The Problem with the Fed’s Economic Stimulus

The United States’ central bank, The Federal Reserve (or “Fed” for short), has, for the past 8 years, attempted to reinvigorate the US economy by undertaking various efforts to suppress interest rates below their natural and market levels.  Interest rates literally represent the cost of borrowing money and, like all other prices such as those for shoes and beef and toothpaste, can and should be set via the free exchange of millions of people throughout the economy on the free market. This is the fundamental economic principle of Supply and Demand: that prices move up and down due to variations in the relationship between these two components of exchange. No government body via intervention into the market can eradicate the law of supply and demand; just like government intervention against the supply and demand relationship would cause problems in the shoe or beef markets, so it causes problems in the interest rate markets.

And yet, the Fed in the US, the European Central Bank in Europe, the Bank of Japan, the People’s Bank of China, and all other major central banks have taken it upon themselves to devalue their currencies (that is, increase the amount of money and credit in circulation) and therefore drive down their interest rates.  Remember supply and demand: whenever the supply of a good (shoes, beef, money) increases, the price for that good tends to fall. And thus, interest rates are at their present lows.

But what is the consequence of the central banks’ economic intervention? What is the result of the government’s abandonment of the free market process? Before we answer these questions, consider how the free market should work:

Because interest rates on the free market reflect the amount of money and capital that millions of people throughout the economy have saved (that is, they chose to delay immediate consumption), interest rates inform entrepreneurs and borrowers of that capital that there is a given amount of resources available for their projects and activities (the lower the interest rate, the higher the capital available).  If interest rates are too high, the entrepreneur will calculate that the project isn’t quite profitable. This is a good thing, because the price of the money reflected the fact that the economy only had enough capital saved for a set amount of projects. But then, what if the interest rates begin to fall and the entrepreneur figures that, suddenly, a profit is more sure because the price of his borrowing has gone down? Again, this is a good thing because this price adjustment came about due to more capital being saved somewhere in the economy (after all, the lower price of money is a result of an increased supply of capital made available).

But in our present interventionist economy, this is not what is happening: the central banks are purposefully trying to drive down interest rates by pumping more money into the system. There is no conspiracy here. This is all according to their economic theory of how to grow an economy; the theory is historically known as Keynesianism, after British economist John Maynard Keynes.