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The Independent Institute

Near Insanity at the Federal Reserve

The latest economic news isn’t pretty. Price inflation is raging everywhere, yet in most housing markets, sales are weak and prices are still in near free-fall. Crude oil and gasoline prices are at record levels and still climbing, despite my recent prediction that oil prices would fall (be patient, they will). Several hedge funds and investment banks have collapsed and bailout talk is everywhere. Finally, the stock market has fallen at least 20 percent from its previous high and a bear market in equities is now official. Welcome to recession 2008.

There is no shortage of explanations for our current difficulties. Some commentators say it’s all due to hedge fund “speculators” or the OPEC cartel or the spendthrift congress or Big Oil. Actually, the root cause of the inflationary recession is far more straightforward and far closer to home. The fundamental culprit is the U. S. Federal Reserve System and the near insane monetary policy it has had since 2001.

To understand how the Federal Reserve has wrecked the economy, let’s “follow the money.” When households save money in savings accounts or in CDs, that money normally finds its way through the banking system into business loans and real estate investments. In some general sense the banking system “collects” the nation’s savings and then invests that pool of savings in long-term projects (housing, capital goods) that promise a profit for the banks and interest income for savers. This process is entirely legitimate for a productive and growing economy.

The Federal Reserve, however, is no ordinary bank, no ordinary intermediary between savers and investors. The Fed does not have to “wait” for savers to save before it can “invest.” Indeed, the Federal Reserve has the legal right to CREATE money and credit by simply purchasing existing bonds or debt or making loans through its discount window.

Here’s how it normally works. Assume that a bank decides to sell some bonds out of its portfolio; assume also that the Federal Reserve decides to purchase those bonds in the open market. After the sale, the bank will eventually get a check from the Fed (or its broker) for those securities. That check from the Fed is NEW MONEY, legally created out of thin air; that money did not exist before the Federal Reserve wrote that check and bought those bonds. And that’s how the money supply increases. The bank, of course, couldn’t care less whether that check represents real savings or newly created credit. They will simply take the funds from the sale of the securities and invest them or loan them out locally.

Under close scrutiny, the problem becomes obvious. Between 2001 and 2005, the Fed inflated the money supply far beyond what households were willing to save out of current income. That easy money/low interest rate policy fueled a massive run-up in housing sales and prices. Eventually that excess credit spilled beyond the housing market into the rest of the economy (indeed, the rest of the world economy) and started to drive up prices for commodities (gold, oil) and eventually almost everything else. And when Greenspan’s Fed finally realized its policy error and raised interest rates, housing went into the tank and so did the financial institutions that had purchased mortgage-backed securities and collateralized debt obligations. The Fed has recently lowered rates but that has only made inflationary expectations worse.

The enduring lesson here is that debasing the currency by inflating the money supply is always counterproductive. The Fed should allow interest rates to rise according to market forces and permit the liquidation of remaining malinvestments. When crude oil prices start falling sharply, we will know that monetary policy finally makes sense.

Dominick T. Armentano is a Research Fellow at the Independent Institute, professor emeritus in economics at the University of Hartford (Connecticut), and author of Antitrust and Monopoly: Anatomy of a Policy Failure.

From Dominick T. Armentano
ANTITRUST AND MONOPOLY: Anatomy of a Policy Failure
Is antitrust law a necessary defense against the predatory business practices of wealthy, entrenched corporations that dominate a market? Or does antitrust law actually work to restrain and restrict the competitive process, injuring the public it is supposed to protect? In this breakthrough study, Professor Armentano thoroughly researches the classic cases in antitrust law and demonstrates a surprising gap between the stated aims of antitrust law and what it actually accomplishes in the real world. Instead of protecting competition, Professor Armentano finds, antitrust law actually protects certain politically-favored competitors. This is an essential work for anyone wishing to understand the limitations and problems of contemporary antitrust actions.