No Silver in the Silver Lining
In a recent edition of the Financial Times, Martin Wolf ends up prescribing more government regulation and intervention, yet his description of the government-backed banks and their nefarious behavior is spot on:
No industry has a comparable talent for privatising gains and socialising losses. Participants in no other industry get as self-righteously angry when public officials — particularly, central bankers — fail to come at once to their rescue when they get into (well-deserved) trouble.
Many economists since Mises have noted that every time the Fed manipulates interest rates it creates bubbles of malinvestment. In addition to reallocating scarce resources in inefficient ventures, one of the problems with artificially lowering interest rates is that, ultimately, someone has to pay for these subsidies.[1]
As with every freebie provided by the government, some faceless individuals will ultimately share this unjust burden. And over the course of the Fed's more-than-90-year existence, individuals with dollar-denominated assets have borne the brunt of this devaluation as the dollar is worth about 5% of its original 1913 value.[2]
The Financial Silk Road
At the global scale, if the Fed were the only bank to lower interest rates, the severity of the ensuing bubble could arguably be minimized. However, many other central banks mix and match their own interest rates in a bid to stay on par with the Fed.[3]
For instance, petro-rich Saudi Arabia, UAE, Qatar, Kuwait, and Bahrain all have their currencies pegged to the dollar. As a result, their central planners believe that they "have little choice but to mirror U.S. moves in deposit rates if they want to avoid attracting capital that would pressure currencies higher."
And while petroleum has historically been a safe investment for prospectors and fund managers, the artificially low interest rates always dilute other industries. So while it may begin with the financial sector — which is the first recipient of new cash — it can trickle down to and contort the petroleum space as well.[4]
Thus, the subsequent malinvestment fallout in the next few years will be compounded with every rate change conducted by the central planners; and therefore the falling floor will not be isolated to a small geopolitical area.
The Players
At the beginning of the year, with an interest rate of 2.75%, Switzerland had the fifth-lowest rate. Japanese planners, appearing as if they feel guilty about usury, practically hand money out for free — topping the list at a mere 0.5%. As an aside, if there is no calculated risk involved as a creditor, it's unconscionable to wonder why so many of their loans go bad![5]
In the middle of the developed pack lies Norway (#21), which raised its lending rate 25 basis points two weeks ago, resting at 5.25%. And at the end of the "major economies" spectrum, after eight interest-rate increases since mid-2006, South Africa lends at 14.5%.
As of this writing, the US Fed (#6) has a lending rate of 3.00% -- having lowered it 125 basis points in the month of January.
What is the correct rate? Why have a rate at all? What is the rate supposed to reflect?
No matter how much economic data a central planning board has, it is always inferior to the market in answering these questions. The marketplace continuously fluctuates based on a seemingly infinite set of variables that attempt to quantify risk. And within a free market, entrepreneurs are charged with the task of due diligence, otherwise they become bankrupt. Not so for banks insured and subsidized by the federal government. Why worry about potentially shoddy business models when you can find a lender to always bail you out?[6]
You Can't Spend Exuberance
One of the incredible statements from the recent World Economic Forum in Davos comes from Steve Forbes. He started out brilliant, saying, "I think the Fed should ignore interest rates and realize that if it has a stable dollar, interest rates fall on their own."
Yet he did not see that the new rate decrease would impede the restructuring process, by shoring up businesses that should disappear. To top that off, he believes that the stimulus package (which in reality is just a forced loan — not a rebate) will somehow swing the economy "back by spring." In his mind: a mere slowdown instead of an all-out recession.[7]
This rose-tinted view wholly glosses over why a slowdown has occurred in the first place, why foreclosures are as popular as iPods, and what expansionist policies encouraged malinvestment.
As Eric Englund chronicled, businesses like Countrywide used government subsidies in the form of guaranteed, soft, artificially low-interest loans in building their myopically shortsighted goal of giving everyone — regardless of financial solvency — a home mortgage.[8]
Therefore, if American investors and financial analysts were dismayed when first-time owners without any credit or even reliable jobs went bankrupt, it would be in their best interest to allow all of the bad loans and businesses to go belly up sooner rather than later. As a consequence, the only thing that this infusion of dishonest money will accomplish is to teach bankers to politic harder the next time they are in a squeeze.[9]
What Goes Around
The subprime mortgage housing bubble was not a microcosm on the North American continent. Asian markets such as Japan and South Korea are only now feeling the credit crunch as their artificially low interest rates also provoked a rash of misguided construction projects and ill-advised investments abroad.[10]
And if central planners around the world continue to manipulate the interest rates there is no reason to believe that the deleterious cycle will stop any time this decade.
