Sunday, March 8, 2009

Explaining: Thomas Woods is Doing it Right II

F.A. Hayek won the Nobel Prize in economics for a theory of the business cycle that holds great explanatory power—especially in light of the current financial crisis, which so many economists have been at a loss to explain. Hayek’s work, which builds on a theory developed by Ludwig von Mises, finds the root of the boom-bust cycle in the central bank—in our case the Federal Reserve System, the very institution that postures as the protector of the economy and the source of relief from business cycles.

Looking at the money supply makes sense when searching for the root of an economy-wide problem, for money is the one thing present in all corners of the market, as Robbins pointed out in his 1934 book, The Great Depression. “Is it not probable,” he asked, “that disturbances affecting many lines of industry at once will be found to have monetary causes?”

In particular, the culprit turns out to be the central bank’s interference with interest rates. Interest rates are like a price. Lending capital is a good, and you pay a price to borrow it. When you put money in a savings account or buy a bond, you are the lender, and the interest rate you earn is the price you are paid for your money.

As with all goods, the supply and demand for lending capital determines the price. If more families are saving or more banks are lending, borrowers don’t have to pay as much to borrow, and interest rates go down. If there’s a rush to borrow or a dearth of lending capital, interest rates go up.

There are some results of this dynamic that contribute to a healthy economy. Start with the case where people are saving more, thus increasing the supply of lending capital and lowering interest rates. Businesses respond by engaging in projects aimed at increasing their productive capacity in the future—expanding facilities or acquiring new capital equipment.

Also consider the saver’s perspective. Saving indicates a lower desire to consume in the present. This is another incentive for businesses to invest in the future rather than produce and sell things now. On the other hand, if people possess an intense desire to consume right now, they will save less, making it less affordable for businesses to carry out long-term projects. But the big supply of consumer dollars makes it a good time to produce and sell.

Thus the interest rate coordinates production across time. It ensures a compatible mix of market forces: if people want to consume now, businesses respond accordingly; if people want to consume in the future, businesses allocate resources to satisfy that desire. The interest rate can perform this coordinating function only if it is allowed to move freely in response to changes in supply and demand. If the Fed manipulates the interest rate, we should not be surprised by discoordination on a massive scale.

Saturday, March 7, 2009

Explaining: Thomas Woods is Doing it Right

F.A. Hayek won the Nobel Prize for showing how the central bank’s manipulation of interest rates – in other words, its intervention into the free market – leads to the boom-bust business cycle with which we are sadly familiar.

Even those who claim to support the free market see nothing amiss in a monopoly central bank with the monopoly power to create money out of thin air. They spend their time talking about what our Soviet commissar in charge of money and interest rates should do, instead of asking whether we need central planning of money and interest rates in the first place.

The housing bubble could not have arisen without the Federal Reserve. Had people started buying houses at unusually high rates, banks’ loanable funds would have begun to deplete, interest rates would have shot up, and that would have been the end of it. That would have discouraged any additional speculation in real estate. But Alan Greenspan and the Fed could create money out of thin air, thus giving the banks more to lend and driving interest rates down, thereby perpetuating the destructive bubble in housing.

In our country we have one group that believes you can print wealth into existence, another that tries to spend it into existence, and a third (and by far the largest) group that believes in both. This is a philosophy fit only for children and ignoramuses, and the editorial page of the New York Times – or perhaps I repeat myself.

Then there’s the fourth group: the grownups, who understand that wealth is created through saving, investment, and entrepreneurial skill; that wealth has to be produced before it can be consumed; and that lending is impossible in the absence of prior saving. Simple things, really, but if it weren’t for the constant denial of these elementary ideas, our talking heads would have nothing to do.

Today, we grownups have to explain these basic principles to the deranged children – as they run around with their fingers in their ears, and screaming "I can’t hear you!" – who run our government, write our opinion columns, and fill American airwaves with stupid and destructive economic advice.