Federal Reserve Kool-Aid

The Federal Reserve could not resist the heat of the subprime mortgage market correction and is passing out more of the same Greenspan Kool-Aid: lower interest rates. This is the same drink that caused the housing bubble to burst in the first place! Every time the Fed lowers interest rates it signals entrepreneurs to mal-invest in long term projects that would otherwise be deemed unprofitable and unwise. When these expanding businesses bid up the price of labor, land, supplies, etc., we all feel the sugar high of the Kool-Aid in the form of increasing wages. Eventually, however, our economy cannot handle this boom and we have the inevitable sugar low of a market correction.

The true signal for businesses to invest more or less is not the Fed, but the natural relationship that exists between the proportion of income we want to dedicate for consuming today and the proportion of income we want to save for the future. This consumer time preference determines the free market interest rate. The more we want to consume today, the higher the interest rate. The less we want to consume today, the lower the interest rate. Think about it, if we expected the world to end next year, we would all want to consume as much of our income as possible before the end and we would save little or nothing. In this case, the interest rates would be very high as nobody would want to lend any money unless the return was extremely high. Conversely, if we were all made immortal, there would be no need to consume our income rapidly. On the contrary, we would want to save as much as possible for the future. In this case, the interest rate would be very low as everybody would be willing to lend money at extremely low rates.

Because of Fed-manipulated low interest rates, businesses believe that our time preference has changed, that we want to consume less now and save more for the future, so they go ahead and mal-invest in long term capital projects, thinking that we have the savings to back-up those investments. In reality, nothing has changed, our time preference has remained the same, we want to continue consuming today the same proportion of our income that we always have consumed. When the higher incomes resulting from the boom hit our pockets, we start demanding more consumer goods today. But the capital structure of the economy is not equipped to supply those goods today because instead, businesses invested in projects to produce goods for the future, not for today. The end result is that the entrepreneurs who mal-invested go out of business, incomes drop, workers lose their jobs, etc. This inter-temporal distortion in our capital structure of production caused by the Fed is the root cause of bubbles and bursts for the past 100 years, including the Great Depression, the stagflation of the 70’s, the high-tech bubble of the 90’s and the current housing bubble.

If we had an actual change in the time preference and consumers indeed consumed less today and saved more for the future, then interest rates would drop and entrepreneurs would get the signal to invest in long term projects. As these projects bid up our wages and the extra income hits our pockets, we would save a higher proportion of our new income and would not cause an increase in the demand of consumer goods for today. Eventually, as the new capital projects start producing consumer goods, the prices of consumer goods fall and our standard of living increases, all without a bust and without inflation, indeed, with a drop in prices or deflation.

The way out of boom and bust cycles is simple: get the government out of the money business and eliminate the Federal Reserve.