The butcher that could teach Ben Bernanke a thing or two.

A butcher crams a pound of beef into a meat grinder. Out comes a pound of ground beef. One pound goes in and one pound comes out. Sure it has changed form, but it has not increased in quantity. It cannot.

Enter the realm of the monetary policy with the Federal Reserve however, and perfectly sane people can believe the impossible.

Substitute a nation’s savings for the butcher’s meat and a nation’s new capital investment for the ground beef. Savings from one person are available to be borrowed by another person. Similarly the total savings for a population of individuals is equal to the total amount of capital available for new investment.

Consider the following example: I am a brick manufacturer and produce 10,000 bricks in a year. I sell 9,000 of them to cover my business and living expenses. The remaining 1,000 bricks are my savings. I can sell them now and keep the savings as cash or keep the bricks as savings and sell them later.

Ernie makes brick fireplaces. He buys my 1,000 extra bricks. Ernie uses my savings to embark on a capital project. One thousand bricks will be transferred from the nation’s savings to the nation’s capital investment.

If Ernie borrows the money to buy the bricks, he must make a calculation as how much interest he can afford to pay and still make an acceptable amount of money to make building the fireplace worthwhile.

If the bank charges a 10% interest rate Ernie may feel it is not worth the trouble, however if the bank charges 3% interest Ernie may very well borrow the money and buy the bricks. A free market where interest rates reflect supply and demand will automatically ration savings (bricks in this example) to the most efficient consumer. If the interest rates are lowered artificially below the free market rate other consumers may enter the fray. Ernie’s brother George for example may decide it is worthwhile borrowing money to buy the bricks and make them into a fireplace.

The problem is that the lower interest rates spur additional demand for a pile of bricks that has not gotten larger. Similarly, Ben Bernanke can lower interest rates to zero percent to increase demand, but he will not be doing us a favor. At some point it will become apparent that the additional demand created for capital goods inputs cannot be met. Prices of labor and capital inputs will rise as a larger demand chases a finite amount of goods.

During the housing bubble builders borrowed money at Fed created low interest rates. The result is they made bad business decisions regarding availability of building materials. When it came time to buy those materials, the increased demand from other builders, combined with the stable supply caused prices to rise. The builders had to sell at ever higher prices until it became apparent that people could not afford the much higher prices, even at the below free market mortgage interest rates.

Similarly, during the dot-com bubble programmers suddenly could command much larger salaries due to a massive increase in demand for their services. This too was stoked by the Federal Reserve’s intervention into interest rate policy. Setting them below the free market rates created a situation where more people demanded programmer’s services when the quantity of programmers had not increased.

Capital investment requires savings. This savings will be used to make the new projects. Those benefits can be in the form of increased productivity or a more desired product. If the savings necessary to complete the projects are not present then the economy is doomed to fail in repetitive boom bust cycles.

The free market is the solution. Just as the butcher knows it would be futile to perhaps mix his ground beef with fillers to somehow pretend he has more than he put into the grinder, it is equally futile to think that the Federal Reserve can lower interest rates below the free market rate and achieve a lasting period of prosperity.

Instead at best it dooms us to perpetual boom bust business cycles, and at worst it creates a series of ever larger busts which will eventually lead to either a deflationary depression as massive debts are defaulted upon or a hyperinflationary depression where the dollar collapses in value and all prices skyrocket.

1 comment:

  1. That's very true ..Let me tell you one funny part. i.e. when Interest Rates were market driven, We used to hear stories like Person take a loan for his daughter's marriage and then can not pay back due to heavy interest ending up in becoming cheap rate slave for "Lender" for his whole life. I mean this is given as one of the reason for central bank deciding interest Rates. Fact of the day is in poor remotely located people these bad practices are still on while we (who believe in saving) face moral hazard due to lower interest rates.