Many Americans believe that government has a responsibility to fight recessions. They should not. Politicians and bureaucrats suck at stabilizing markets. Usually their scents do more harm than good.
Economics textbooks will tell you that there are two ways for the government to smooth out the business cycle. The first is fiscal policy. By increasing spending, Congress and the President can kickstart the economy. The second is monetary policy. The Federal Reserve, our nation’s central bank, can meet extraordinary demand for liquidity by printing new money. What manuals rarely say – and this should be front and center – is that the former rarely works, and the latter only works under very specific conditions.
Let’s start with fiscal policy. For government spending to shake up the economy, it must increase aggregate demand (total spending on goods and services). But often, if Uncle Sam spends more, someone else has to spend less. Public spending crowds out private spending. When this happens, fiscal policy does not create jobs or raise incomes. It simply reshuffles existing jobs and incomes.
But let’s be charitable and assume that fiscal policy can help. There is an even bigger problem: effective fiscal policy must be timely, targeted and temporary. Timely means that the spending plan must pass Congress and get the President’s signature before markets improve on their own. Target means that spending should be concentrated on the sectors of the economy that have the most room for manoeuvre. And temporary means spending has to come down once the economy recovers or we’re setting up an unsustainable boom.
Given everything you know about politics, how likely is emergency spending to meet these three criteria? Do you trust elected officials to decide quickly, spend responsibly and voluntarily turn off the tap once the economy stabilizes?
I’ll wait until you’re done laughing.
Let us now turn to monetary policy. Unlike spending, printing money is quite effective in increasing aggregate demand. When the Fed buys assets, such as government bonds, it credits its counterparty’s bank account with newly created money. In economics jargon, the Fed responds to an increase in demand for money by increasing the money supply. This can prevent a slowdown if done right. Since the Fed has a statutory monopoly on base money (the narrowest measure of money supply, made up of bank deposits held at the Fed and physical currency), it’s the only game in town when it there is a flight from securities to dollars.
But don’t trust central bankers too much. They mess up all the time. To stabilize the markets, monetary expansion must be scaled just right. Guess what happens if it’s too big? That’s right, inflation! Currently, we are experiencing the greatest price pressures in 40 years. Perhaps the Fed’s doubling of the monetary base from spring 2020 to fall 2021 has something to do with it. Milton Friedman was right after all: “A faster increase in the quantity of money than in production” is a predictable recipe for inflation.
This is not the only type of money mischief. The expansion of the money supply sometimes lowers interest rates. All other things being equal, the more cash circulating in the capital markets, the lower the price of capital, ie interest, will be. When interest rates fall due to a genuine increase in savings, all is well. The fall in the price of capital signals to investors that loanable funds are more abundant. But what happens when interest rates fall only because of the Fed’s “funny money” effect? Investors are fooled into thinking that capital is more abundant than it really is. As a result, they undertake a bunch of unsustainable projects. The boom inevitably turns into a bust. If that sounds familiar, that’s because it happened with the subprime mortgage crisis of 2008. We built too many homes and securitized too many mortgages because the Fed held interest rates too low for too long from 2003 to 2005.
In truth, we don’t need a central bank at all. A free market for money and finance works just as well as for pizza, laptops and sports coats. As long as we’re stuck with the Fed, we have to tie their hands with a hard rule. Like medicine, monetary policy is first and foremost about doing no harm. No inflationary expansions. No misleading interest rates. Congress can and should rein in the Fed by ordering the central bank to keep the value of the dollar stable.
Besides the economic harm, there is another pernicious effect of government intervention: we become less free. Every time the economic outlook deteriorates, the government plots to spend more, regulate more, and print more money. As a result, markets are becoming increasingly dependent on government largesse. US financial markets, once the envy of the world, have become addicted to loose spending and easy credit. Political patronage sustains entire industries. Private property and voluntary contract are meant to protect our independence and livelihood. However, under cover of stabilization policy, Washington transforms these instruments of freedom into tools of servility.
Political planning and technocratic tinkering make markets less stable, not more. With each passing crisis – probably created by the government in the first place – the national debt and the balance sheet of the Fed grow more and more. Our nation would be freer and richer if Uncle Sam stopped trying to micromanage the economy.
Alexander William Salter is the Georgie G. Snyder Associate Professor of Economics at Texas Tech University’s Rawls College of Business, a research fellow at TTU’s Free Market Institute, and a community member of the Lubbock Avalanche Logdrafting committee. Opinions in this column are his own.