November 16, 2010
The Trillion Dollar Gorilla in the Economy – Looming issues with the Fed and Inflation
In the early days of the American financial crisis, when floor was just beginning to fall out from under the subprime mortgage market, there were calls from lenders to reduce the federal funds rate in order to allow banks to more cheaply lend to each other and keep their balance sheets fall in line with government regulations. This rate is used as a barometer of the money supply. The lower the rate, the faster the money supply can grow because the low cost of inter-bank borrowing increases what is called the velocity of money, or the rate at which it changes hands. Higher velocity essentially multiplies the amount of money in the economy, effectively growing the supply and increasing the rate of inflation.
The idea behind cutting rates is simple: lower rates = bigger money supply = more money in peoples/banks pockets = more spending/lending = happy economy. But, cutting rates makes the economy more susceptible to the problem of inflation. The federal funds rate is a tool that can be used to decrease the money supply to lower the rate of inflation, working in more or less the inverse of the procedure outlined above. Higher rates = higher cost of short term lending = smaller money supply = lower inflation. This also has the nasty side effect of torpedoing aggregate demand, lowering both spending and lending and essentially kicking the tepid American economic recovery right where it would hurt the most: in consumer spending. This leaves the fed in a nasty predicament because inflation can also severely damage the recovery. If people’s dollars lose value, people will spend them quickly due to fear of their dollars farther losing value. Then, whoever gets those dollars wants to get rid of them, and the cycle continues. The velocity of money increases exponentially and inflation moves in lock step with it. Essentially, the dollar could be turned into a toxic asset. Don’t believe me? Look at Germany after world war one, where hyperinflation created a situation where children played with bricks of deutschmarks like Legos, or in present day Zimbabwe, where a wheelbarrow full of currency won’t even buy a loaf of bread.
If the Federal Reserve were the only actor in this problem, it might be manageable because the fed would be well capable of cleaning up its own mess. If it lets rates drop too low, it can simply raise them to undo any damaging swelling in the money supply and vice versa. However, there is one other actor in this situation who makes the problem utterly dismal: the federal government. The federal government, through both the Troubled Asset Relief Program as well as the American Recovery and Reinvestment Act, have increased the money supply by over a trillion dollars through deficit spending and other bailout measures. This action wrests control over the money supply away from the Federal Reserve and instead into the hands of an entity that can only spend. The federal government has shown a remarkable talent for running deficits. And even if it were to run a surplus, it’s incapable of reducing the money supply because this surplus is simply reinvested and spent back out. This creates a situation where the money supply can only grow and control of the money supply is taken away from the organization that is supposed to control it.
The entire premise behind the federal reserve is to safeguard the value of the dollar; with the national government growing the money supply and the fed unable to counter the inevitable inflation by raising rates for fear of damaging the economic recovery. The Fed has been bastardized into a tool of economic and fiscal policy and has lost its true purpose of safeguarding the dollar. Without the fed to protect the continued value of the dollar, the US risks seeing the dollar fall out of favor as a currency of global trade. Furthermore, the threat of rampant inflation is actually causing organizations to withhold loans because inflation makes lending a losing proposition. If dollars are losing value at a higher rate than the rate of interest on a loan, the money being paid back is worth less than the money being lent out. Firms are afraid of this coming to pass, so they’re holding out on borrowers. So, the tool that was intended to stimulate lending instead has cooled the sector to the point that it’s dragging down the recovery it was intended to benefit.
The Federal Reserve has lost its way through politics and has become a tool of policy instead of economic health and sustainability. Only by giving the fed back its metaphorical cahones by distancing it from the federal government, perhaps by altering the appointment process so the federal reserve is no longer directly accountable to the government. Many opponents will argue that this is a dangerous precedent, but the entire idea behind the Federal Reserve is that it must be free to operate as it sees fit. That way, it can act in the best interest of the national economy instead of pandering to political pressures. A strong dollar is always in Americas best interest, keeping the dollar on top when it comes to global trade and ensuring that any recovery is built on solid ground instead of empty promises and the continual threat of rampant inflation.
