Latest posts by Richard Ebeling (see all)
- How the Word Liberalism Came to Mean Its Opposite - February 14, 2019
- The Dangers of Negative Interest Rates and a Cashless Economy - January 9, 2019
- Classical Liberalism and the Limits to Compromise - January 7, 2019
When is the price of some marketable good or service at or near zero? When either the supply of it is so plentiful that virtually any demand, no matter how great, can be satisfied. Or when no matter how large or small the supply of it may be, people’s demand for it is so low that nobody is willing to practically pay anything for it.
On Thursday, September 17, 2015, Federal Reserve Chair, Janet Yellen, announced that, once again, America’s central bank was leaving a key interest rate – the Federal Funds rate at banks lend money to each other overnight – at barely above zero. The Federal Reserve has manipulated and maintained this interest rate near zero for almost seven years, now.
Fed Policy Has Created Zero and Negative Interest Rates
When adjusted for inflation, the Federal Funds rate and the yield on one-year U.S. Treasury securities have been negative for almost all of the time since 2009. In real buying terms borrowed money has been either costless or actually given away with a positive real return to the borrower!
In other words, imagine that you borrowed $100 from someone with the promise that in one year you would return the $100 plus $2, or a two percent return on the lender’s money. But suppose that in a year’s time, you pay back the lender only $98.
That is what a negative real rate of interest means. After adjusting for inflation, the lender has less real buying or purchasing power than he did before with the principle of his loan. If you have lent that $100 but over the year price inflation has been, say, four percent, then when you get back $102 from the borrower (your $100 of principle and $2 of interest), this is not enough to buy at higher prices what the $100 had bought in the market before you lent that sum of money a year earlier.
As a reflection of this, the prime rate of interest – the rate of interest normally charged by banks to most “credit worthy” borrowers – has been around 3.35 percent since 2009. Even with price inflation (as measured by the consumer price index) relatively low since 2008, averaging in the range around 1.5 to two percent for the last seven years, this means that when adjusted for inflation, such borrowers have been paying a real rate of interest of barely two percent for most of that time.
At the same time, mortgage rates on 30-year conventional loans have been between 3.5 to 4.5 percent since 2011, so again when adjusted for price inflation, real mortgage costs for a homeowner has been between 1.5 and three percent.
By historical standards, it has cost little or almost nothing to borrow funds in the American financial markets, courtesy of the former chairman Ben Bernanke and current chairwoman Janet Yellen and the other members of the Board of Governors of the Federal Reserve, who possess the monopoly manipulation authority over the quantity of money in the banking system.
This interest rate manipulation has also served the U.S. Treasury’s purposes, considering that the Obama Administration has added $8 trillion to the federal government’s accumulated debt, from $10.6 trillion when Barak Obama took office in 2009 to $18.4 trillion today. The cost of U.S. government debt payments would be far greater if the Federal Reserve had not kept interest rates artificially low and created the illusion that the interest cost of government borrowing can be almost ignored.
The Fed Pays Banks Not to Lend with Created Money
Nominal and real Interest rates would have been even lower and price inflation, no doubt, significantly higher if the Federal Reserve during this time had not played an interesting game. While keeping the Federal Funds rate at barely above zero due to the vast amount of money that has been infused into the banking system since 2008 through its “quantitative easing” policy – around an additional $4 trillion in the banking system – the Federal Reserve has paid banks a rate of interest slightly above the Federal Funds rate for those banks not to lend this created money to other banks or to the borrowing public.
Thus, over $2.8 trillion of this Federal Reserve created money has sat in the banks as unlent “excess reserves.” But even with this benching of much of the money created by the Fed, the huge amount has nevertheless, no doubt, worked it usual effect of distorting financial markets, misbalancing the relationship between savings and investment, and generated misdirection of resources and labor, and malinvestment of capital that will show themselves when the current economic recovery ends. It will be seen to have been at least partly built on the shifting sands of monetary wizardry having little to do with sustainable economic balance and growth.
Interest rates are market prices that are meant to provide relevant and meaningful information to market participants about the realities of supply and demand. Income earners choose to set aside a certain percentage of their income in the form of savings. They deposit these sums into various financial institutions that, then, funnel out the pooled savings to interested and credit-worthy borrowers.
