By Pater Tenebrarum at Acting Man blog
A recent report on Reuters cites various Fed officials on the topic of bubbles, with the headline “Fed officials say rates should not be used to fight bubbles”. This is the headline we have attempted to fix above, since by inference, rates are obviously only to be used to blow, rather than fight, bubbles.
From the article:
“A trio of Federal Reserve officials who disagree deeply with one another over the appropriate stance of monetary policy on Friday expressed a shared distrust for using interest rates to head off asset bubbles and other forms of financial instability.
Both Richmond Fed President Jeffrey Lacker, a policy hawk, and San Francisco Fed President John Williams, a centrist, told reporters after a policy conference here that they would not want to risk unmooring the public's expectation that inflation will rise back to the Fed's 2 percent goal in the next few years.
That, Williams said, is what appears to have happened in Sweden and Norway after those countries raised rates to address financial stability risks. Fed economist Andrew Levin had shown a slide making that point earlier at a presentation that both policymakers attended. Chicago Fed President Charles Evans, one of the Fed's most ardent doves, echoed those sentiments.
"Degrading monetary policy tools to mitigate financial instability risks would lead to inflation below target and additional resource slack," Evans said in slides released Friday for a talk he is set to give in Istanbul on Monday.
The role financial instability concerns should play in Fed policymaking has long been a subject of debate at the U.S. central bank. Over the past year, Fed Governor Jeremy Stein has argued strongly that there may be times when the Fed should raise rates to stamp out potential bubbles. Stein left the Fed earlier this week to return to his post at Harvard University, leaving the Fed without a forceful public advocate of that idea.
Philadelphia Fed's Charles Plosser told reporters on Friday he was "kind of on the same page" as Williams and Lacker, in terms of rejecting a financial stability mandate for the Fed. But he added that he is worried about the risk that the Fed's extraordinarily easy policies over the past five years themselves could stoke financial instability.”
Indeed, Mr. Plosser has every reason to be worried, because it is absolutely certain that the 'extraordinarily easy policies over the past five years' will 'stoke financial instability'. It would actually be better to say that they are doing so already. There is definitely no need to speculate over whether it 'could' happen.
US broad money supply TMS-2 (without memorandum items, which add several 10s of billions more). Could it be that 'financial instability' will result from this massive growth in the money supply? We would argue it is absolutely certain – click to enlarge.
The Myth of Divided Fed Officials
There are several points that need to be addressed here. One is the myth that Fed officials are 'deeply divided'. Naturally, there are a number of differences between various Fed members. These differences inter alia result from the manner in which Fed officials are appointed. In the districts, member banks have more control over the appointments of boards and presidents than the board of governors (which only gets to appoint one third of the district board members). The board of governors, the chairman and the vice chairman in Washington are by contrast purely political appointments (appointed by the president, and confirmed by the Senate).
This means that at times, district presidents with more down-to-earth, business-oriented views such as e.g. Richard Fisher of the Dallas Fed or former Kansas Fed president Thomas Hoenig will emerge. However, it more often than not turns out that the 'disagreements' are basically for show: they are a good way of ensuring that the frog is boiled slowly, as so-called 'hawks' and 'doves' are seemingly publicly dissenting over policy. See, there are a few guys who will make sure that nothing untoward happens with inflation! The central bank nonetheless remains an issuer of fiat currency and a central economic planning agency whose primary purpose it is to continually inflate the money supply.
Res ipsa loquitur, in this case. Watch what they do, instead of listening to what they say. Just take another look at the chart above. How could anyone come away with the impression that they are doing anything but inflating the money supply? Not only that, they are in fact inflating it at something like warp speed. So what practical effects do these 'deep disagreements over policy' actually have?
We would suggest that the difference is in practice approximately similar to the lower boundary of the corridor for the Federal Funds rate: a big fat zero.
Keynesian Myths About the 'Price Level'
The Keynesian myth that 'low inflation causes resource slack' (voiced by Mr. Evans) needs to be debunked at every opportunity. In an unhampered market economy (obviously, an 'unhampered' market economy would have no need for a central bank, and we would not even have this discussion), economic progress is among other things as a rule accompanied by falling prices for consumer goods (just as is the case even now in industries that exhibit productivity growth that exceeds the rate of monetary inflation by a sufficiently large margin). Presumably Mr. Evans would be at a loss to explain why there are no hi-tech companies complaining about 'resource slack', in spite of the fact that the prices of their products almost continually decline. We would also be interested in hearing his explanation for why the historical period during which the highest real economic growth per capita in US history was experienced (the 'Gilded Age'), was a period of mildly declining prices, with no central bank planning for 'success'.
Real economic growth in the US per capita during the 'Gilded Age' – there was no central bank and its 'flexible currency', and government spending amounted to about 2% to 4% of economic output. Not surprisingly, in this age when government intervention in the economy was almost non-existent, economic growth was both more equitable and faster than in any time period since. QED - click to enlarge.
