Fed Officials Can't See What's Right In Front Of Them
While the Federal Reserve has an explicit dual mandate to keep prices stable and maintain full employment, they have unofficially taken on new goals like maintaining financial stability. Bernanke, Yellen, and other officials have noted how traditional monetary policy is a limited and blunt tool to accomplish this goal, which is why the Fed has, in recent years, exercised and flexed its regulatory muscle.
The Minnesota District Bank president, Neel Kashkari, recently wrote an article about the dilemma the Fed faces regarding asset bubbles and whether or not they should be met with raising interest rates. He summarizes in five points:
- It is really hard to spot bubbles with any confidence before they burst.
- The Fed has limited policy tools to stop a bubble from growing, even if we thought we spotted one.
- The costs of making policy mistakes can be very high, so we must proceed with caution.
- What we can and must do is ensure that the financial system is strong enough to withstand the inevitable bursting of a bubble. And finally,
- monetary policy should be used only as a last resort to address asset prices, because the costs to the economy of such a policy response are potentially so large.
In an addendum to his article, he admits that it is possible artificially low interest rates increase the probability of asset bubbles forming: “low rates ... could make bubbles more likely to form in the first place.” He laments that there is no economic theory to back this up, to the unending frustration of Austrian economists everywhere. Indeed, F. A. Hayek won a Nobel Prize in economics in part for his work on a business cycle theory that blames central banks for causing, among other things, bubbles.
ABCT Isn’t So Controversial
Despite the lack of representation in Federal Reserve and government offices, the theory is not as controversial as it is made out to be. Just a week before Kashkari’s post, Bloomberg.com published an article on a bubble in the automobile industry that singled out the cause of increased subprime auto loans: “While caution may be good for banks’ balance sheets, it doesn’t offer much relief for automakers, who relied on cheap credit to fuel a seven-year stretch of booming sales.”
In fact, artificially low interest rates and expansionary monetary policy have the explicit goal of stimulating borrowing and spending. This is no secret, as Kashkari explains: “we lower interest rates to try to stimulate economic activity by reducing borrowing costs.”
Now take Kashkari’s first and second points in view of this. If central bank policy is responsible for creating bubbles, then how could a central bank official say that spotting and preventing bubbles is “really hard”? It’s like a detective admitting he’s stumped about who is starting all of these fires around town, while he’s holding a container of fuel, a matchbook, and a book titled Arson for Dummies.
Broken Clocks and Broken Records
While Hayek certainly deserved his Nobel Prize, it is well-known that he was following Ludwig von Mises and his work on business cycles. Together, they constructed the framework for what we know today as Austrian business cycle theory, expounded and expanded more recently by Murray Rothbard, Joseph Salerno, Roger Garrison, Jesús Huerta de Soto, David Howden, Philipp Bagus, and many others.
Kashkari referred to those who try to identify bubbles as broken clocks. This characterization is unfortunate. Broken clocks do not explain why. If Austrian economists were only accidentally right some of the time, then they would not be able to point to the specific causes of the business cycle.
A broken clock, for example, would not explain, pre-1929 crash, the causes of the “inevitable crisis”:
Government agencies responsible for financial policy, directors of the central banks of issue and also of the large private banks and banking houses ... failed to recognize the fundamental problem. They did not understand that every increase in the amount of circulation credit (whether brought about by the issue of banknotes or expanding bank deposits) causes a surge in business and thus starts the cycle which leads once more, over and beyond the crisis, to the decline in business activity. In short, they embraced the very ideology responsible for generating business fluctuations. (Ludwig von Mises, Monetary Stabilization and Cyclical Policy, 1928)
Perhaps a broken record is a more apt analogy for modern central bankers (even a broken clock is right occasionally). After every financial crisis, in the midst of every recession, we hear the same line: “Let us stimulate the economy with expansionary monetary policy.” There is no adequate explanation of where the crises keep coming from, except for vague accusations against unregulated financial markets. And there is always another crisis on the way. The booms and busts are taken as a given, it seems. The Fed doesn’t try to solve the problem of the business cycle. They have given up on that task — they just try to make them smaller and smoother when they do come. Kashkari admits this in his article (point four): “What we can and must do is ensure that the financial system is strong enough to withstand the inevitable bursting of a bubble.”
The High Costs of Artificial Credit
Finally, Kashkari’s remaining words of warning in points three and five, that bad monetary policy is very costly, are the same as Mises and Hayek’s words of warning. The only difference is what counts as a “policy mistake” and where to look for the costs of wrong-headed policy.
For Mises and Hayek, the policy mistake involves any creation of credit out of thin air. If the Federal Reserve decreases interest rates below what would prevail on an unhampered credit market, then an artificial, unsustainable boom is set in motion. If any central bank increases the money supply through the financial system, it means that borrowers have the privilege of being the first to bid up prices as the new money ripples through the economy.
It means that nominal incomes, employment, consumption, the prices of capital goods, and other asset prices will increase. It means that capital will be directed into new, longer, and riskier lines of production, beyond what would have happened at the prevailing levels of real saving. These lines of production will turn out to be unprofitable as the increasing scarcity of capital becomes apparent and the costs of production become prohibitively high. Incomes, employment, consumption, and stock prices plummet as laborers and capital owners seek productive and profitable employment. The bust is made up of all of the necessary corrections for the errors made during the boom. Additional artificial credit will only delay this process and make it more painful when the day comes.
Contrast this view with that of Kashkari or this supportive Business Insider article: “the main, unspoken reason for pushing interest rates higher was to tame runaway stock and credit markets, which have broken all sorts of records under the Fed’s zero-rate policy ... [Kashkari] makes a solid case in an essay this week as to why this is a terrible idea.” They seem to understand that fiddling with interest rates and flooding the economy with artificial credit has numerous unintended consequences and potentially high costs.
Why is it such a stretch to posit that the bubbles, recessions, and depressions created by these policies are too high a cost? Why is it so controversial to suggest that we should leave interest rates and credit markets alone? Perhaps monetary policy is not a blunt tool, but a dangerous weapon — one that should be confiscated from those who have wielded it for too long.