Dr. Bernanke’s Fed Funds Patent Tonic with Opium

If you look at the weekly price chart for either gold or silver for the week ending January 27, 2012, you can make out a distinct “J” shape in prices of both metals. Tuesday the prices were suppressed, and then on Wednesday they spiked upward. You can actually pinpoint on the charts the moment the Federal Reserve announced its intent to keep the Federal Funds Rate at nearly zero percent until late 2014.

Low interest rates are supposed to spur economic growth, or at least that is what the textbook for my International Political Economy course said, so what could possibly be wrong with low interest rates?

Of course, low interest rates provide an incentive to borrow money. However, they also form a powerful incentive to avoid saving money – if you don’t get any returns on saving your money, then you are more likely to spend it and get some immediate enjoyment from it.

It is important to remember that our economy is rife with other government-backed incentives, everything from tax credits for “green” cars to FHA mortgage insurance. Low interest rates will exacerbate these incentives even further, giving powerful incentives to borrow money for houses, cars, consumer goods, and government spending.

If you are seeing this, your Custom URL is not pointing to the correct image!This is the stated intention, and we are constantly told that consumer spending is the bulk of our GDP, and that it is critical that we stimulate demand – that is, fill the economy up with refreshing and energizing financial methamphetamine. The result will be exactly the opposite.

With every reason in the world to borrow and spend money, and with absolutely no reason to save or invest it, the United States will witness a continued depletion of our domestic capital pool. Capital will be shifted away from funding businesses, factories and production, and towards non-productive spending, just as it was during the housing boom. (If you have the time, find a chart of average home prices for the US from 2000 onwards and compare it to the US trade deficit for the same time period.)

Money has inherent opportunity costs. If you spend it, then you cannot save or invest it. The Federal Reserve and the Federal government together have decided that spending is what counts, and that spending borrowed money is the greatest virtue of all. As a result, the same bank that wouldn’t give you a line of credit for your small business will give you an FHA-insured home mortgage at 3.25% APR.

As the capital pool shrinks, the Fed will try to fund this new bubble with inflation, but while a government can print currency, they cannot print capital – as they increase the money supply, the prices for consumer and capital goods go up, eating up all of the new “liquidity“ from the central banks.

In short, the low interest rates will have the exact opposite effect as intended. Borrowing and consumption will likely go up as Bernanke theorizes, that much is true, but production-based economic activity will not. Retailers might hire a few more clerks, and banks might hire a few more mortgage brokers, at least for a while. Unable to borrow production capital, more businesses will fail. Able to borrow revolving credit, some consumers will spend. Already burned by the last housing bubble, Americans are unlikely to be suckered into another one, so the effects on housing prices are likely to be minimal – people will buy, but probably not at current prices.

The Fed thinks they are providing the economy with an upper, a powerful stimulant, and they are expecting a jolt of frenzied energy to follow. In reality, they have provided a powerful opiate; one which will not bring any recovery to the economy but will help mask the pain of an economy that is consuming itself.

If I am right, it will be evidenced by persisting unemployment, more business closures and an increase in the trade deficit.

About the Author

Mr. Waechter is an attorney and a recent graduate of Drake University.

 

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