Most people would find it strange to hear about potential problems with a booming economy these days. After all, we are in the midst of a recession and some people fear the onset of a depression like deflationary collapse. It is however, worth noting that the Federal Reserve Banks has cut The Federal Funds Rate half a point to 1%. This is the lowest level for this rate since 2004. The Fed is moving aggressively supposedly to save the economy from its current dire condition. What the Fed is actually doing is interfering with adjustments in markets previous cuts in interest rates. It is setting the stage for another boom in the economy, to be followed by a recession. The business cycle does follow a fairly discernable pattern, in the aggregate. The Fed finances booms with bank reserve expansion and reduced interest rates. As inflation becomes more obvious the Fed then hits the breaks, thus causing yet another perceived crisis.
What we need to recognize is that the actions of the Fed today are not correcting markets and saving us from further failure. The manipulation of interest rates by the Fed are distorting capital markets, this manipulation is preventing capital markets from sorting out the last set of errors that the Fed created with the artificially low interest rates it set back in 2004 (among other times).
The real solution to the problem of the business cycle is to recognize the true function of interest rates. The Federal Reserve is being run according to the Keynesian idea that interest rates function as a mechanism for stimulating or chocking off aggregate demand. Now that aggregate demand appears insufficient, Ben Bernanke is moving to stimulate the economy. At some point some years from now Chairman Bernanke or his successor will find that aggregate demand is excessive, and will raise interest rates to a point where capital markets will crash and a recession will ensue. What is missing in Chairman Bernanke’s analysis is the idea, developed by Mises and Hayek, that interest rates coordinate the planning of future economic activity among and between individual households and businesses. Interest rates and credit markets facilitate exchange between savers and borrowers as people plan out future production and consumption. Interest rate manipulation does not simply choke off or stimulate aggregate demand, it causes dis-coordination between individuals who trade in credit and capital markets.
Ben Bernanke is now charting a course that will lead to yet another boom, a corresponding period of perceived prosperity only part of which is real, and yet another crash and recession. Hopefully the next recession will do less undeserved damage to the reputation of capitalism and free markets. Better still we can hope that more people will realize that it is Federal Reserve policy, based on faulty Keynesian economic reasoning, that is to blame for the business cycle.
(DW MacKenzie teaches economics at The Coast Guard Academy. The views of this paper do not represent the official views of The Coast Guard Academy.)