Given the Fed’s continued actions to keep interest rates low and its reported plans to keep them that way beyond 2014, now seems a good time to revisit the deleterious effects that monetary expansion has on the economy.
The data makes all too apparent the relevance of the Austrian Business Cycle in explaining the results of years of easy money.
Loose central bank policy fuels artificial credit expansion—economists like Bernanke would say this is the point of his policies, but he ignores the problems that cheap money creates. Fed-induced cheap credit fuels an artificial boom—that is to say, consumers and producers have access to liquidity that they otherwise wouldn’t had the central bank not intervened. However, artificially low interest rates distort both consumption and investment from their efficient market allocation.
As interest rates plummet, firms shift production from present to future as long-term investment becomes less expensive to finance. But consumers haven’t changed their consumption-saving patterns—meaning that they still consume and save at the same levels as before the Fed altered interest rates. Consumers still prefer to consume today while firms plan as if they instead demand to consume tomorrow. Monetary expansion effectively decouples investment from consumer time preferences of consumption. And the interest rate thereby ceases to serve its equilibrating function between the two.
This very process was at work in the two largest American recessions over the past 60 years. Before economic turmoil took hold in the mid-‘70’s and the late 2000’s, prices for capital goods—those that firms buy when undertaking long-term investment—had skyrocketed in the preceding years. Consumer prices also increased—though by a smaller amount—as firms invested in long-term projects instead of producing for present consumption, thereby reducing supply for present consumption goods among an unaltered demand.
Below is an enlargement of the 1995-2010 period of the graph, without the double-digit inflation of the Carter years augmenting the increments of the vertical axis. After the recession in the early 2000’s (also during which there was higher demand for capital goods—but not as much as in the other deeper recessions), the Fed kept interest rates low and fueled inflation in capital goods until the beginning of the crisis in 2008.
Firms face growing unit labor costs as a result of the higher wages being paid out from the increased demand in capital goods. But because low interest rates signal an increase in future demand, employers believe they will make up the increased costs with increased sales. This is yet another mirage of easy money. In the run-up to the busts of the ‘70’s, early 2000’s, and late 2000’s, unit labor costs climb before bottoming out. You will notice that labor cost increases lag inflation in the capital goods market by about 1 year. This is normal, as wages do not adjust to market conditions as fast as prices do.
Below is a 1995-2009 blow-up of the previous graph to again factor out the inflation of the ‘70’s from distorting the vertical axis.
Increases in the money supply correspond to these periods of Fed-driven boom. Broad money (M3) was increasing before stagflation in the ‘70’s and had been increasing at record levels since 1995— fueling the dot com bubble and the 2008 crisis.
As firms continue to invest in new projects and hire new workers, people are led to believe the economy is booming. Unfortunately, this is an illusion. Total savings—the source of credit and the driver of the interest rate—hasn’t increased. Instead of being the result of more savings, lower interest rates are the consequence of newly minted money.
The whole charade comes crashing down once markets realize the unprofitability of business investments predicated on artificially low interest rates. Triggers of this revelation range from bursting asset bubbles à la 2008 to the Fed shutting out the lights on its free money binge party
Enter the bust.
Firms take losses and layoff employees, causing artificially inflated prices and wages to plummet back to levels commensurate with market proportions of consumption-saving.
The painful adjustment is necessary to restore levels of consumption, saving, and investment that correspond to one another—thereby restoring the equilibrating mechanisms of the market to proper function. But as long as the Fed delays this process by continuing to dope up markets on freshly printed money, it perpetuates the cycle of boom and bust and sows the seeds for yet more economic disaster in the near future.
*All data is from the OECD iLibrary.