The federal reserve’s extreme measures are exactly the wrong response to the recession in the wake of the covid-19 crisis and will make the current grim situation even worse, the Mises Institute, a leading think tank, said in a May 26 paper.
Politicians, academics, journalists and business leaders began calling for the federal reserve to rescue the economy in the early days of a full-blown novel coronavirus outbreak, when the government began imposing restrictions on business — including forced closures of businesses and schools, home quarantines and travel bans — that sharply curtailed business activity.
Needless to say, the fed has lived up to its expectations in this crisis, pulling out one bombshell after another. But as the mises institute notes, “it is precisely these policies that have done so much damage to the U.S. economy.”
To be specific
First, the recession was caused by the huge impact of restrictions on the supply side, not the demand side. As government officials and “experts” began urging people to stay at home, even before state and local officials forced them to, most companies stopped producing and providing many goods and services. Knowing little about supply chains, professional material and human resources, capital structures and other aspects of production, politicians and experts see the world only from a Keynesian perspective and resort to what they consider to be the “magic bullet” : monetary and fiscal stimulus. But the mises institute points out that printing money does not create real goods and services when workers are banned from working by law.
Second, measures such as keeping interest rates artificially low and promising to keep them low, as well as purchases of investment-grade corporate bonds, should have helped companies maintain employment levels. But look at history: the employment rate for those aged 15 to 64 was close to 72 per cent at the end of 2007, but did not recover to that level until the end of 2019 after the financial crisis. Is there a 12-year lag in the effectiveness of monetary policy?
Third, measures such as the primary and secondary market corporate credit instruments (PMCCF and SMCCF) were supposed to keep the credit markets functioning, enabling Banks to avoid growing excess reserves. Yet the truth is that excess reserves soared from $1.8 billion in December 2007 to $2.7 trillion in August 2014. Non-performing loans, another measure of bank performance, were about 1% in the third quarter of 2007, rising to nearly 6% in 2010, before falling to 1% in the second quarter of 2018. As a result, mises argues, it is hard to attribute any improvement in the banking sector to monetary policy.
Austrian business cycle theorists have long argued that monetary expansion redistributes wealth through the Cantillon Effect, leading to bad investments in the allocation of resources across time periods that do not correspond to consumers’ time preferences, and ultimately to price inflation. Then there is the “lower bound” problem: with interest rates already close to zero, the fed can do little to stimulate real economic activity. (note: the “cantilone effect” refers to the difference in the impact of changes in the quantity of money on the real economy depending on how money is introduced into the economy and who is the holder of the new money.)
However, “ill-gotten gains” are as popular as ever. Despite the objections of most mainstream economists, many proponents of modern monetary theory (MMT) still believe that MMT, through the magic of the “printing press”, allows people to have everything they want without sacrificing anything.
No one at the fed seems to be publicly supporting the MMT right now, but the mises institute notes that chairman colin Powell’s recent comments suggest he sees no difference between the goals of monetary policy and other government programs designed to support companies, industries and other interest groups. The fed is just another government planning agency, not an “independent” monetary authority with a dual mandate: low inflation and full employment.
Most critics of the fed’s recent actions recognise the futility of using expansionary monetary policy to counter real supply shocks. But there are more fundamental reasons to worry about the long-term effects of “unconventional” monetary policies such as quantitative easing.
The long-term effects are more worrying
The mises institute notes that unlimited purchases of U.S. Treasury bonds, government-backed securities and commercial mortgage-backed securities have artificially inflated the prices of those securities. In the case of government bonds, buying long-term bonds means the fed is “pegging” their yields. This opened the door to political interference, with the federal reserve being pushed to fund deficits under the guise of promoting social welfare. That, of course, would make it easier to increase government spending on various projects, along with price inflation and other distortions.
As Austrian business cycle theory points out, inflation driven by credit expansion leads to artificially low interest rates, which encourage entrepreneurs to overinvest in interest-sensitive asset classes whose earning power is driven by artificially high demand. It would also encourage Banks to engage in moral hazard and invest in risky businesses (because “normal” businesses are less profitable) in the hope of future bail-outs.
In simple terms, the fed’s recent interventions to combat the recession will produce what the economist duzenberry calls a “ratchet effect,” in which people’s spending habits become irreversibly easy to adjust up, but difficult to adjust down.
After the financial crisis, quantitative easing was described as a once-in-a-lifetime intervention to stop the global economy from collapsing. However, in the context of novel coronavirus pandemic, it has become a common and even inevitable policy response, which may become the “new normal”.
The mises institute stresses that the fed’s extreme measures are precisely the wrong response to the recession in the wake of the covid-20 crisis, and will make the current bad situation even worse.
