, such policies tend to make
matters worse; they feed the inflation and aggravate the economic decline,
which the shrinking dollar and numerous recessions clearly indicate.
Most Americans probably never heard a frank and
impartial explanation of the business cycle. They do not realize that
economic stagnation and recession are the final phase of a business cycle,
the readjustment phase. A cycle begins when the Federal Reserve System, in
order to stimulate the economy or assist government deficit financing, lowers
its discount rate below the actual market rate at which the supply of and
demand for savings are evenly matched. Or it may decrease interest rates
through open-market operations of buying government securities. Capital at
bargain rates excites many businessmen and encourages them in their
investment decisions. They may expand and launch many new projects which make
business thrive and boom. But as soon as goods prices and wage rates begin to
rise, businessmen need additional funds. As long as the Fed provides them, the
boom can continue and even accelerate. It comes to an end when the Fed ceases
to throw new funds on the loan market or the quantity launched no longer
suffices to feed the boom. At that time, the readjustment, that is, the
recession begins.
The present cycle undoubtedly began after the
bursting of the stock market bubble in 2000 and the terror attacks on the United States
in 2001 when central banks everywhere braced for deflation and recession. In
fear and trepidation they lowered their interest rates, the Bank of Japan to
zero, the Federal Reserve to one percent, and the European Central Bank (ECB)
to two percent, the lowest levels since World War II. In most countries the
policy seemed to work as housing construction, which always is interest-rate
sensitive, came to life again. Even the doubling of oil prices and other
energy costs could not dampen the excitement. Goods prices rose moderately
due to low-cost imports and some relocation of production, but business
profits improved visibly
Artificially low interest rates not only stimulate
economic production but also excite capital markets. As corporate profits
rise, stock prices tend to soar. Real estate prices increase as buyers can
shoulder greater mortgage debt. Even the loan market may flourish as foreign
banks, for various reasons, acquire large quantities of American I.O.U.s. Massive trade deficits always add their quandary
and risk. Last year, the U.S.
balance-of-payments deficit amounted to $805 billion or 6.4 percent of gross
national product. This year, it is expected to be even larger.
Fears of growing imbalance and potential crisis
finally prompted central banks to raise their rates, at first the Fed, then
ECB, and now also the Bank of Japan. The Fed raised its discount rate 15
times in ¼ percent increments to 4.75 percent, ECB twice to 2.75 percent, the Bank of Japan tightened its discounts and
advances. But these reactions merely moved the rates closer to the true
market rates. The central banks did not set the markets free to find their
true demand-and-supply rates which are "gross rates" consisting of
three distinct components: (1) an originary rate
which reflects the lower valuation of all future goods when compared with
present goods; (2) an inflation component which compensates lenders for the
depreciation of their money during the loan; (3) a debtor's risk component
which is determined by the credit rating of a debtor; it usually is
negligible in Federal Reserve loans to member banks. But the other two
components are ever present. Originary rates
reflect human nature and inflationary components mirror the anticipated rate
of money depreciation. At the present, this writer surmises a gross market
rate of some five to six percent consisting of 2-3 percent originary rate and 3 percent inflation component. If
inflation should accelerate in coming months, the gross rate may rise much
higher in anticipation of more inflation to come.
No matter where the Fed may set its rate, it is
unlikely to be the true market rate; it may cause new maladjustments while
many businessmen are laboring to correct their old
mistakes. All along, legislators and regulators are sitting in judgment of
the monetary policies conducted by the Federal Reserve governors. They are
interrogating and quizzing them frequently and adding their recommendations. When
interest rates are rising and some maladjustments
become visible, they sound the alarm about Fed "overshooting" the
interest rate. But when the governors lower the rate, the political directors
usually applaud and acclaim the policy. They pay great tribute to former
Federal Reserve Chairman Alan Greenspan for having lowered the discount rate
to one percent when the economy was about to readjust.
No matter what the future may bring, legislators and
regulators everywhere will hold forth about monetary matters. Foreign central
bankers and regulators will hold American officials responsible for the pains
of maladjustments. Their American counterparts surely will return the charge:
According to Fed Chairman Ben Bernanke, "The
main causes of the imbalance lie outside the United States. Less developed
countries seek to expand their export industries which generate trade
surpluses. The United
States merely is a willing recipient of
their exports. The Fed is rendering an important balancing service." And
American legislators and regulators like to add joyfully: "The lion's
share of American debt is denominated in U.S. dollars while most American
investments abroad are stated in foreign currencies. A fall of the dollar
obviously diminishes American debt while it raises the value of American
investments abroad, enriching American investors. Nothing is said of the
countless victims at home and abroad who are suffering in silence.
The Fed's "balancing act" is a political
composure act that seeks to please legislators and regulators sitting in
judgment of Federal Reserve policies. Popular monetary and economic thought
obviously shape their policies. Ever since the 1930s popular thought has been
molded by various schools of inflationomics,
such as Keynesian and Institutionalist thought,
that made the U.S. Treasury responsible for prosperity and full employment
and the Federal Reserve for providing the necessary funds. They have
fashioned the trade-cycle system and relied on a Federal Reserve balancing
act ever since.
Dr Hans F. Sennholz
www.sennholz.com
Dr. Sennholz is President of
The Foundation for Economic Education, Irvington-on-Hudson, New York and a
consultant, author and lecturer of Austrian Economics.
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