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News Link • Federal Reserve

How the Fed Wrecks the Economy Over and Over Again

• By Michael Maharrey

When people talk about the economy, they generally focus on government policies such as taxation and regulation. For instance, Republicans credit President Trump's tax cuts for the seemingly booming economy and surging stock markets. Meanwhile, Democrats blame "deregulation" for the 2008 financial crisis. While government policies do have an impact on the direction of the economy, this analysis completely ignores the biggest player on the stage – the Federal Reserve.

You simply cannot grasp the economic big-picture without understanding how Federal Reserve monetary policy drives the boom-bust cycle. The effects of all other government policies work within the Fed's monetary framework. Money-printing and interest rate manipulations fuel booms and the inevitable attempt to return to "normalcy" precipitates busts.

In simplest terms, easy money blows up bubbles. Bubbles pop and set off a crisis. Rinse. Wash. Repeat.

In practice, when the economy slows or enters into a recession, central banks like the Federal Reserve drive interest rates down and launch quantitative easing (QE) programs to "stimulate" the economy.

Low interest rates encourage borrowing and spending. The flood of cheap money suddenly available allows consumers to consume more – thus the stimulus. It also incentivizes corporations and government entities to borrow and spend. Coupled with quantitative easing, the central bank can pump billions of dollars of new money into the economy through this loose monetary policy.

In effect, QE is a fancy term for printing lots of money. The Fed doesn't literally have a printing press in the basement of the Eccles Building running off dollar bills, but it generates the same practical effect. The Federal Reserve digitally creates money out of thin air and uses the new dollars to buy securities and government bonds, thereby putting "cash" directly into circulation. QE not only boosts the amount of money in the economy; it also has a secondary function. As the Federal Reserve buys U.S. Treasury bonds, it monetizes government debt. The central bank can also buy financial instruments like mortgage-backed securities as it did during QE1 in 2008. This effectively serves as a bank bailout. Big banks get to remove these worthless assets from their balance sheets and shift them to the Fed's. Theoretically, this makes the banks more solvent and encourages them to lend more money to ease the credit crunch that occurs when banks become financially shaky.

This monetary policy results in a temporary boom. All of that new money has to go somewhere. It could result in rising consumer prices (inflation), but generally, it pumps up the price of assets such as real estate and stock markets, creating a fake wealth effect. People feel wealthier because they see the value of their assets rapidly increasing. With plenty of debt-driven spending and rapidly increasing asset prices, the economy grows, sometimes at a staggeringly fast rate.

This process also creates inequality. The first receivers of this new money – generally bankers and politically-connected individuals and institutions – get the most direct benefit from the newly-minted dollars. Their decisions on where to spend the money create artificially high demand in the chosen industries or asset classes. Think the housing market in the years leading up to '08 or tech companies during the dot-com boom. This amplifies distortions in the capital structure. The first receivers also get to spend the new money before the inflationary effects take hold and prices rise. Those who receive the money later on down the line, say through pay raises, don't get the same benefits as the first users. Price inflation eats up their gains.

Meanwhile, surging economic growth, shrinking unemployment and rising stock markets driven by money-creation give the illusion of a healthy economy, but the monetary policy hides the economic rot at the foundation.

In order to sustain an economic expansion, you need capital goods — factories, machines, natural resources. Capital goods are produced through savings and investment. When central banks juice consumption without the requisite underlying capital structure, it will eventually become impossible to maintain. You can print all the dollars you want, but you can't print stuff. At some point, the credit-driven expansion will outstrip the available stock of capital. At that point, the house of cards begins to collapse.

Imagine you plan to build a giant brick wall. With interest rates low and credit readily available, you borrow all the money you need to complete the job. But two-thirds of the way through, a brick shortage develops. You may have plenty of money, but you've got no bricks. You can't finish your project.

This scenario provides a simplified picture of what happens in the economy during a Fed-fueled economic expansion. Flush with cash, investors begin all kinds of projects they will never be able to complete. Eventually, the malinvestments become apparent and the boom teeters and then collapses into a bust.

Of course, the Fed helps this process along as well.

Once the apparent recovery takes hold, the Fed tightens its monetary policy. It ends QE programs and begins to nudge interest rates back up. When the recovery appears to be in full swing, the central bank may even shift to quantitative tightening — shrinking its balance sheet. During the boom, governments, consumers and companies pile up enormous amounts of debt. Rising interest rates increase the cost of servicing that debt. They also discourage new borrowing. Easy money dries up. This speeds up the onset of the next recession and the cycle repeats itself.

To understand this, we can look back at the past three boom-bust cycles.

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