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 are 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 malinvested, 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 malinvested 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 rollin,’ 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.