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Blame The Federal Reserve, not the Human Heart

Americans today live like there’s no tomorrow. You can see this in the data regarding retirement. People behave like they will never retire, and the prophecy is self-fulfilling. Under these conditions, they won’t.

A new survey shows that 57% of households have less than $25,000 in total household savings and investments. And the trend line looks terrible and is getting worse.

Meanwhile, everyone is living longer, but not healthier, meaning that people will be more dependent in their older years than ever before.

The moralists are quick to condemn this as resulting from a deep character problem in all of us. But economists prefer to look more deeply at institutional factors. What could account for such shabby planning on the part of American households?

Look at monetary policy. Where’s the reward for saving? It’s not there. The Federal Reserve has nearly abolished the normal rate of return on savings.

More than that, a policy of zero interest encourages living for the day, spending as much as you can, and leveraging up lifestyle. After all, where’s the downside? Zero rates suggest little or no risk to borrowing.

They suggest that there is no reward for saving. The signal is all is right with the world, so spend, spend, spend. In other words, this isn’t a character flaw at work. People are merely responding to the signals they get. The Federal Reserve, not the human heart, deserves the blame.

I’ve spent a good part of the week doing a close study of Ludwig von Mises’ writing on the business cycle, which Laissez Faire has collected in a handy volume called The Illusion of Wealth, edited by Robert Murphy.

What I found here has surprised me. What we get from this theory is not a mechanistic caricature as portrayed by Paul Krugman and others. It’s not as easy as: 1) The Federal Reserve expands money, 2) production revs up, 3) price inflation goes nuts, and 4) the system crashes.

Mises’ views are much more subtle and complex than that. The effects of loose money and artificially low interest rates do not always show up in the form of a general increase in prices. It all depends on the response of the banking system and the expectations of consumers.

More likely, the price effects will show up in particular sectors like the stock market and wages. This is where the cyclical activity can be observed, says Mises. All the while, such a policy depletes capital and savings, leaving the economy more fragile in dealing with future contingencies.

According to Mises, there are two vehicles for economic progress: ‘the accumulation of additional capital goods by means of saving’ and ‘improvement in technological methods of production.’

If you look around the world today, you see gobs of technological improvement. In fact, we’ve seen astonishing amounts of it over the last 15 years. This is exactly what Mises’ theory would predict. When The Federal Reserve lowers the interest rate, the pace at which new technologies come to market increases. The risk of failure is lower.

The common view is that when scientists and engineers discover stuff, it is quickly shoved out into use and becomes part of our lives. End of story.

This is not how Mises views the situation at all. In his view, there is vastly more technology available than is ever put to use at any moment of time. It’s like it is stored in a huge warehouse.

The hand of the market – powered by capital accumulation – reaches into the warehouse and pulls out technology and tries it out in the marketplace to see if it can succeed or if it will fail. The entire process is nicely balanced: New things are supported by savings and capital.

The entire balance is upset when The Federal Reserve lowers rates of interest and injects speed into the system. The hand that reaches into the knowledge warehouse works at a much faster pace. We get ever more cool things to use at an ever increasing pace. This innovation is not fake; it really is a source of economic progress.

So what’s the problem? The problem occurs on the other end of the scale, in the realm of saving and capital. Here we see depletion. Consumers leverage up. Businesses expand dramatically. Everything in sight is put to use as soon as possible. There is no rest, no pulling back, no waiting. Everything must happen now, as if there is no tomorrow. This particularly affects the financial industry, which grows larger and larger despite fewer and fewer real resources.

This tendency toward relentless capital depletion, combined with a hyped-up pace of technological development, perfectly describes our economic times.

If we look at what has happened to individuals saving since the Federal Reserve got in the business of interest-rate manipulation as a full-time gig, we see a steady rate of savings become utterly wild. It is depleted in the boom, and then panic sets in during the bust. Once the crisis settles, private saving plummets again.

This is a direct result of Fed policy that has been driving rates systematically lower over the decades and intervening ever more in the market’s signalling mechanism.

Meanwhile, we are literally addicted to technological progress. We have to have it at increasing rates else we stop growing. The progress is real, but too necessary to sustain prosperity.

It’s like a person who goes to the gym and gets stronger and stronger, but must or else he can’t run or walk at all. The economy is not self-sustaining. The credit has to flow and flow to keep underwriting innovation.

And as Mises would predict, what seems like economic progress is not entirely fake but it comes with a rub. Incomes aren’t really increasing, because capital is not being accumulated. Prosperity exists and continues apace, but it has a very weak foundation. It is nothing more than a ‘castle in the air’, as Mises would say. (In the original German, the word is Luftschloss, meaning a dream that is not realistic.)

Notice that the scenario that Mises maps out here can include such things as the hyperinflation of history and legend, but it need not. Bad money does damage either way. And the damage is long term – not a crisis tomorrow or the next day, but a long-run effect that slowly erodes the foundation of a growing economy.

This is not the usual business cycle story that we hear attributed to the Austrians, but it is the one told by Mises in his most mature writings collected in this wonderful book, The Illusion of Wealth. The scenario doesn’t make the headlines and doesn’t embolden politics movements, but it is no less real.

People can live in a house a long time without paying attention to the reality that the foundation that holds up the building is cracked and rotting. What’s the way out in this case? We need sound money with market-based interest rates. It’s not we who are corrupt, but the policymakers behind the Federal Reserve who are choosing short-term gains over long-term sustainability.

Regards,

Jeffrey Tucker
for The Daily Reckoning Australia

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The Daily Reckoning
The Daily Reckoning offers an independent and critical perspective on the Australian and global investment markets. Slightly offbeat and far from institutional, The Daily Reckoning delivers you straight-forward, humorous, and useful investment insights from a world wide network of analysts, contrarians, and successful investors. Founded in 1999, The Daily Reckoning is published in 7 countries with a worldwide readership of almost 1 million people.
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1 Comment

  1. pravin says:

    this is the most amazing thing i have read in a while.time to buy The Illusion of Wealth

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