Investment Bank of Last Resort

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When a central bank devalues its currency, markets respond rationally, as always. Devaluation of a fiat currency (one with value not tied to gold) is done by injecting more currency than is demanded by economic activity. Importantly, a central bank may inject excess liquidity while alternatively setting commercial bank interest rates low or high. Either rate environment allows for devaluation. The interest rate set by the Federal Reserve simply determines whether small and medium-sized business can obtain bank credit at market, or lower rates in order to participate in the inflation-driven economic activity.

In 2004, the Federal Reserve began raising the overnight inter-bank reserve loan interest rate, which U. S. commercial banks use as a benchmark for setting rates on loans. When the overnight loan rate is higher than the market would normally set it, market participants who depend on banks are effectively denied credit at reasonable cost. Businesses too small to borrow through commercial paper or corporate bonds have been denied credit at market rates since 2005 by the Federal Reserve’s actions, thus shutting down vigorous job creation and economic growth permitted by cuts in marginal income tax rates in 2003.

While fostering a slowdown in economic activity through high, artificial rates for bank customers, the Federal Reserve injected additional liquidity through 2006 despite a fall in dollar demand brought about by slower growth. This revealed itself through the dollar's fall relative to gold. A sharply inverted yield curve confirmed that borrowers from banks could not get loans at rates near what the market deemed reasonable. Commercial paper and bond rates were very favorable by comparison, and monetary liquidity flowed to non-bank borrowers through innovative debt instruments designed in the financial markets. Those lenders and borrowers made credit decisions that were rational in devaluing currency conditions, but highly problematic with a stable or strengthening currency.

In 2007, the Federal Reserve stopped injecting new liquidity, but maintained the high cost of bank credit which disfavors smaller borrowers. By August, credit decisions made during the period of high liquidity became problematic, and the Fed began its series of fire drills designed to alleviate the crises arising in credit markets. In September, the FOMC began a series of reductions in the overnight interest rate (thus in bank credit costs), that continue to date, but which still leave the yield curve partially inverted and bank credit above market. Credit dislocations remain, economic growth is stifled, and the dollar’s value plumbs historic depths.

To its credit, the Federal Reserve’s actions appear designed to avoid adding permanently to the monetary base. New currency is being added temporarily as collateralized loans. New permanent liquidity may have to be added eventually, depending on the terms and outcome of the Bear Stearns transaction and any similar Fed undertakings. These are “mop-up” costs of salving crises caused by the central bank’s strident devaluation of the dollar during 2004-2007.

Almost all economists desiring a stronger, stable dollar hold the mistaken view that a higher overnight funds rate will provide it. They are just as much in error as are Keynesians who urge (and persuade) the Federal Reserve to devalue as the path to a positive current account balance. Keynesians are sorely wrong in asserting that a current account surplus is mandatory, or even necessarily desirable in America’s quest for prosperity. All who espouse central bank manipulation of interest rates (whether higher or lower) lend aid and comfort to the use of currency as a weapon of trade war, and to central planning of bank credit costs and asset prices.

Defective U. S. monetary policy has caused serious dislocations in the credit markets, distrust of credit quality and distrust of the dollar. None of these three serious concerns will be resolved, and certainly not for the long term, without reforming monetary policy. The Federal Reserve is not the cavalry riding to rescue private wagon trains in trouble of their own making. Crises addressed by the Fed are of the Fed’s making. Chairman Bernanke has steered the Federal Reserve into a role of investment banker of last resort, a high risk business whose prospective losses will be paid by further devaluation of the peoples' money.

Orthodox Keynesian theorists see dollar devaluation as a good thing, yet paradoxically argue price inflation is bad and ought to be fought with higher interest rates and higher unemployment. Dollar devaluation makes price increases inevitable, and unemployment is merely one mechanism for lowering the standard of living. Keynesian doctrine guiding the Federal Reserve may get the economy through this federal election year without catastrophe, but it is incapable of producing a good outcome over the longer term.

President Bush needs better economic advice. Someone should tell him he can issue an executive order requiring the Federal Reserve to allow markets to set the overnight funds rate, while at the same time requiring our central bank to target $500/oz. gold as the dollar’s value. Otherwise, after November 4, high inflation, high interest rates and economic recession will tarnish the legacy of his originally successful 2003 tax cuts.

Wayne Jett is managing principal and chief economist of Classical Capital LLC, a registered investment advisory firm in Pasadena, CA. He can be reached at
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