Thursday, November 19, 2009

The Strange Pricing of Money

Strangely enough, the economies of the United States and all other major countries rest on prices set by the government. Market forces establish most prices. Governments--specifically, central banks--set the price of money.

The price of money is usually seen as the interest rate paid for loans. In general, central banks set short term interest rates for loans they make to banks, and for interbank loans (i.e., loans between banks). The Federal Reserve in the United States does this primarily through its discount rate, and the fed funds target rate. In addition, the Federal Reserve has gone farther than usual during the current economic crisis by purchasing large quantities of Treasury securities and mortgage-backed securities in order to hold down long term interest rates.

Federally prescribed interest rates are tools for combating economic problems. As the economy nosedives, the Fed lowers interest rates in order to soften the impact of the plunge and foster recovery. When inflation flares, the Fed raises interest rates in order to dampen pricing pressures.

It goes without saying that political considerations affect the government's pricing of money. In order to stave off a depression, the Fed last year reduced its fed funds target to a range of 0 to 0.25%, about as low as you can go. The European Central Bank, created against the backdrop of the German hyperinflation of the 1920s and the political extremism it fueled, focuses primarily on keeping prices stable, and was less aggressive on cutting rates.

Market forces seem to have little to do with government pricing of money. Commercial and consumer loan markets set the price of individual and corporate creditworthiness, with recognition (most of the time) that not everyone will repay a loan. But the price of money itself is set by governments to advance governmental goals.

How does the government know what price for money is right? Without the interaction of supply and demand to settle upon an equilibrium, can the government establish a price level that allocates resources efficiently? Or will it set a price that is politically expedient but not economically sound?

The pure time value of money, without considering credit risk, inflation or other factors, is believed to be somewhere around 3%. At the beginning of 2001, the fed funds rate was targeted by the Federal Reserve at 6%. Inflation in 2000 was 3.4% (as measured by the CPI-U), so a 6% fed funds target rate pretty much squared with the natural time value of money. But as the tech stock bubble collapsed, and then the 9/11/01 bombings took place, the Fed went whole hog for stimulus, lowering the fed funds target to 1.75% by the end of 2001. It didn't stop there, reducing the fed funds rate to 1.25% late in 2002 and to 1% in June 2003. Inflation averaged just under 2% per year from 2001 to 2003. When inflation is added to the 3% pure time value of money, one would have expected a free market to offer interest rates of around 5%. So the government's pricing of money was, in effect, negative. It shouldn't be surprising that everyone in the country with a pulse and a signature wanted a mortgage loan, regardless of their ability to pay. Giveaways attract interest. And this giveaway pumped up a big bubble in the housing and credit markets. We know the rest of the story.

Today, inflation in the last year is just barely negative, and the fed funds target rate is just barely positive. So another government sponsored giveaway is in progress. The Fed's purpose--revival of the economy--is salutory. But market forces, even when ignored or disrupted, have a way of coming back at you. A shipload of stimulus/accommodation/bailout money is funneling overseas via the carry trade to revive commodities prices and the economies of other nations. Fed governors seem to believe asset bubbles to be theoretical and not to be found in the wild. Foreign officials have already expressed concern over ongoing dollar-driven asset bubbles. Add to this continuing questions about how mere green shoots could support a 60% stock market rally in the last eight months, and the specter of asset bubbles grows.

Other cheap federal money sits on bank balance sheets, waiting to offset likely writedowns for yet more real estate lending losses. Scant portions of federal money have reached the real economy.

With so little federal money reaching the real economy, the question arises whether today the Fed's pricing of money allocates resources efficiently and spurs productive economic activity. GDP is growing again. But that's to a large degree because the federal government portion of GDP is growing. Take away this statistical effect, and the picture is less rosy. The government can always pump up GDP statistics by borrowing or printing more money. But with unemployment rising, there is a serious question how much good it's actually doing.

It would seem that for the second time this decade, the Fed has mispriced money. The first time, it produced gross distortions in the real estate and credit markets. There are signs it's producing more distortions now. Realistically, no modern industrialized economy can exist without fiat money (i.e., government issued currency). Complex economies require enormous amounts of exchange to circulate, and there isn't enough gold, silver and copper in the world to accommodate the need. But when the government misprices its currency, bad things will happen. Market forces, one way or another, will clear. It took them a while during the recent real estate and credit boom to bust, but bust they did and how. The Fed's stated intention of keeping short term interest rates at zero for the foreseeable, extended future is coming dangerously close to violating the law of unintended consequences.

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