Wednesday, February 02, 2005

Sunrise, Sunset

Every news network today was a buzz with the Fed’s decision to raise the federal funds rate (FFR) by a quarter of a point, yet not one of them went into much discussion about what it means. The banking industry has huge ramifications throughout the entire economy and the interest rate is one of it central mechanisms. Let’s take a moment and unravel what today’s news really means.

The interest rate is basically the price of money, reflecting the time preference of lenders and borrowers. If the rate is 3%, then $1,000 now will cost you $1,030 later. Borrowing money is useful for economic development because it provides the funds needed to expand production. The FFR is the rate which banks charge each other. Since banks can always borrow from other banks to have the money lend to customers, changes in the FFR directly change the interest rates for consumers and businesses (which are used to build factories, start businesses and so on).

The Fed claims it needs to adjust the FFR as to create a balance between growth and inflation. What the Fed doesn’t tell the public is that its constant meddling in this vital tool for economic growth causes instability and recessions.

This is the Austrian theory of the business cycle. By artificially lowering the interest rate, businesses borrow and expand their production (the boom), thinking the lower interest rate is due to people saving more. If businesses produce more, people will take money out of the bank and use it to spend on the new goods and services. But because these consumer cash reserves don’t actually exist, the businesses won’t sell any of these goods (the bust) and recession—or worse—will set in. Firms will have loans without any way to repay them. This theory was first proposed by Ludwig von Mises, who used it to predict the Great Depression. He was the only economist at the time who foresaw the collapse.

Today we see a similar pattern. The Fed pushed the FFR down to about 1% to counterfeit a boom after 9/11). Its recent increases (six since last summer) are attempts to hold back inflation amidst a recovering economy. But the FFR is still just 2.5%, hardly enough to staff off the bust that will inevitably follow the oncoming (and false) boom. While Americans are celebrating the newly expanding economy, we should watch our back; in 20 or 30 years, it’ll be 1999 all over again.

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