[Part 1 of this series concluded by asserting that Federal Reserve creates boom and bust cycles through its manipulation of currency–an activity as widely accepted as it is pernicious.]
The Fed can endlessly create new money out of thin air by simply creating additional reserves in some banks. As the Fed pumps more money into the banks’ reserves, it artificially lowers interest rates in the economy. In recent history, the Fed has artificially lowered interest rates through the manipulation of the Federal Funds rate (“Funds rate”). Without getting too technical at this time, the Funds rate is the rate of interest charged between banks that impacts other interest rates throughout the economy. As the Fed pumps more money into the banking sector, the Funds rate decreases and the other interest rates correspondingly fall as well.
The artificially lowered interest rates create an economic boom. Lower interest rates make it more affordable for entrepreneurs and businesses to borrow savings and invest in capital creation and long term production. (As explained in another series, capital and savings our tools for production and economic growth.) In addition, the lower interest rates make it more affordable for consumers to borrow savings to fund additional consumption of housing, cars, and other consumer goods.
As banks loan out more and more money due to the lower interest rates and increasing reserves, the money supply further increases from all the newly created bank credit. This increase in the money supply eventually circulates through the economy, resulting in rising nominal profits, growing consumption, and even rising revenues for governments. In short, during this boom, prosperity appears to be growing for businesses, consumers, and governments. Businesses invest in more long-term production projects, consumers consume more, and governments spend their rising revenues on new programs and growing pensions. All is well.
This economic boom is not sustainable. Interest rates are merely a signal in a free market that coordinates a rational equilibrium between production and consumption. When individuals choose to consume more in the future in lieu of the present, they build up their savings. As an accumulation of savings builds up in the economy, interest rates drop, reflecting the desire to consume more in the future as opposed to the present. The lower interest rates allow entrepreneurs to borrow the accumulated savings and invest in long-term production projects in anticipation of the desire of consumers to consume more in the future. Conversely, higher interest rates signal a shrinking amount of savings in response to a desire to consume more in the present as opposed to the future. With higher interest rates, it does not make financial sense for producers to invest in long-term production projects since consumers desire to consume more now.
Consequently, artificially lowering interest rates diminishes the market’s rational coordination between production and consumption. When interest rates are artificially lowered, it does not magically create more savings in the economy, much less the amount of capital available at any moment in the economy. Instead, the artificially lower interest rates create a false signal to producers that more savings are available to invest in production, in anticipation of a greater desire to consume in the future. They also fund additional present consumption. Thus, like an inevitable traffic jam at an intersection with malfunctioning traffic lights, artificially low interest rates create an imbalance between the use of our limited resources available for production and consumption.
The boom in production and consumption resulting from the artificially low interest rates is not sustainable, because producers and consumers are competing for a diminishing amount of savings. Imagine a children’s play center with a bunch of kids excited over a large bin of building blocks. They are all determined to build their own large castles. Eventually it becomes clear that there are not enough blocks to build all of their envisioned castles. The kids start fighting over the blocks and a teacher makes them share. The consequence is that all the kids probably have to shrink the size of their castles.
The same thing happens when the Fed artificially lowers interest rates. The lower interest rates lead producers go into further debt and invest our economy’s limited resources of savings, capital, and labor into long-term production projects. Often the investments are made into assets like stocks and housing that increase in nominal value as the money supply increases. The rise in the nominal value of stocks and houses creates the illusion of increasing wealth. This illusion of wealth leads to an increase in debt-induced consumption.
As the assets and the economy in general skyrocket in price from the increasing money supply, the Fed is forced to raise interest rates to slow down the rise in prices. The rising interest rates reveal that many of those investments were not maintainable but for the artificially low interest rates and growing money supply. In short, many of the producers’ investments go bust. Similarly, consumers find themselves stuck with burdening debt. It becomes evident that those production projects and the various retail companies that benefited from the increased consumption were financial bubbles. When the bubbles collapse the economy is broke. We have mal-invested our limited resources of savings and capital into fictional sources of wealth and over-consumption. Finally, governments, including Ohio’s, find themselves in budget crises when the revenues are no longer available to fund the financial commitments made during the illusionary boom.
All opinions expressed belong solely to their authors and may not be construed as the opinions of other writers or of OCR staff.
NEXT IN THIS SERIES: OUR RECENT BOOM AND BUST CYCLES. Check OCR tomorrow for the next installment of “Our Coming Economic Collapse.”