Booms and Busts and Interest Rates

The Austrian Business Cycle Theory (ABCT) teaches us that a loose monetary policy, with low interest rates, will send false signals to the marketplace.  The extra money and artificially low interest rates misleads people to believe that there has been more prior savings than what has actually occurred.  This leads to artificial booms in certain sectors.  When the loose monetary policy ends, or at least tightens somewhat, then the previous false signals become evident and the boom turns to bust.

We saw this happen with real estate.  It boomed up until about 2006 or 2007.  When it became evident that it was unsustainable and that the long-term savings just weren't there, then the housing boom turned into a housing bust.

Interestingly, the Federal Reserve buys mostly government debt.  It has, just in recent years since the housing bust, bought some mortgage-backed securities.  Therefore, the Fed has a significant impact on interest rates.  By buying government bonds, it bids up the price of the bonds.  As long as there is no major expectation of severe price inflation, then the Fed's buying will generally lower interest rates.  Again, this sends false signals to the marketplace, although we are in a much different economy now than when the rates were artificially low 10 years ago.

So what would happen if the Fed created money out of thin air, but did it in a way that didn't directly affect interest rates?  The Fed, with a monopoly over the money, can buy almost anything.  It could decide to buy big screen televisions, although I'm not sure what it would do with them all.  It could buy stocks.  It could buy gold, which ironically, just like buying stocks, would bid the price up through its actual buying and from the monetary inflation.

But let's even say that the Fed could create monetary inflation more uniformly.  It is impossible to do it completely uniformly because the new money has to go somewhere first.  And if you just handed out new money to everyone, do you do it with equal amounts to everyone or do you do it on a proportional basis of how much each person already holds?

I suppose the Fed could simply pay for the government's bills without formally buying government debt, but even here there would be booms in whatever the government spends it on.

Regardless of how the Fed creates new money out of thin air, I contend that it would have some kind of impact on interest rates.  But even if that were not the case, the monetary inflation would still cause distortions in the marketplace.  So maybe the booms and busts would take on a different way of playing out.  Maybe we would see different sectors experiencing the bigger booms and busts.  But no matter how you cut it, there will be a misallocation of resources.

Just with the presence of inflation, certain behavior is affected.  It encourages more debt.  It encourages consumption at the expense of saving.  If your money is continually devalued, you are less likely to save it and watch it lose value.  You are more likely to buy something that will more likely hold its value or that you can at least use.

So while manipulating interest rates plays a big role in the Fed's policies, I contend that monetary inflation alone, no matter how it is done, will misallocate resources.  As long as we get monetary inflation from the Fed, our standard of living will be less than it should be.