The Magazine

Money in Bad Faith

The depredations of the Fed.

Jan 28, 2013, Vol. 18, No. 19 • By JUDY SHELTON
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The Federal Reserve is not your friend. Whether you reside on Wall Street or Main Street, whether you are a borrower or a saver, whether you lean toward the Tea Party or the Occupy Wall Street movement​—​or whether you simply believe in free markets and free people​—​loose monetary policy is bad for you and for your economic prospects.

homes foreclosed on

Would a friend lure you into taking unjustified risks in pursuit of a false promise of monetary gain? Would a friend try to pull the wool over your eyes by paying you with cheapened tokens? Would a friend induce you to seek financial rewards through speculative conniving instead of virtuous endeavor?

If the GOP wants to be the party of sound money​—​not only as a vital tenet of government fiscal responsibility but also as the ethical foundation for free-market capitalism​—​Republicans should start focusing on the harmful consequences of unwarranted money creation by our central bank. People need to understand how the Fed’s efforts to “stimulate” economic activity through monetary policy are fomenting a destabilizing fissure between the real economy and the precarious world of high finance.

When money creation is out of sync with productive economic growth, the link between honest effort and reward is damaged. It is disheartening to keep working away at providing real goods and services while others are seen to receive arbitrary gains whenever the Fed bestows its latest quantitative easing gifts on financial markets. And it’s discouraging to plan carefully for the future only to have seemingly prudent economic decisions transformed into disappointing, life-altering mistakes.

How can we blame people for buying homes they can’t afford when interest rates were lower than inflation during the 2000-2003 period? As John A. Allison, former head of banking giant BB&T, explains in The Financial Crisis and the Free Market Cure: “This creates a huge psychological and economic incentive to borrow.” Banks were also motivated to make as many loans as possible​—​not only to serve customer demand but also because the Fed’s policy of low-but-perpetual inflation indicates a government bias toward continually rising housing prices.

Who could have foreseen a global financial crisis that would utterly confound such reasoning? Certainly not the Fed; our central bank was clueless about the credit bubble that would burst in 2008, despite its central role in fueling it.

So did those homebuyers act irresponsibly? Should the bankers be condemned as “predatory” lenders? Or did well-intentioned individuals respond logically to faulty price signals engineered through the defective monetary policies of the Fed? It’s time to recognize the social costs imposed by such distortions as well as the economic losses. Money miscalibration sets people against each other for reasons having more to do with skewed incentives than selfish motivations.

Today we are witnessing an increasingly divisive tension between high-profit activities conducted at trading desks for big money-center banks and next-to-nothing returns offered to average savings account holders. The Fed’s aggressive liquidity injections are showing up as asset bubbles in sophisticated global financial markets even as domestic consumer price indices show only modest increases; this two-tier effect favors “whales” who can wager millions on exotic credit instruments while stiffing modest savers with negative real returns.

According to the latest semi-annual report issued by the Bank for International Settlements, the gross market value of outstanding over-the-counter derivatives is $25.4 trillion​—​yes, trillion​—​with 75 percent of the contracts linked to interest rates: forward rate agreements, swaps, options. In June 2008, shortly before the crash, the gross market value of outstanding OTC derivatives was $20.4 trillion, with 46 percent linked to interest rates.

So what has actually changed since the precrisis financial situation? Instead of tamping down speculative betting on interest rates in favor of rational market pricing of loanable funds, the Fed’s monetary policies are stimulating it. No wonder traditional financial intermediation​—​the kind that used to channel depositor funds toward promising new businesses​—​is now oriented toward gaming various hunches about the Fed’s next move. Even smaller banks are learning to churn their Treasury holdings rather than make loans to private-sector borrowers​—​especially since federal regulators are evaluating their portfolios.

Productive economic activity requires a commitment of resources based on faith in the future; it’s inherently risky, but that’s the nature and genius of capitalism. Unfortunately, the Fed’s tactics for suppressing interest rates have brought about conditions antithetical to entrepreneurial capitalism: loose money, tight credit.

If we want to preserve the morality of a free-market system, we cannot permit our central bank to carry out monetary policy in ways that play favorites. It’s especially egregious that the Fed has become complicit in drawing off capital into the abyss of deficit financing; clearly, our central bank is catering to the political class, bailing out Washington itself through massive purchases of government debt obligations. Monetary policy today delivers the biggest benefits to the world’s largest borrower​—​our federal government.

If we continue to allow the Fed to underwrite deficit spending and inflict the resulting monetary distortions on the people who actually contribute real value to the economy, who live and work in the belief that saving is a virtue, we will witness the steady demoralization of democratic capitalism.

Judy Shelton, author of Fixing the Dollar Now: Why U.S. Money Lost Its Integrity and How We Can Restore It, is a senior fellow at the Atlas Economic Research Foundation and codirector of the Sound Money Project.

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