I have followed the discussion on the Federal Reserve lately, not only how it is meddling with the currency and thereby trying to push the market in one direction or another. My interest has been mainly in the arguments for and against “the Fed,” i.e. reasons it exists and results of its existence (and meddling).
The proponents of a central bank claim there is a general need for a centralized power to create stability in the market and counteract the boom and bust cycles that we’re experiencing. The proponents of a market freed from a central bank claim the exact opposite: that the Fed through its meddling with the currency and interest rates create the boom and bust cycles. So how are we to find out which of these parties has got this right and which is utterly confused?
One way is to think about it for a minute or two. It isn’t too hard to realize what underlying philosophies make people take these two positions. In the former case, the market itself is unstable and needs to be corrected. So it is saying that there is some kind of friction or instability in the market that it cannot sort out itself, and therefore we need political instruments to take care of it. Sounds like a reasonable conclusion given that the premises are correct.
So let’s have a look at the premises. Why does the market fluctuate in big wave-like motions up and down, in which everybody frantically collectively buy everything or sell everything? Marx claimed it was the underlying contradiction in capitalism that caused these booms and busts. Because of oppression and the ongoing class conflict between the propertied and unpropertied (proletarian) classes there is tension, and the exploitation of labor workers makes capitalists literally go “wild,” which in turn makes the market unstable. (This is a very simplified version of Marxian business cycle theory, of course.)
What these booms and busts really mean is that people tend to act “like one” and therefore when someone starts buying everybody starts buying – and when someone starts selling everybody starts selling. This might seem intuitive, but since we know everybody in the market is trying to make a profit this simply cannot be the case. There are panics, of course, when the market is already going up or down very rapidly. When you realize something strange is going on and that you are about to lose all your money, you might panic. But that still doesn’t explain why the market goes down before people panic.
Let’s think about it, when the market is going up at a modest rate, why in the world would a lot of people suddenly sell all they have and leave the market? If the market is going up we would of course have some people selling to realize their profits, but there is no reason to not invest more or stay in the market with some investments when it is going up. It simply doesn’t make sense for everybody to collectively sell everything they have and put the money in a bank account instead of taking advantage of the economic growth.
The same thing is true for the opposite situation. In a market with falling indexes there is no reason for everybody to collectively and suddenly start buying and thereby change the direction of how the market develops. If people really did collectively make a decision – wouldn’t we know of it? Wouldn’t we have a huge information problem to solve first? And if everybody follows a leader, wouldn’t we know who that leader is? Wouldn’t we be able to identify him or her? (After all, we are parts of the market.)
No one working in the financial markets will tell you they are but sheep following a leader or that they are acting collectively on some kind of invisible command. They might tell you that they could panic in certain situations and at that time act like sheep or follow someone’s lead. But then we’re back at the same problem again: the panic doesn’t arise out of thin air, it is caused by something – and it is usually caused by drastic change in the markets. Now, if everybody is acting on drastic change – where the hell does the change come from? “The market,” after all, is but an abstraction of all the people and transactions out there – drastic change cannot happen in the market before people act [on it], because such a change is the result of their actions.
This cause of the problem is what Marx tried to explain with the “inherent contradiction” in capitalism, even though I don’t think he did a very good job (at least not if this theory is applied to the concept of the market in general). However, most people working in the financial markets have adopted this Marxian view of what they are doing. This is evident from how they view the Federal Reserve: most financial analysts claim, and they do so sincerely, that the Fed is necessary to counteract the booms and busts. So they seem to believe that they aren’t able to trade with each other using reason and acting upon it – they can only act collectively and irrationally, and therefore they are doomed to create these booms and busts.
I doubt anyone working in and with the markets would choose to tell you they are all brainless drones acting collectively without ever thinking of what they are doing. On the contrary, many of them spend most of their time analyzing facts trying to make as fact-based and rational decisions as possible.
Now, even if Marx was wrong – this is surely a contradiction. These people claim there is a need for a centralized power counteracting the effects of their collective and irrational actions in the market place whereas they also claim to invest based on as thorough rational analysis as is possible given the ever existing constraints in supply of time and money. We can only conclude these people are wrong in one of these claims: either they are just trying to cover up their “sheepness” through faking analysis, or they are not normally acting like sheep.
The proponents of a market free from the Fed and its meddling with the currency and interest rates claim there are no natural boom and bust cycles in the market. People do panic when the market suddenly and drastically changes, but these sudden and drastic changes are in turn caused by over- and underinvestment triggered by attempts to artificially make capital cheaper and more expensive through meddling with currency and interest rates. What they are saying (and my use of the word “meddling” should give me a way as one of them) is that the boom and bust cycles were originally caused by the central bank trying to politically increase (politicians hardly ever want to decrease) growth through artificial measures.
They lowered interest rates (the price of capital) to spur investment or printed more money in order to “invest” in wars or welfare systems and other benefits to get re-elected. What would such a shock to the market system result in? The obvious answer is that when the price of capital suddenly and somewhat drastically goes down a lot of business people act on this incentive – they get their hands to this money and make investments they otherwise wouldn’t make. Why wouldn’t they make these investments otherwise? Because they make the investments they can afford, and they choose the ones they believe are most profitable – when the price of capital is artificially lowered they can suddenly afford the more risky and less “safe” investments and do so in order to maximize profits.
You can’t really blame people acting in their own interest and acting as they have always act. The reason they make these extra risky investments is because someone lowered interest rates to a level the market itself doesn’t consider reasonable.
The extra investments cause a boom, of course, since investments increase dramatically. And the extra investments, since they are riskier, tend to be bad investments much more often than the investments that were made with capital at market price. It is also important to realize that this “stimulation” of the market usually is a one-time thing – the state does not have any reason to always keep interest rates low (which is very costly – for everybody), they only do this as a way to win the election.
So what happens when the investments start failing (and a lot of them will)? The market is pushed downward at a rate not possible were it not for the artificially cheap investment capital that a lot of people took advantage of. After having spent all money available on investments people tend to underinvest – they have already invested as much as they dare (even considering the cheaper capital). So they start to cut back, especially when they realize some of the extra investments were in fact not very good. So we have a recoil to the artificial boom – a bust.
How does the state, through the Fed, react to these cycles? Just like they react right now: “oh my god, there is a lot of bad investments out there, a recession is coming – we need to lower interest rates to get the market going again.” Well, this might work a couple of times – but it creates but another boom before another bust, and each time the Fed needs to use more drastic measures (i.e., lower the interest rate more or print even more money) to really change things.
Anybody see an evil circle? Anybody see who’s the culprit? Yep, the Fed.
So we have these two positions, and they both are available in a number of different versions, that either the Fed helps a market that cannot take care of itself or it causes the problems it claims to fix.
One can only ask: how come anyone survived before the Fed was founded in 1913? The history books should be brimful with depressions much worse than the one starting in 1929. After all, in 1929 we had the Fed to save us.