INVESTMENT BANK OF LAST RESORT
When a central bank devalues its currency, markets respond rationally, as always. Devaluation of a fiat currency (one with value not tied to gold) is done by injecting more currency than is demanded by economic activity. A central bank may inject excess liquidity while setting commercial bank interest rates low or high. Either interest rate environment allows devaluation. The interest rate “target” announced by the Federal Reserve effectively determines whether small and medium-sized business can obtain bank credit at market or lower rates in order to participate in the inflationary economic activity.
By Wayne Jett
© March 20, 2008
This Inflationary Interest Rate Cycle
In 2004, the Federal Reserve began raising the overnight inter-bank reserve loan interest rate target, which U. S. commercial banks use as a benchmark for setting their interest rates on loans. When the overnight loan rate is higher than the market would set it, market participants who depend on banks are effectively denied credit at reasonable cost. Businesses too small to borrow through commercial paper or corporate bonds have been denied credit at market rates since 2005 by the Federal Reserve’s actions, shutting down vigorous job creation and economic growth permitted by cuts in marginal income tax rates in 2003.
While retarding economic growth with high interest rates for bank customers, thereby reducing market demand for dollars, the Federal Reserve injected additional liquidity through 2006. With lower demand and greater supply, naturally the dollar’s value fell relative to gold. A sharply inverted yield curve confirmed that main street borrowers from banks could not get loans at rates near what the market deemed reasonable. Commercial paper and bond rates were highly favorable by comparison, because investors in commercial paper and corporate bonds must compete to acquire the debt instruments. Unlike the Fed’s manipulative assist to commercial banks in setting loan rates without real competition, investors in CP and bonds bid interest rates down and monetary liquidity flowed to non-bank borrowers through innovative debt instruments designed in the financial markets. Lenders and borrowers made credit decisions that were rational in devaluing currency conditions, but not the same decisions they would make if they were using stable or strengthening currency.
The Turn in the Cycle
In 2007, the Federal Reserve stopped injecting new liquidity but maintained the high cost of bank credit disfavoring smaller borrowers. This produced less excess liquidity while assuring the available liquidity would continue flowing to big corporate borrowers. By August, credit decisions made during high liquidity became problematic. The Fed engaged in fire drills to alleviate crises arising in credit markets. In September, the FOMC began a series of reductions in the overnight interest rate (thus in bank credit costs) continuing to date but still leaving the yield curve partially inverted and bank credit above market. Credit dislocations remain in March, 2008, economic growth is stifled, and the dollar’s value plumbs historic depths.
To its credit, the Federal Reserve’s actions appear designed to avoid adding permanently to the monetary base. New currency is being added temporarily as collateralized loans. New permanent liquidity may have to be added eventually, depending on the terms and outcome of the Bear Stearns transaction and any similar Fed undertakings. These are “mop-up” costs of salving crises caused by the central bank’s strident devaluation of the dollar during 2004-2007.
Avoid Keynesian Errors
Almost all economists who desire a stronger, stable dollar hold the mistaken view that a higher overnight funds rate will provide it. They are just as much in error as are Keynesians who urge (and persuade) the Federal Reserve to devalue as the path to a positive current account balance. Keynesians are sorely wrong in asserting that a current account surplus is mandatory or even necessarily desirable in America’s quest for prosperity. All who espouse central bank manipulation of interest rates (whether higher or lower) lend aid and comfort to use of currency as a weapon of trade war and to central planning of bank credit costs and asset prices.
Defective U. S. monetary policy cause dislocations in the credit markets, distrust of credit quality and distrust of the dollar. None of these three serious concerns will be resolved, and certainly not for the long term, without reforming monetary policy. The Federal Reserve is not the cavalry riding to rescue private wagon trains in trouble of their own making. Crises addressed by the Fed are of the Fed’s making. Chairman Bernanke (if not Secretary Paulson) has steered the Federal Reserve into a role of investment banker of last resort, which is a high risk business whose prospective losses would be paid by further devaluation of the people’s money.
Investment banking risk taken on by the Federal Reserve is one more role assumed by a central bank because it has already strayed from the only fundamental purpose it is fit and able to serve: providing currency with stable value. The Federal Reserve could provide stable currency if it focused on that one objective. It cannot do so while manipulating interest rates, unemployment and asset prices. Assuming investment risk inevitably involves creating money to meet the costs of that risk, and doing so at a time when the central bank’s primary duty ought to be stabilizing the currency. That is not a good change in policy. Superior policy is providing all investment banks and other market participants stable currency and hold them responsible for their financial decisions without a guarantee by the central bank.
Make Sense Out of Chaos
Orthodox Keynesian theorists see dollar devaluation as a good thing, yet paradoxically concede price inflation is bad and propose that it ought to be fought with higher interest rates and higher unemployment. Dollar devaluation makes price increases inevitable. Unemployment is merely one mechanism Keynesians use to lower the aggregate standard of living in proportion to the currency devaluation. Keynesian doctrine guiding the Federal Reserve may get the economy through this federal election year without catastrophe, but it is incapable of producing a good outcome in the longer term.
President Bush needs better economic advice. Someone should tell him he can issue an executive order requiring the Federal Reserve to allow markets to set the overnight funds rate and to target $500/oz gold as the dollar’s value. Otherwise, after November 4, high inflation, high interest rates and economic recession will tarnish the legacy of his originally successful 2003 tax cuts. ~