The Fed needs to free the market

SAN FRANCISCO (MarketWatch) — The Financial Crisis Inquiry Commission issued its finding that the devastating economic events of the past few years were “preventable.” The FCIC heaped the blame on many parties, but drew the wrong conclusion when it faulted the government and Federal Reserve for lax oversight.

On the contrary, the government and Fed encouraged the bubble and crash, and current policies are doing the same.

Nobel laureate Friedrich Hayek said that in order to understand how things can go wrong with the economy, we must first understand how they ever go right. In the view of Hayek, markets use the price system to coordinate the actions of producers with the desires of customers and the available resources. The interest rate is a special price that helps ensure a balance between how much households are saving and how many long-term investment projects businesses start.

According to Hayek, this “regulatory” function of interest rates is distorted when the central bank — the Federal Reserve in the United States — pushes down interest rates through an injection of artificial credit. This “easy money” policy appears to stimulate the economy, but the growth is unsustainable and the prosperity an illusion. The boom period inevitably ends in a crash, where resources and workers have to be redirected to more appropriate niches. This period of retrenchment is what we recognize as a recession.

Day of reckoning

The Hayekian explanation for the business cycle applies to our recent boom and bust in housing. After the dot-com crash and the 9/11 terrorist attacks, then-Fed chairman Alan Greenspan brought interest rates down to (inflation-adjusted) lows not seen since the late 1970s. At the time, people praised Greenspan for providing a “soft landing,” but in retrospect many analysts realize he simply postponed the day of reckoning and made the adjustment process that much more painful.

In this respect, the FCIC is correct to say the financial crisis was avoidable. Yet in their summary of conclusions, their first main point states: “The sentries were not at their posts, in no small part due to the widely accepted faith in the self-correcting nature of the markets and the ability of financial institutions to effectively police themselves.” They go on to argue that if only the SEC, Federal Reserve, and other regulators had exercised their existing powers more properly, the financial sector’s growing vulnerability to risky derivative assets could have been nipped in the bud. Read our news coverage of the FCIC report.

Such government intervention will always appear superior to private investors, after the fact. In reality, government and Fed officials denied that a housing bubble was in progress. Ben Bernanke himself was wrong at every stage; a YouTube search of “Bernanke was wrong” leads to a cringe-worthy compilation of his botched predictions to the media and Congress.

As the FCIC report itself indicates, various regulators already had the necessary power to avert the developing bubble, and yet they chose not to use it. Why would we expect “reforms” that give even more control to bureaucrats to achieve better results going forward? Why should we trust that the wise experts at the SEC — who didn’t stop Bernie Madoff despite years of warnings from people in the private sector — will spot the next bubble before it gets too big?

Every trick in the book

The government and the Fed are currently doing the same things that got us into trouble. Bernanke has pushed interest rates lower and pumped in far more money than his predecessor Greenspan did. And rather than letting the housing market self-correct and find its natural bottom, the federal government is using every trick in the book to boost home prices.

Two strategies aim to contain imprudent risk-taking and speculation: One is to have the Fed inject boatloads of new money, while the government bails out banks that make bad loans, but hope that regulators can spot and defuse any trouble before it gets out of hand. We’ve already tried that and it didn’t work.

The other strategy is for the Fed and government to stop trying to steer the economy, and let private investors reap the benefits — or the losses — in a free and open market. Let’s try this approach this time around.

Robert P. Murphy is a senior fellow in business and economic studies at the California-based Pacific Research Institute.

Nothing contained in this blog is to be construed as necessarily reflecting the views of the Pacific Research Institute or as an attempt to thwart or aid the passage of any legislation.

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