Investment Needs Savings and Takes Time
Investment requires the availability and application of real resources – the allocation of raw materials and the use of a portion of the existing labor force to manufacture and at least maintain the capital goods – tools, machinery, equipment, plant and factory structures – with which the finished and final goods and services are produced and made available on the market that consumers desire.
But all this takes time, repeated periods of production, through which goods are not only made once or even twice, but continuously so every day, every week, every month, every year there is a constant flow of those desired goods and services at our disposal when and where and in the quantities and qualities that we are interested in buying.
Consumption and production may appear to be synchronously going on, seemingly without having to wait for the desired good to be available until a period of production has been completed. But this is like the assembly line on which at the very moment the production of some good is beginning the assembling process at one end, a finished product is coming off the conveyer belt at the other end.
But each individual unit of this good must go through the time consuming process of each of the stages of being assembled at the respective production points along that conveyer belt.
If resources, capital equipment, and labor are not put aside and maintained, again and again, to begin the process of assembling the next unit, the production process would in short order come to a halt and there would be no new units coming off the completion end of the assembly line.
It also needs to be remembered that depending on the nature, type and manufacturing requirements of each good from start to finish, the respective periods of production may run from a few weeks to months or even several years.
There must be the necessary savings in the economy to purchase, apply and use the required raw materials, capital equipment and laborers so each of the goods in progress in partly completed sequence can be brought to its final finished, useable form ready to be sold to consumers in the market.
The revenues earned, if consumer demands have been successfully anticipated by the entrepreneurs guiding, directing and overseeing the production process, will recoup the investment costs that have been incurred during the time-consuming periods of production, including the principle and interest of the borrowed money to undertake the projects, plus maybe a net profit as the entrepreneurs’ reward for a job well done.
Of course, particular entrepreneurs, having to anticipate future consumer demands in deciding what to produce and over what time-frame to have a good to sell in that future, may have faulty expectations resulting in losses suffered. If they persist this will see them lose control over their production processes and the businesses will pass into more competent enterprisers’ hands.
New Investments Need More Savings and Often More Time
If new investment projects are to be undertaken, or existing investment activities are to be enlarged or expanded, then more of the society’s resources, capital equipment and labor services must be saved and set aside from earned income rather than being used for immediate consumption goods production purposes.
There is no alternative to these trade-offs between more immediate consumption goods production and longer-term investment goods production to enhance the quantities, qualities and varieties of available goods further in the future. The means at our disposal, as individuals and as members of society, are limited, and they are used either for one purpose or the other. Scarcity is a constraint inescapable under the human condition.
Goods and services of all types are bought and sold through the medium of money. But pieces of paper money, or even minted coins of gold or silver, cannot make the scarcity of real raw materials, capital equipment, or labor services disappear or less constrained. Printing pieces of paper currency does not create out of thin air more coal, iron, or platinum. Such paper money does not result in capital equipment miraculously falling from the sky. Nor do they make materialize more working age laborers ready to be assigned to desired jobs.
Interest Rates Balance Savings and Investment
One essential and crucial function of market-based and generated rates of interest for borrowed savings is that it helps coordinate and confine investment projects undertaken to the limits of the resources freed up to bring them to completion and there after maintained (to the extent to which the investing entrepreneurs have made market-oriented correct decisions concerning the products consumers will want to buy when the production process is completed).
This balancing and coordinating function of interest rates in financial markets is undermined and distorted by central banking “activist” monetary policy that injects more money into the banking system. Since money is the medium through which the savings and investment process is carried out, the additional quantities of money made available for lending purposes creates the false impression that there is more savings to support longer and more time-consuming investment projects than is actually the case. And the artificially lower interest rates make it appear that these new or extended investment projects are more profitable they would seem if higher market-based interest rates prevailed in the financial markets.
To use our earlier imagery, new assembly line production projects are invested in and begun, and some existing production processes are expanded by undertaking lengthier and more time consuming assembly activities involving more stages added to the conveyer belt process to take advantage of greater productivity arising from a more intensive division of labor of specialized steps.
Interest Rate Manipulation and Distorted Investments
But given the actual decisions by income-earners to divide their incomes between consumption spending and savings, the patterns and time horizons of the new or expanded production processes are eventually found to be unsustainable in terms of being completed and-or maintained.
