The Risks of Monetary Policy Based on Perfection

The bursting of the credit bubble has reached beyond subprime loans. Prime mortgage and home equity loan defaults are rising, as are auto loan defaults and credit card defaults. Corporate loans, particularly to the less creditworthy companies, are also showing signs of trouble. Leveraged buyout debt has been orphaned at the banks that provided interim financing. Foreign governments warn of the spreading impact of the U.S. economic slowdown on the rest of the world.

U.S. monetary policy, as implemented by the Federal Reserve, has relied heavily on promoting cheap credit to stimulate economic activity. Easy money encourages consumers to consume, home buyers to buy and home equity borrowers to borrow. Cheap credit also makes dicey business investments look less risky.

The problem, as we now all know, is that cheap credit also encourages risk taking--a lot of risk taking when the credit is really cheap. To make the easy credit monetary policy work, employment levels must stay very high, consumers have to keep consuming more and more, and asset values have to keep rising. In other words, the Fed’s easy credit policy of recent years has been based on everything being perfect. There was no slack. When bad things happened, the financial system took a fright and froze up. It’s still in the process of thawing out, and the prognosis is guarded.

In reality, the Federal Reserve did not ease the market for credit, but disrupted it. It substituted its judgment for what the price of credit should be, in place of the equilibrium the markets would have attained. By making credit really cheap, it laid the foundation for asset bubbles. But when the bubbles burst, what was the Fed’s response? More cheap credit. We are tempted to mumble something here about moving up the learning curve. But sometimes futility is evident.

Dysfunction continues apace in the credit markets. Prices appear lower, but sellers--i.e., lenders--don’t want to sell at low prices. Lower interest rates won’t make a person with no documented income, assets, or employment any more creditworthy. With increased downpayment requirements and other changes in lending standards, the real price of borrowing, if it occurs at all, is rising even as the Fed lowers nominal interest rates. One lesson is that markets try to function even if they are obstructed by government policy. When the government sets an artificially low price for credit, lenders will find ways to raise the real price. That’s sensible from their standpoint but it counteracts the Fed’s intended stimulus.

We know from financial history that the private markets tend to achieve equilibrium through rather volatile and painful processes. The financial panics of the 19th and early 20th centuries are illustrative. It’s in the nature of the political process to try to shift risk and pain onto the government (for both good and bad reasons). The Federal Reserve is today held to a no mistakes, no recessions standard. Given that the financial markets are basically a confidence game anyway, the Fed can’t afford to admit to any weakness, lest it precipitate the mother of all financial panics. It is forced by circumstance to pursue bad options rather than admit it has no good options.

Today’s Fed isn’t aggressive. It’s cautious. In lowering interest rates at the slightest whimper from the stock market or Congress, it’s following a well-trodden path that will be accepted and even applauded by the constituencies with the best access to the press. The fussbudgets and old coots that point to the limited effectiveness of interest rate cuts and their inflationary potential can be ignored (at least for now) amidst the loud acclamation that accompanies any government handout.

Too much is expected of the Fed. It is supposed to maintain the safety and soundness of the banking system, guard against inflation, keep the U.S. economy growing briskly, and allow nary a layoff. The Fed can fulfill these goals only if conditions are perfect. Sometimes, they are. Then again, sometimes, they aren’t. By placing these ultimately conflicting responsibilities on the Fed, we are gradually creating a command and control financial system where the key decisions about price and resource allocation are made by the federal government instead of the collective interactions of the markets. Resource misallocation is inevitable, most recently with too much capital flowing into real estate, commodities (like oil), and the opaque products of financial engineering.

The Fed cannot be all things for all constituencies in the economy. Ideally, it should be responsible only for maintaining the safety and soundness of the banking system, and safeguarding the dollar against inflation. To require the central bank to lay the economic foundation for the entire citizenry's pursuit of happiness is to ask too much.

America will grow comparatively poorer in relation to other nations as its wealth is squandered through government resource misallocation. Many individual Americans today are growing poorer after squandering their wealth in poorly conceived real estate loans. The national impact will follow. You don’t have to take our word for it. Just look at Japan, a country that has gone pretty much nowhere since it misallocated too much capital to real estate and stocks 20 years ago.

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