Tuesday, April 14, 2009

Interest Rate Manipulation and the Recession

The current financial crisis was caused in no small part by false signals created by the Federal Reserve. Others have pointed out the role of government pressure to increase home ownership as a source of this crisis – which was the source of Fannie Mae’s and Freddie Mac’s troubles – but, in the end, such pressure would have come to naught had it not been for the low interest rates created by the Federal Reserve’s keeping the interest banks can charge each other so artificially low, which put downward pressure on overall interest rates.

Nobel Prize winning economist F. A. Hayek observed in “Individualism and Economic Order” that “general reluctance to undertake any risky business might drive the rate of interest down to nearly zero.” If we invert this, we see how interest rates act as a signal to the economy regarding risky behavior. If people are reluctant to take risks, interest rates go down, because loaning money costs less, being less risky. This makes money more available, encouraging borrowing for all sorts of ventures, including risky ones, which are also more affordable to pursue. As risky ventures and investments increase, interest rates go up, reflecting the costs of those risks. Low interest rates arise out of a low-risk culture, and encourage more risk-taking; high interest rates arise out of a high-risk culture and encourage less risk-taking.

This, of course, is under natural market conditions. What we have not had for almost two decades now is natural market conditions in the determination of interest rates. Rather, we have had the controlling hands of Alan Greenspan and Ben Bernanke, who thought centralized control of interest rates to be superior to market forces. To “cool” the economy – discourage economic activity by encouraging saving and discourage risk-taking – interest rates were increased; to “warm” the economy – discourage saving and encourage risk-taking – interest rates were decreased. But in fact, interest rates were kept low during most of the past twenty years. Thus, risky loans were encouraged, since risk-taking had such low costs. Throw in a government saying how nice it would be if more people owned their own homes, and you have economic, social, and political enticements to make riskier home loans. Other kinds of risks were also encouraged by such low interest rates.

Even though riskier and riskier loans were being made, the interest rates remained low. This acted as a false signal to the financial sector. The low interest rates told lenders there was not a lot of risk being taken in the economy, even when in fact there was. And, as we have since learned with the subprime mortgages, there most certainly was.

In other words, central planning by the Federal Reserve caused this current collapse of the financial system and of the world economy into a severe recession. The manipulation of interest rates by the Federal Reserve sent false signals to the financial sector regarding the relative risks being taken by borrowers. Had market forces been allowed to work, interest rates would have been and would be much higher, reflecting the true level of risk-taking in the economy at large. This would have resulted in fewer home sales and, thus, would have prevented the housing bubble whose collapse brought about the collapse of the financial sector. Home ownership would be at a healthy level – those who could afford a house would be in one, while those who could not would not be – and risk-taking overall would be at a healthy, sustainable level. We are on the verge of another depression not because free markets failed to work, but because the Federal Reserve did not allow them to work. In other words, even limited central planning (or, if you will, Keyneseanism applied to interest rates) fails yet again.
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