Central banks live by a simple financial principle: Whenever economic activity stagnates or declines, they quickly lower their interest rates and expand their credits. But when business seems to improve, they hesitate and vacillate in removing the rate cuts. The consequence is a permanent addition to liquidity. According to calculations of the German central bank, between the end of 1997 and September 2006 the stock of world money nearly doubled, but nominal economic production rose only by some 60 percent. Such an imbalance is bound to either cause consumer prices to rise or create price bubbles in stock, loan, or real estate markets. When they finally burst they are likely to inflict many personal losses and force businesses to repair and readjust.
Every week we may hear and read about new corporate mergers and acquisitions. Flush with cash, private equity firms are ever ready for more deal-making, bidding for and acquiring another company. The merger and acquisition boom is buoying stock prices across the board, which is benefitting most investors. Moreover, as some corporations are being taken private and others are engaged in stock buybacks, thereby reducing the overall supply of corporate shares, the stock market is enjoying an extraordinary boom which many investors hope will never end.
Some economists are scoffing at such optimism; they like to point at the bursting of the bubble in 1929 which led to the Great Depression of the 1930s. They also remember the bursting of the Japanese bubble in the early 1990s, which kept the Japanese economy depressed for nearly a decade. And they cannot forget War II and postwar monetary policies which, by the beginning of the 1970s, had flooded the world with U.S. dollars. Some countries finally removed their currency ties to the dollar, and the oil-exporting countries cut their supplies of oil, which caused raw-material prices to soar. In the early 1980s, it took major Federal Reserve restraint to restore some measure of stability and several years for business to repair some damage and allow the American economy to expand again.
At the present, government planners and central bankers are making the same mistakes all over again. They all seem to like low interest rates, thereby rendering capital less expensive. When real interest rates are depressed, as has been the case all over Europe and in the United States early in the present decade, the economy loses a sense of direction, which may allow even unproductive producers to remain in business. In the long run, without the guidance of true market rates of interest, economies lose efficiency and productivity.
In a free economy, interest rates play a role similar to those played by prices and wages. They all spring from the people’s choices and value judgments, giving rise to “demand and supply” and guiding producers in their decisions. The market rate of interest is a gross rate usually consisting of three distinctive components: the pure rate, the depreciation rate, and the debtor’s risk premium. The pure rate is the very core stemming from man’s very nature which forces him to view economic phenomena in the passage of time. He ascribes a lower value to future goods and conditions than to present provisions; the difference is the pure rate. The depreciation component appears whenever government or its central bank inflates, thereby depreciating the currency; the rate of currency depreciation determines the size of the component. The debtor’s risk premium, finally, reflects the reliability and trustworthiness of the debtor.
Central bankers rarely pay attention to the market rate. Their policies are guided by popular doctrines calling for stimulation of national employment and income. They seem to be unaware that all rates other than market rates give false signals to producers and consumers alike; they cause maladjustments. Rates that are lower than market rates promptly increase the demand for credit. With all recent rates below the market rate it cannot be surprising that total American debt has surged by several trillion dollars. Last year, household debt alone rose by more than one trillion dollars. The federal government itself has been adding more than two billion every day. The Federal Reserve System, together with some 7,900 commercial banks, provided the funds; and foreign central banks and commercial banks invested their dollar earnings in nearly one-half of the federal government’s debt.
Such credit expansion, unsupported by genuine savings and capital formation, generates illusionary gains making people believe that they are more prosperous than they actually are. Stock and real estate prices soar, tempting people to spend their gains, improve their homes and build mansions. Actually, they all — businessmen and stockbrokers, executives and workers — may consume their material substance. But no matter how low the Federal Reserve may set its rate, the boom is bound to come to an end as soon as the maladjustments inflict losses on business. As more and more businesses face difficulties or even fail, the readjustment begins, forcing them to respond to the actual conditions of the market.
Today, the Federal Reserve is doggedly ignoring the market rate of interest. It continues to direct the credit expansion, which not only has turned housing into a large bubble and rekindled the stock market but also has given rise to a voluminous foreign trade imbalance. Both domestic and foreign maladjustments are inflicting growing pains on commerce and industry.
Some economists are convinced that central banks may have a ready escape from the dilemma: they may gradually return to higher rates of inflation which forces all fixed-income receivers and bond holders to bear the most losses. Optimists even like to point to the impact of globalization, which seems to limit the inflationary effects to real estate and the booming mergers-and-acquisitions market. But most economists are fearful of a recession which is a normal part of a business cycle. Fear may take hold of the minds of businessmen, production may be curtailed, and unemployment may rise. Government is bound to embark upon employment programs and assume increased public welfare responsibilities. It may even reduce some taxes, increase its budget, and force its central bank to lower interest rates another notch. The rate of inflation is bound to soar.
A few pessimistic economists are convinced that a devastating economic cataclysm lies ahead. They usually point to three threats that may have a serious impact on the American economy. There is the burgeoning tower of public and private debt resting on a foundation of greed and overindulgence. There are a multimillion-dollar list of promises to a retirement system and a vast building of government guarantees and promises that are bound to be unkept. There even is a world of complex derivatives, the value of which depends on something else, such as stocks, bonds, futures, options, loans, and even promises. They all, according to these economists, will be the victims of the coming cataclysm.
This economist, who has observed central bank policies since the 1950s, is in basic accord and feels sympathy for these pessimists. They seem to have a clear view of the principles of money markets and the policies conducted by governments ever since they discarded the natural money order, that is, the gold and silver standards. But these pessimists tend to ignore the countless ruses, devices, and stratagems used by government officials and central bankers to hide the consequences of their policies. Long before there will be a financial Armageddon, there will be a myriad of government regulations, controls, edicts, and rulings that hide the consequences of monetary policies. Policies will be readjusted frequently to cover the actual effects. Given the public confusion and unfamiliarity with monetary policies and their consequences, a large majority of the public is likely to accept official explanations and welcome the regulators and controllers.
After a short period of price and wage controls, the voices of reason, which at the present are barely audible, may be heard again. They may even be allowed to get the American economy moving again, by abolishing the myriad of price and wage controls and allowing wages and prices to readjust to market forces. They may even have to conduct a currency reform, that is, issue new money at various ratios to the old. Most countries all over the globe have suffered currency reforms in recent decades; it would be a new experience for Americans.
We cannot tell what the future will bring, but we must always prepare for it. This economist is bracing for a gradual increase of political controls over economic life, leading to countless maladjustments, distortions, and stagnations. But this trend of policy and its harmful effects is contravened by the world-wide movement toward globalization. As trade doors open all over the globe and business capital is free to move to friendly countries enjoying rapidly rising levels of productivity and living, it will be difficult for American political controllers and regulators to hold on to their powers and move toward a command system. They cannot douse the light of economic freedom shining in so many places.