Luckily, it can be explained: the prices of consumer goods don't matter for corporate profitability. The spread between the cost of factors of production and the prices of the goods produced with their help is what matters. It is simply a fairy tale that the economy needs a growing money supply in order to thrive, or that it requires one of its pernicious effects, namely a continual decline in money's purchasing power to remain in good health. Anyone with a smattering of common sense should realize that this cannot be so, but apparently, many mainstream economists have great faith in the 'inflation is good' myth.
Members of a central planning agency whose agenda it is to inflate the supply of money and credit and manipulate interest rates are of course essentially forced to adopt bad economic theories. If they didn't do so, they would all have to resign, due to the inescapable conclusion that their activities are not only surplus to requirements, but are in fact highly damaging for the economy. Unfortunately, large time lags and the mirage of 'phantom prosperity' provided by boom periods and asset bubbles associated with them, make it very difficult for people to realize how cause and effect are interlinked.
Moreover, the mainstream media are almost never questioning the wisdom of central planning of the economy. At most, they will contrast competing 'plans', but the premise that some sort of planning by establishment-anointed 'wise men' is necessary is never once doubted. In fact, if one looks at the Reuters article excerpted above, it is noteworthy that Mr. Evans' words of wisdom on inflation are not even deemed in need of further elucidation. Readers are simply supposed to 'know' that this is how things allegedly work! It is really quite amazing how pro-inflation propaganda has seeped into every nook and cranny of public discourse.
In order to see where we are coming from, it is also necessary to consider what 'bubbles' really signify. Asset bubbles don't just drop from the sky, and they are certainly not a sign of a well-balanced, prosperous economy. Although even a severely hampered market economy cannot help but produce a lot of genuine wealth, it does so in spite, not because of the interventions that lead to bubbles.
Asset bubbles essentially reflect mainly the misallocation of scarce resources as well as the decline in money's purchasing power which result from inflationary policy. It seems therefore legitimate to refer to all economic activities that spring up on the back of such interest rate and money supply manipulation as 'bubble activities'. In short, these are all those economic activities that are undermining the creation of real wealth rather than contributing to it.
The economy's pool of real funding is finite; it may be quite large and may even manage to keep growing in spite of the harm wrought by inflationary policy, but there is no reason to assume that it cannot be severely damaged or that its continued growth should be taken for granted. What damages it is the fact that the creation of money ex nihilo allows for exchanges of nothing for something. No contribution has been made to the economy's pool of real funding, and yet, new money can be used as if such a contribution had in fact occurred. For all those engaged in real wealth generation, this creates problems, as they are forced to compete for scarce capital against those who have inaugurated bubble activities with the help of money from thin air (readers interested in the crucial role of the pool of real funding in the economy are advised to check out Richard von Strigl's 'Capital and Production'. An excellent and easy to grasp explanation has also been provided by Frank Shostak here).
It should be clear that altering the supply of the medium of exchange cannot alter the amount of real capital in the economy (apart from the so-called 'forced saving' effect, which is however nothing but the other side of the malinvestment coin). Money is a sine qua non in a complex exchange economy – without it, there can be no economic calculation, and hence no rational economy. However, what ultimately is needed for wealth creation in the economy is not just money, but capital. If all it took was money, Zimbabwe would surely have turned into a Utopia of riches (as an aside, its stock market was going gangbusters, even as 80% of the workforce found itself unemployed. One company after another had to stop operating as vitally important inputs were no longer available. This shows empirically what we know already theoretically, namely that rising stock prices do not provide proof of growing economic prosperity).
The title of this post was a bit tongue in cheek, but then again, we think it actually describes reality rather well. When Fed officials state that “rates should not be used to fight bubbles”, they might as well admit what they are actually used for: namely, blowing them.
Keep in mind here that we are not trying to make an argument about what the Fed 'should' do. We are not trying to sell a 'better plan'. We believe that there should not even be a central bank, so with respect to what it 'should do', we would only recommend that it should abolish itself as soon as possible.
That may be an unrealistic wish, but the realpolitik implications are quite distinct from the question whether a free market in money and a free banking system would work better than the centrally planned cartel in place at present. The answer to this question should be obvious.
Shouldn't we defer to the situation 'as is' and attempt to be constructive by proposing a 'better policy' than the one currently pursued? The answer is no, definitely not. Just as no-one currently making decisions at the Fed can possibly know what the correct interest rate or the proper size of money supply should be, so can no-one else. These are questions that can only be settled by the market. Central banks are a foreign element in the market economy and are in a sense faced with a special case of the socialist calculation problem. As J. H. de Soto has put it:
“Sooner or later the system will inevitably run up against the impossibility of socialist economic calculation, the theorem of which maintains it is impossible to coordinate any sphere of society, especially the financial sphere, via dictatorial mandates, given that the governing body (in this case the central bank) is incapable of obtaining the necessary and relevant information required to do so.”
A recent history of Fed-policy induced bubbles and busts, as illustrated by the federal funds rate – click to enlarge.