Are Happy Days
Here Again?
By Dr. Shawn Ritenour
Grove City College
&Mises Institute in Auburn, AL
Ben Bernanke, chairman
of the Federal Reserve, is a better historian of
economic thought than monetary theorist. In reference
to the current financial turmoil he is quoted as
saying that classic central-banking theory instructs
us that the Fed should accommodate banks and other
lenders when they experience sudden outflows of
cash, like some banks are now. In other words, central
banks are to serve as a “lender of last resort”
whenever their inflationary chickens come home to
roost.
Bernanke is certainly right when he says that is
what classic central-banking theory says. He implies,
unfortunately, that this theory is correct and can
serve as a guide out of our present financial troubles.
Bernanke utterly fails to see that the very mess
in which we found ourselves was caused by the very
sort of accommodation that Bernanke is pursuing.
When the Federal Reserve injects liquidity into
the financial system, like it did with Tuesday’s
dramatic rate cut, it does so by expanding credit,
making it possible for banks to offer artificially
lower market interest rates. Businesses acquire
new money at the lower rates and their entrepreneurial
ambitions expand, which results in an economic boom.
New businesses are started, using the new money
to buy land, labor, and capital goods. Wages increase
and happy days appear to be here again. Alas, these
new projects appear profitable only because market
interest rates are pushed artificially low.
Unfortunately, the new structure of production does
not reflect voluntary saving patterns. Investors
are led to make investments as if more real savings
are available, when in fact they are not. Unless
larger amounts of new money is again injected into
the system, market interest rates will return to
their original higher levels and much of the newly
begun projects will prove to be unprofitable. These
investments have to be liquidated or abandoned.
Some businesses become bankrupt and their workers
lose their jobs. Asset values fall. Stock prices
tank. Retirement funds shrink. Banks contract credit
as borrowers face financial difficulties while firms
need cash to pay off debts and stay financially
afloat. Depositors begin withdrawing money out of
their savings. All of this results in the “sudden
outflow of cash” that keeps central bankers
up at night. Such an inflationary boom-bust pattern
has been the recurring story for the past twenty
years.
Immediately after the great stock market crash of
1987, the then new Federal Reserve Chairman, Alan
Greenspan, assured investors that the Fed stood
ready to provide whatever liquidity was necessary
to keep the markets on a solid financial footing.
The solution to the crisis was inflating the money
supply via credit expansion. The Fed’s solution
to the 1990s recession and Mexican Peso crisis was
more of the same.
Investors flush with new cash were looking for opportunities
and became hip to the next big thing: technology
and the Internet. Money was poured into that sector,
capital was mal-invested, and the new economy proved
to be not so new after all. Economic law asserted
itself and unwise investments proved themselves
to be as unprofitable as ever. Tech stocks crashed.
The Fed responded by doing what it does best: assuring
investors by expanding credit and increasing the
money supply. The Fed repeated their “accommodation”
after the 9/11 terrorist attacks. Many investors,
bitten by the tech crash, wanted to direct their
new money into investments whose value they thought
only appreciates: real estate. Capital was mal-invested
again, being poured into—among other things—sub-prime
loans that looked great as housing prices increased
but cannot be repaid in a market where house prices
are actually falling.
Recent history and sound monetary theory teaches
us that when central banks expand credit and increase
the money supply, what they really accommodate is
the boom/bust business cycle. What the Federal Reserve
is doing right now, in its effort to keeping the
good times rolling, is setting in motion the next
inflationary boom/bust cycle. New money created
by the Fed will be poured into the next big thing,
and many of the investments will prove to be unwise.
People will go bankrupt, and the Federal Reserve
will assert itself as the national economic protector
once again, never willing to admit that it is the
source of the mess in the first place.
The solution to the problem we are in is to put
an end to the cause of our financial woes, not to
merely treat its symptoms. At the very least the
Federal Reserve should stop inflating the money
supply every time bankers and investors make bad
choices. Even better would be to abolish the Federal
Reserve altogether and establish a thoroughly private
banking system that requires banks to maintain 100
percent of their deposits on reserve for immediate
redemption. Only such a system would prevent the
recurrence of the boom/bust cycle that results from
monetary inflation via credit expansion. (Dr. Shawn
Ritenour is an associate professor of economics
at Grove City College, contributor to the Center
for Vision & Values, and adjunct professor at
the Mises Institute in Auburn, AL.)
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