The cumulative effects of the play-off between political advantage and economic necessity is the theme of Hayek’s [1941] critique of Keynesianism. Excerpts of “a forty years’ running commentary on Keynesianism by Hayek,” compiled by Sudha Shenoy, is appropriately entitled A Tiger by the Tail (1972).
The Federal Reserve is once again poised to pursue a policy of economic stimulus for the U.S. in the form of cheaper credit. The Fed’s Open Market Committee adjusts two key interest rates as a matter of policy—the discount rate, the interest rate banks pay to borrow cash directly from the Fed, and the federal funds rate, an interbank lending rate. The Federal Reserve makes these changes in order to effect changes in borrowing, spending, employment and investment economy-wide. This Free Market Minute looks at some competing perspectives on Fed policy, and considers how the Federal Reserve’s power to affect the price of credit has different economic effects in the long run than it does in the short run.
First, a look at the Fed’s evolving mission, in terms of our national economy. At its creation in 1913 the Federal Reserve was given the general objective of ensuring that financial markets functioned smoothly. That would eventually include a need to collect and analyze data, determine the correct supply of money and credit on a periodic basis, and finally, adjust the quantity of credit available to loan markets. The policy was made more specific in 1977.
Against the backdrop of poorer economic performance in the 1970s, the Congress gave the Federal Reserve explicit goals in a 1977 amendment to the Federal Reserve Act. These goals were stated in terms of maintaining long-run growth of monetary and credit aggregates that would promote “maximum employment, stable prices, and moderate long-term interest rates.” Thus, the mandate really contained three goals, but the last one has been widely interpreted as those long-term interest rates consistent with the first two goals, giving the Federal Reserve a “dual mandate” of maximum employment and stable prices.>
Can changes in credit and the money supply achieve these objectives, or all three objectives at the same time? Rival theories about the role of money in an economy, and how and whether monetary policy could reverse an economic downturn, address that question very differently. The following discussion outlines some points from three differing perspectives—the Keynesian, Monetarist, and Austrian schools of thought.
The Depression-era writings of John Maynard Keynes emphasized a policy of government spending, virtually ignoring monetary policy, to stimulate the economy. The recent interest rate announcements from today’s Fed would have been seen as useless.
Instead of viewing money as ‘a joint linking the ability to demand with the willingness to supply’ goods and services over time, Keynes saw in money only as a ‘broken joint.’ This means that while market-oriented economists believe that a fall in lending rates should create new economic activity—stemming from the lower price of credit—in Keynes’ view it would not. He theorized that if the public has very pessimistic or perverse expectations, the lower price/interest rates would simply be ignored. It would be better, according to Keynes, to create new demand in the economy through the sure thing of government spending. For Keynes himself, then, money was a ‘broken link’ or ‘broken joint’ between policy and economic growth.
The Monetarist school of thought, of which Milton Friedman is the best-known scholar, reversed Keynes on the importance of money in coordinating economic plans. In the 1970’s, money and the money supply, credit rates, and the Federal Reserve became central to U.S. macroeconomic policy. The early tendency in Monetarist thinking to assume too tight and exact a relationship between the Fed’s policy actions, and policy effect, should remind us that some consequences take time to appear.
When we put extra cash and spending power into the hands of businesses and consumers, when we lower loan rates in particular, we expect businesses and consumers to spend and invest it in new goods and projects, more or less right away. That’s the short-run ‘up’ side. But lags between the monetary policy and its effects could be notoriously long and variable, a fact that was eventually recognized and modeled.
Austrian school economists see the long run results of policy as an inevitable consequence of the Fed’s short run policy. Every time the Fed lowers interest rates, banks obtain cash more cheaply, and offer more loans at lower rates. We know that lower loan rates make borrowing more attractive to customers. This is especially true for customers in the most interest-sensitive markets, like mortgages and capital investments.
But there’s a catch: the profitability or affordability of an interest-sensitive asset over the life of a 10 to 30-year repayment period depends critically on keeping the borrower’s interest rate low. Without the Fed’s repeated injection of cheap credit, lender’s interest rates tend to revert back to their natural levels.
To prevent that, the Fed must repeatedly add liquidity to markets. It can continue on that path only as long as inflation does not appear to be becoming excessive. Eventually, inflationary pressures will appear, and the Fed will have to slow down or stop its credit expansion. Fueling the credit expansion beast keeps the economy happy—for a time. Letting go of the policy means liquidating some number of suddenly unaffordable or unprofitable investments.
This is where the Tiger by the Tail analogy may apply. Monetary policy is extremely powerful, and its effects reach economy-wide. But the effects are also sequential and uneven. The benefits to borrowers that stem from cheap credit are reversed once the Fed stops pumping money into credit markets. Bad investments in housing and capital projects will need to be cleared out once genuine market conditions—including accurate risk and return assessments—reestablish themselves.
By then, of course, huge losses may have accrued to previously misled investors. And even consumers who were not part of the credit boom are likely to be facing the other long-run consequence, which is general price inflation. Hitting the monetary brakes, in terms of investment, employment, and economic growth, can be very like hitting an iceberg. No wonder the Fed most often opts to continue on the credit-growth path as long as possible.
Monetary policy; tiger or Titanic? Neither, or both; a benevolent tiger long as we continue to feed credit into the system; a potential shipwreck in the longer-term, since credit expansion must inevitably slow or halt, with the painful inflation, misdirected resources, and need for liquidation of bad investments made along the way.