In this video, Vincent Reinhart, resident scholar at AEI, debates the relative merits of QE2 with Michael Cloherty, head of US interest rate strategy at RBC Capital Markets. Reinhart gives his qualified approval for the Fed's policy, noting that with high unemployment and low, declining CPI numbers, the Fed has to do something and QE2 is "the only game in town".
Cloherty disagrees, arguing that QE2 makes the Fed's exit difficult. When it comes time to tighten rates, the Fed's "swollen balance sheet" will be difficult to unwind and its attempt to mop up the mess it made will cause liquidity problems in the markets. Amusingly, Reinhart does not disagree with this criticism. He even strengthens Cloherty's position by saying "the Fed is a serial bubble blower" and that the risks of QE2 creating another bubble are real.
Reinhart's affirmation seems to be guided by two things: (1) the government-granted monopoly that controls the money supply must do something. If you have power, you must use it. (2) Low interest rates encourage economic recovery. The first is a political assumption. The second, an economic one. Both assumptions are wrong.
Government should avoid doing anything in the marketplace aside from protecting property rights. You don't need to be an anarcho-capitalist to recognize the problems of government intervention.
Free markets do a wonderful thing. Without any need whatsoever from central planners, they regulate the supply of the goods and services people want, making sure that scarce resources are allocated to their most valued uses. This near-miracle is conducted via the price mechanism. No one sets a price. Prices are derived from the sum of interactions between buyers and sellers over a period of time.
Every time the government intervenes in this complex ecosystem, it destroys the delicate balance of resource allocation. Scarce resources get channeled into things that have less value than the goods and services deprived of these same resources. As a whole, society is poorer as a few benefit from the distortion at the expense of the many.
Therefore, we should assume the government's best course of action in an economic downturn is to do nothing. That was Warren G. Harding's approach during the Depression of 1921 and his policy worked so well, no one even remembers that downturn. The one we remember best involved government intervention on steroids.
This principle of non-interference can be directed against Reinhart's second mistaken assumption. Keeping interest rates low is a government intervention. The Fed is sometimes called a private institution, but since no other private institution can expand the money supply without going to jail for counterfeiting, we can safely say that manipulating interest rates is a government-sponsored intervention.
Interest rates are simply the price of money. The Fed's target rate is a special kind of price control. The free market produces a natural interest rate as people with money to lend interact with people who want to borrow. The Fed manipulates the price of money by creating it out of thin air (to lower the interest rate) or sending it back into nothingness (to raise it).
The Fed thinks it can stimulate a sluggish economy by lowering the interest rate. In terms of immediate effects, this can work...sometimes. Assuming people aren't hiding money under the mattress out of fear for the future, the Fed can get more people to borrow money by lowering the price. More borrowing leads to more investing in capital projects. More capital investment leads to economic growth. Right? No….wrong actually.
The Fed's strategy for economic growth ignores the complex ecosystem of the free market and its delicate allocations of scarce resources. The natural interest rate of the free market reflects our overall preferences for how much we want to consume versus how much we want to save.
If we all are in a major consumption mode, we save less. That reduces the supply of loanable funds and interest rates go up. That's a good thing. The higher interest rate tells entrepreneurs that people are buying up finished goods and services. Resources are heavily allocated to the retail end of production. It's not a good time to compete for labor and materials at the early development end of production (mining, refining, research and development). If you invest in that end of production at those prices, the cost of the finished product will be too high and you won't make a profit.
On the other hand, if people, after being sated by their spending spree, begin to feel they haven't saved enough for a rainy day, they start putting more money into the loanable funds market and the interest rate goes down. This is a good time to invest in early-stage development. People are buying less at the retail end of production and early-stage investment won't produce any finished goods for a long time. Just enough time for people to shore up their savings and collect some interest on the money they save, so they'll be eager to buy the finished products when they roll off the assembly lines.
The coordination of time, interest rates, and the allocation of resources to various stages of production is truly a miracle of nature. And it's completely destroyed by the Fed's attempts to control it according to various interests. Artificially low interest rates misallocate resources at all stages of production and distort our preferences for saving and consumption. We wind up with things like huge inventories of expensive housing that nobody wants or can afford.
Artificially low interest rates got us into this mess. Do we really want to assume they can get us out of it?