Income earners, as expressed in their consumption-savings choices desire to have more resources, capital equipment, and members of the labor force employed in production processes with short-term time horizons and quicker production turnarounds to have a larger quantity of desired consumer goods closer to the present.
As this point, the investment boom stage of the business cycle comes to an end; investment projects cannot be completed or cannot profitably be maintained if brought on line. The downturn of the business cycle sets in. The imbalances between savings choices and investment decisions, and allocation and use of resources, capital and labor between shorter and longer production processes become visible.
There needs to be a rebalancing of supplies and demands, prices and wages, resource, capital and labor uses among different sectors of the economy to more correctly reflect post-boom realistic market conditions and profitabilities.
Jobs are temporarily lost, the unsustainable and unprofitable investment projects must be written down or written off, and illusionary wealth positions will be found to be not as great or as high as they appeared in the earlier boom phase of the business cycle.
Market Corrections and Central Bank Interference
A healthy restoration of actual market stability and coordination between savings and investment, between supplies and demands, requires an end to the monetary expansion and the reemergence of market-based interest rates that can tell the truth about the availability and cost of borrowing money and the real resources they are supposed to represent, so investments undertaken stay within the bounds or types and time-durations consistent with the saved means of production upon which they are dependent.
For seven years, now, since the financial, housing and investment collapse of 2008, the Federal Reserve has prevented the full and necessary correction process to play itself out due to its huge monetary expansion and persistent prevention of allowing interest rates to tell the truth.
That does not mean that there has not been some degree and form of real market adjustment and correction and return to business profitability and employment opportunities. But overlaid on any reasonable and market-guided economic recovery has been, inevitably, new investment activities and labor and resource misallocations driven by the false signals of manipulated lower interest rates that have been financed not by real savings but by the lure of plentiful money created by the Federal Reserve’s “easy money,” quantitative easing policies.
Indeed, how can anyone know the real availability of savings and the real profitability of various time-consuming investment projects when the market rates of interest that are supposed to serve as the coordinating mechanism for this to be possible have been prevented from working, in fact, even from fully existing?
A near zero set of rates of interest surely are sending out false signals that savings and the resources they represent are available in such plentitude that anything to be invested in is there for the taking.
What has restrained the American investment boom from being as large and misdirected as it otherwise might be, are other Federal Reserve and government policies. Among these are most especially the Fed’s bribing banks not to lend all that the central bank has created as addition loanable reserves in the banking system, and the policies and environment of anti-business and anti-capitalist policies that the Obama Administration has introduced in the marketplace. Higher taxes, heavier and more intrusive regulations, and uncertainties about in what direction will the government’s interventions come next have all brought about their own effects in retarding normal market recovery, growth and job creation.
Business Cycles are Made by Central Banks
What has happened over the last decade is that a housing, stock market and investment boom that was fueled by a Federal Reserve easy money policy beginning in 2003 finally came crashing down in 2008-2009. Then, in the name of preventing the downturn mutating into a feared new deflation-driven “great depression,” the Federal Reserve has opened the monetary spigots for the last six years setting in motion the same type of stock market rise, capital malinvestments, and labor misallocations that its monetary intervention had caused earlier in our century.
Now the Fed authorities want to rein in the monetary expansion and “nudge” interest rates up to prevent a future “overheated” economy as measured by their statistical macroeconomic benchmarks. But if they do, this threatens to shake out and bring down the imbalanced market relationships their own monetary policy has created.
This is how and why the rollercoaster of the business cycle keeps repeating itself, though each phase of the cycle varies in duration and many particular characteristics depending upon the specific historical circumstances of the time. The Federal Reserve’s own expansionary monetary policy sets off the boom that finally turns into a recession that the Fed authorities view themselves as responsible to prevent or ameliorate, which only sets in motion the next unsustainable boom by a new compensating monetary expansion.
So while the Federal Reserve has chosen to keep the Federal Funds rate near zero, it is merely delaying the inescapable and inevitable result of its own monetary policy – another needed economic correction that its actions will have generated but which it will, no doubt, blame on the supposed “failures” of the market economy.