crisis: Meltdown – How the Fed Creates Booms & Busts

Thomas E. Woods, “Unnatural Disaster:  How the Fed Creates Booms & Busts”, America Spectator, March 9, 2009.   Woods is that author of the New York Times bestseller, Meltdown: A Free-Market Look at Why the Stock Market Collapsed, the Economy Tanked, and Government Bailouts Will Make Things Worse.  From the article (adapted from the book):

F.A. Hayek won the Nobel Prize in economics for a theory of the business cycle that holds great explanatory power—especially in light of the current financial crisis, which so many economists have been at a loss to explain. Hayek’s work, which builds on a theory developed by Ludwig von Mises, finds the root of the boom-bust cycle in the central bank ..

Looking at the money supply makes sense when searching for the root of an economy-wide problem, for money is the one thing present in all corners of the market, as Robbins pointed out in his 1934 book, The Great Depression. “Is it not probable,” he asked, “that disturbances affecting many lines of industry at once will be found to have monetary causes?”

In particular, the culprit turns out to be the central bank’s interference with interest rates. Interest rates are like a price. Lending capital is a good, and you pay a price to borrow it. When you put money in a savings account or buy a bond, you are the lender, and the interest rate you earn is the price you are paid for your money.

As with all goods, the supply and demand for lending capital determines the price. If more families are saving or more banks are lending, borrowers don’t have to pay as much to borrow, and interest rates go down. If there’s a rush to borrow or a dearth of lending capital, interest rates go up ..

Thus the interest rate coordinates production across time. It ensures a compatible mix of market forces: if people want to consume now, businesses respond accordingly; if people want to consume in the future, businesses allocate resources to satisfy that desire. The interest rate can perform this coordinating function only if it is allowed to move freely in response to changes in supply and demand. If the Fed manipulates the interest rate, we should not be surprised by discoordination on a massive scale.

But suppose the Fed lowers rates so that they no longer reflect the true state of consumer demand and economic conditions. Artificially low interest rates mislead investors into thinking that now is a good time to invest in long-term projects. But the public has indicated no intention to postpone consumption and free up resources that firms can devote to those developments. On the contrary, the lower interest rates encourage them to save less and consume more. So even if some of these projects can be finished, with the public’s saving relatively low, the necessary purchasing power won’t be around later, when businesses hope to cash in on their investments.

And as a company works toward completing its projects under these conditions, it will find that the resources it needs—labor, materials, replacement parts—are not available in sufficient quantities. The prices will therefore be higher, and firms will need to borrow to finance these unanticipated increases in input prices. This increased demand for borrowing will raise the interest rate. Reality now begins to set in: some of these projects cannot be completed ..

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