Are Happy Days Here Again?

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Ben Bernanke,
chairman of the Federal Reserve, is a better historian of economic
thought than monetary theorist. In reference to the current financial
turmoil he is quoted as saying that classic central-banking theory
instructs us that the Fed should accommodate banks and other lenders
when they experience sudden outflows of cash, like some banks are
now. In other words, central banks are to serve as a “lender
of last resort” whenever their inflationary chickens come home
to roost.

Bernanke is
certainly right when he says that is what classic central-banking
theory says. He implies, unfortunately, that this theory is correct
and can serve as a guide out of our present financial troubles.
Bernanke utterly fails to see that the very mess in which we found
ourselves was caused by the very sort of accommodation that Bernanke
is pursuing.

When the Federal
Reserve injects liquidity into the financial system, like it did
with Tuesday’s dramatic rate cut, it does so by expanding credit,
making it possible for banks to offer artificially lower market
interest rates. Businesses acquire new money at the lower rates
and their entrepreneurial ambitions expand, which results in an
economic boom. New businesses are started, using the new money to
buy land, labor, and capital goods. Wages increase and happy days
appear to be here again. Alas, these new projects appear profitable
only because market interest rates are pushed artificially low.

Unfortunately,
the new structure of production does not reflect voluntary saving
patterns. Investors are led to make investments as if more real
savings are available, when in fact they are not. Unless larger
amounts of new money is again injected into the system, market interest
rates will return to their original higher levels and much of the
newly begun projects will prove to be unprofitable. These investments
have to be liquidated or abandoned. Some businesses become bankrupt
and their workers lose their jobs. Asset values fall. Stock prices
tank. Retirement funds shrink. Banks contract credit as borrowers
face financial difficulties while firms need cash to pay off debts
and stay financially afloat. Depositors begin withdrawing money
out of their savings. All of this results in the “sudden outflow
of cash” that keeps central bankers up at night. Such an inflationary
boom-bust pattern has been the recurring story for the past twenty
years.

Immediately
after the great stock market crash of 1987, the then new Federal
Reserve Chairman, Alan Greenspan, assured investors that the Fed
stood ready to provide whatever liquidity was necessary to keep
the markets on a solid financial footing. The solution to the crisis
was inflating the money supply via credit expansion. The Fed’s
solution to the 1990’s recession and Mexican Peso crisis was
more of the same.

Investors flush
with new cash were looking for opportunities and became hip to the
next big thing: technology and the internet. Money was poured into
that sector, capital was malinvested, and the new economy proved
to be not so new after all. Economic law asserted itself and unwise
investments proved themselves to be as unprofitable as ever. Tech
stocks crashed.

The Fed responded
by doing what it does best: assuring investors by expanding credit
and increasing the money supply. The Fed repeated their “accommodation”
after the 9/11 terrorist attacks. Many investors, bitten by the
tech crash, wanted to direct their new money into investments whose
value they thought only appreciates: real estate. Capital was malinvested
again, being poured into – among other things – sub-prime
loans that looked great as housing prices increased but cannot be
repaid in a market where house prices are actually falling.

Recent history
and sound monetary theory teaches us that when central banks expand
credit and increase the money supply, what they really accommodate
is the boom/bust business cycle. What the Federal Reserve is doing
right now, in its effort to keeping the good times rollin’,
is setting in motion the next inflationary boom/bust cycle. New
money created by the Fed will be poured into the next big thing,
and many of the investments will prove to be unwise. People will
go bankrupt, and the Federal Reserve will assert itself as the national
economic protector once again, never willing to admit that it is
the source of the mess in the first place.

The
solution to the problem we are in is to put an end to the cause
of our financial woes, not to merely treat its symptoms. At the
very least the Federal Reserve should stop inflating the money supply
every time bankers and investors make bad choices. Even better would
be to abolish the Federal Reserve altogether and establish a thoroughly
private banking system that requires banks to maintain 100 percent
of their deposits on reserve for immediate redemption. Only such
a system would prevent the recurrence of the boom/bust cycle that
results from monetary inflation via credit expansion.

September
21, 2007

Dr. Shawn
Ritenour [send him mail]
is an associate professor of economics at Grove City College, contributor
to the Center for Vision & Values, and adjunct professor at
the Mises Institute in Auburn, AL.

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