Notes
[1] While there are numerous areas that the Austrian method has contributed to the field of economic science, the business cycle is perhaps its best known and most articulated. Its proponents discuss what money is and how the expansion of credit through fiat results in a devaluation of the currency along with malinvestment. For more discussion on the ABCT, see The Austrian Theory of the Trade Cycle compiled by Richard M. Ebeling, Money, Bank Credit, And Economic Cycles by Jesús Huerta de Soto, and "Expectations and Austrian Cycle Theory" by Frank Shostak.
[2] In terms of purchasing power, according to the Consumer Price Index, an item that cost $1 in 1913 cost over $20 in 2006. See also: "Why the U.S. Dollar Constantly Loses Value" by Robert Morley.
Also, in an attempt to plan and manage the economic actions of 1.4 billion people, the People's Bank of China actually subsidizes the value of the dollar, artificially strengthening it to the detriment of the residents' standard of living. Be sure to read "The $1.4 Trillion Question" by James Fallows at The Atlantic and "More Salad, Less Twinkies" by Peter Schiff.
[3] The dollarization of foreign currencies is an odd phenomenon. On the one hand, many governments have inflated their currencies into oblivion. Yet, despite pumping billions of paper notes into economic markets, the American dollar — and to a growing extent, the euro — are inflated relatively less than the absolutely worthless Zimbabwean dollar. And as a consequence, they are adopted — both officially and unofficially — as the local currency by numerous countries.
This occurrence lends credence to Kenneth Gerbino's maxim:
If you don't trust gold, do you trust the logic of taking a pine tree, worth $4,000–$5,000, cutting it up, turning it into pulp, putting some ink on it and then calling it one billion dollars?
[4] For instance, the "easy" loans could entice entrepreneurs to incautiously drill or mine in an area without proper research. The resulting consequence is that of the Broken Window — opportunity costs that economically harm everyone. Anyone who watches the Discover Channel will no doubt be familiar with the megaprojects series that showcases the monumental investment of offshore oil platforms. Artificially low interest rates could divert scarce human labor needed to construct and design them, from roughnecks to engineers, divert heavy machinery (such as large cranes or barges), and otherwise dilute and misuse capital intensive resources. The end result could increase the project costs more than they would have normally been with unmolested interest rates.
[5] While Friedrich Hayek is perhaps better known for his critique of socialism vis-à-vis the "knowledge problem," Ludwig von Mises arguably offers a stronger, more robust denunciation of planned chaos through the calculation problem. Regarding the centralization of knowledge and prices, see "Socialism: A Property or Knowledge Problem?"
by Hans-Hermann Hoppe and "Why a Socialist Economy is 'Impossible'" by Joseph T. Salerno. See also "Knowledge vs. Calculation" from Stephan Kinsella.
[6] On The Last Laugh, John Fortune and John Bird — the politically incorrect comedic duo — discuss the ruinous foundations of the subprime business model. No job, no money, no credit? No problem! See also: here and here.
[7] Gerard Jackson offers perhaps the best refutation of the nonsensical "irrational exuberance" hermeneutics.
[8] One of the consequences of subsidizing home mortgages under the auspices of Fannie Mae and Freddie Mac is the fact that the government itself is directly responsible for contributing to the maligned "urban sprawl." They helped contribute capital finances to fund a shoddy business model that went on a building frenzy. This is compounded by the fact that the federal government has also subsidized and financed — through taxpayer revenue — rural telecom services. The USF subsidized rural buildouts at the expense of the urbanites who funded it. And, perhaps most egregiously overlooked, because the federal government infuses billions of dollars into highway construction, it directly diverted capital that could have been used to build local subways, bus depots, and rail systems. With all of this redirected capital and resources one possible alternative could be larger, relatively greener population centers, capable of profitably operating these services. The plethora of realistic possibilities is left to the conjecture of the mindful reader.
[9] Some decoupling proponents suggest that the US economy no longer has a vital role in the collective world economy. However, as noted by Paul Kedrosky, despite the ballyhooed growth of developing economies, the US GDP as a percentage of global GDP has remained relatively steady at around 30% for the past four decades; a trend that shows no signs of diminishing. Thus, if America goes into a recession, the rest of the world will feel its pain.
[10] See: "Korea Set to Inject Cash Into Market" from The Korean Times and "Bank of Japan warns of increased downside risks" from Forbes.
