Let's Scrap the Fed's Open Market Committee
The central planning board met every five to eight weeks. Sometimes it had special meetings to address emergencies. Over a 70-year period, it brought together 12 of the most brilliant economic minds the nation had to offer: bankers, academics, career public servants, even captains of industry. These experts voted to set a price, the most important price in the nation, and arguably the world.
But the board had had a shaky record, especially in recent years. It had been blamed for fueling a financial mania that precipitated a financial crisis and the worst global recession in almost a century. Yet its solution for ending the great stagnation was the same basic policy that had caused it. People were openly questioning whether the central planning board should be abolished.
This is not the story of some fictional, totalitarian dystopia. This is our story. The central planning board in question is the Federal Reserve's Federal Open Market Committee, and the price it sets is that of credit, which plays the critical role of coordinating savings, investment, and the allocation of resources across time. Strictly speaking, the Committee sets a target for the federal funds rate, at which banks borrow from each other to meet their required reserves (also set by the Federal Reserve). This target is achieved through open market operations, the buying and selling of United States Treasury bonds.
Defenders of the current Fed system point to its ability to stimulate the economy, but if anything, this should be an argument for decentralization and unleashing market forces. The Fed has generally targeted an annual growth rate of 3 percent for the money supply, to match the historical growth rate of the American economy. Unfortunately, its leaders have often strayed from this standard, fueling high inflation during the 1970s and multiple asset bubbles over the last three decades. Worse, it has enabled a massive expansion of government by lowering borrowing costs.
As Nobel Prize-winning economist F. A. Hayek noted, central bank actions-such as empowering one institution to manipulate the money supply and set the price of credit-can cause huge distortions in the market by disrupting the price signals that convey information to players in the market process.
Worse, as Ludwig von Mises showed in his magnum opus Human Action, the monetary expansion that results from this arrangement fuels booms of unsustainable malinvestment which inevitably lead to recessionary busts. Inflation creates the erroneous perception of lower interest rates, simultaneously reducing saving and increasing borrowing, driving investment in projects that offer a return below the true interest rate. Entrepreneurs eventually realize that the capital abundance they perceived was largely a mirage. Some liquidate their projects, triggering a recession; others take out short-term loans to complete them. Building on Mises's insights, Horwitz and Boettke have demonstrated how loose Fed policy fueled the real estate bubble of the previous decade.
The full faith and credit of the United States is essentially accepted at face value. Therefore, Treasury Bond rates dictate the "riskless rate" of borrowing, which serves as a reference point for all other interest rates throughout the American economy. Many other countries either use the dollar as their official currency or hold large dollar reserves (less than half of all dollars are actually in the United States) and America comprises a huge proportion of the global economy. Thus, as the Fed goes, so goes the world.
The world should find this profoundly disturbing. One of the first lessons of economics is that markets set prices and allocate resources more efficiently than central planners-as the old joke about left shoe surpluses in the Soviet Union illustrates. The dangers posed by the Fed may be modest in comparison to those of Soviet tyranny, but that does not mean they are not serious. Adjusting the interest rate at arbitrary intervals by arbitrary amounts according to what are essentially guesses about the state of the economy is indefensible. Leading Austrian monetary economists Lawrence White and George Selgin have proposed a system of "free banking," where monopolistic restrictions on issuing currency would be lifted, allowing for competing currencies and a true market for credit.
Central banking is central planning. Policymakers should acknowledge this and finally wind down the Federal Reserve System, in favor of a free market in currency and loanable funds. Until that occurs, our economy will remain exposed to the risk of monetary expansion and all the inflation, bubbles, asset misallocation, wealth destruction, and pain it creates.