In a completely market driven economy, interest rates—like all other prices—are determined by supply and demand. The Fed largely determines interest rates in the U.S., however, and for this we pay a heavy price. Earlier this month, even Fed Chairman Ben Bernanke himself acknowledged that the Fed’s “easy money” policy during the early 2000s contributed to the housing boom and subsequent bust. Yet, the Fed is on course to repeat its mistakes once again.
Let’s say you ran a bank and were free to determine your own interest rates. How would you decide what to charge your customers? You might start with projected inflation to compensate for the fact that the money you get back in the future will be worth less than what you loan out today. Inflation would also be factored into the interest rate you pay on your deposits, a key source of the cash you need for loans. You’d also have to add enough to cover your overhead and the risk associated with the various types of loans (in case you don’t get your money back). Finally, you’d add some profit. Other banks would consider these factors as well, so rates would be driven down to levels that reflect the best management of risk and overhead, with only modest profits.
In a centrally planned economy, interest rates are determined by government officials who might consider some of these same factors before assigning rates based on sophisticated economic models and presumed acumen. Although our economy is relatively market-oriented, such is not the case in the banking industry. Instead of relying largely on savings to finance loans, banks can get their money directly from the Fed at lower rates set by Bernanke’s team. In effect, the Fed sets the rates charged by banks.
In a representative democracy like ours, allowing a quasi-government entity like the Fed to manipulate interest rates can be deadly. Political pressure mounts and the Fed usually responds with rates lower than the market would otherwise support, especially in a down economy. Few Americans complain because they like the lower rates. They just don’t understand the long term damage.
When the price of money—the interest rate—is too low, businesses and consumers will want to borrow more. This means more cars, houses, business expansion, consumer goods, and ultimately MORE DEBT. For any economic growth to be sustainable, debt must be supported by a commensurate level of savings (preferably not by the Chinese). If not, the house of cards will tumble down and create another crisis, more political pressure, and the need to artificially lower interest rates again. Add to this the irresponsible, unsustainable spending in Congress and it’s easy to see why BOOM AND BUST is common to our economy.
Many Keynesian economists are suggesting that the Fed raise the interest rates they charge to banks to address this problem. They are missing the point. No central planning entity—not even the Fed—is capable to calculating optimal interest rates. While most of us are comfortable letting market forces largely determine the price of consumer goods, we are told that only highly trained economists should determine the price of money. Nothing could be further from the truth.
The sooner we abolish the Fed the better. We need to rebuild our economy on solid footing, and the hocus pocus of both artificially low interest rates and massive government spending should be rejected. At the present rate, we are merely laying the foundation for the next economic collapse, and this one could be even bigger.
I don’t get it, how did low interest rates create a housing boom?
The interest rate you pay on your mortgage drastically affects your payment. A $1000/month payment at 5% could be around $1500 at 7.5%. When the economy is good and interest rates are pushed down by the Fed, renters want to buy and owners want to trade up to “more house” than they can really afford. Many borrow close to 100% of the value of their homes and/or take home equity loans to maximize their debt. Everything is fine as long as housing prices rise. The Fed damages the economy by promoting moderate inflation to push housing prices up. This is the ARTIFICIAL BOOM.
When the economy dips and people are out of work, housing prices fall. This time, the extent of the economic damage has been too great for the Fed to contain, even with interest rates to banks close to zero. 1 in 4 Americans currently owe more on their home than it is worth. THIS IS THE BUST.
Dr. Parnell, Some are calling for a balanced budget amendment. Seems to make sense. Would this handle the problem you describe above? In other words, would a balanced budget amendment put any reins on the Fed?
It would help a little. A gold standard is ideal and would help immensely because money could not be created unless there was sufficient gold to back it. This would satisfy the same objective as a balanced budget amendment, which is precisely why the gold standard was completely abandoned in 1972. Until we can restore such a standard, a balanced budget amendment requiring a 2/3 majority to override would help deal with the problem in Congress, but not entirely with the Federal Reserve. The Fed creates its own money by extending credit to banks, manipulating the discount rate, and buying/selling securities in the open market. It can pump money into the credit markets without Congressional approval, so a BBA would have more of an effect on Congress than the Fed.