Thursday, November 14, 2013

How the Federal Reserve Defies the Laws of Economics

For an agency run by economists, the Fed seems non-economic.  Its quantitative easing program--now snarfing up bonds at the rate of $85 billion a month--defies one of the basic premises of economics:  the concept of scarcity.  Scarcity is crucial to establishing price.  If something is available in infinite amounts, it has to be priced for free because there's no limit to supply.  Scarcity acts as a constraint, forcing prices up as demand increases.  Price increases in turn compel actors in the market to think and rethink the utility of the thing that's getting costlier, and adjust their use of it.

The problem with the Fed's QE program is that it's paid for with printed money.  In other words, to get the $85 billion it needs each month, the Fed simply makes a few electronic entries into its computer system and, voila, money blossoms.  There is no scarcity.  The Fed doesn't have to get the money from anywhere.  Unlike taxes or borrowings, no one else has less money when the Fed prints some. 

In times past, when central banks pulled such financial alchemy, inflation would flare.  By reducing the value of the currency, buying power would become scarcer and discipline would be imposed.

But today, there is very little inflation--and, indeed, central banks seem to want more.  Thus, there are no constraints on money printing.  And, by all indications, the Fed governors whose voices count intend to keep the printing presses rolling.

Numerous skeptical observers haven't been able to complete the journey to Wonderland and believe that there will be no cost to all this.  And the truth may be that there has been and will be costs.  At the first hints of tapering earlier this year, a number of emerging markets began tanking and some have tanked hard.  Real estate sales have slowed dramatically as longer term interest rates have risen and the real estate recovery may have stalled out.  Gold and silver have fallen sharply, and other commodities prices have eased back. 

The Fed seems to have not really noticed that monetary policy now affects asset values more than consumer prices.  The tech stock boom and bust, the real estate and mortgage boom and bust, and the 2008 financial crisis can all be traced in part back to very generous Fed easy credit policies.  Central banks may be unable to foster inflation, perhaps for reasons that aren't fully understood yet.  But they can foster asset bubbles, and that's a strong reason for easing out of the QE business.  The last thing we need is to again have more government sponsored asset bubbles.

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