The Federal Reserve and the Crisis

“[There is] no longer any fear on the part of banks or the business community that some sudden and temporary business crisis may develop and precipitate a financial panic such as visited the country in former years…We are no longer the victims of the vagaries of the business cycle. The Federal Reserve System is the antidote for money contraction and credit shortage.”

-- Andrew Mellon, Secretary of the Treasury, April 14, 1928

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What would the world be like without the Federal Reserve System? Why is it commonly believed that they have superior knowledge and always have everything under control? Do they really know exactly what is going on? At least one member of the Federal Reserve Board, Janet Yellen, President of the San Francisco Fed, has admitted they do not. She has essentially confirmed that their “solutions” have been a series of experiments. They threw some things at the wall to see what would stick, and some did. Now comes the far greater challenge – determining when to remove the unprecedented interventions. Will they remove this excess money in time to avoid adverse effects? Unfortunately, the last quarter century does not give us much hope on that front.

By keeping interest rates artificially low during the so-called Great Moderation, or the period from the early 1990s through mid-2000s that saw strong economic growth with little volatility, the Fed signaled investors that there were more savings in the system than actually existed. Without the Fed intervening in markets, interest rates would have fallen when there was a high amount of savings in the system and risen when savings available to fund investments was low. (Like corn, supply and demand for capital would dictate its price, or rate.) Savings rates since the early 1990s were low and falling, so interest rates would likely have been much higher than they were over the past several years. In effect, the price mechanism for capital was (and is) manipulated by the Fed, which creates false signals for investors and savers. This helped asset markets (stocks, real estate) to bubble and led investments to be funneled into unproductive areas for too long. (Higher interest rates – owing to low savings available to fund investments – would have restrained housing market activity, for example.) In effect, the stimulus provided by cheap money was not withdrawn when it should have been and the mess we’re in is at least partially a result. These false signals continue and it is difficult to imagine the Fed withdrawing excess liquidity anytime other than too late. Unfortunately, the Fed has shown they are more likely to be wrong late than right early.