Get Fed out of interest rates

The Federal Reserve is once again in the headlines because of speculation over what it’s going to do with interest rates and when, after taking no action. This question begets a bigger and more fundamental one: Why in the world is the Fed — or, for that matter, any central bank — trying to manipulate interest rates in the first place?

The blunt truth is that the Fed has no business engaging in this form of price control. The U.S. and other global economies would be infinitely better off if central banks allowed borrowers and lenders to set their own prices. What the Fed, the European Central Bank, the Bank of Japan and the Bank of England have done with their zero-interest-rate policies and various permutations of quantitative easing is to severely hamper the global recovery from the 2008–09 economic crisis. 

{mosads}It’s one thing for a central bank to set the rate it charges banks or any other borrower of its own funds. But it is manifestly altogether different when a central bank tries to impose price controls on what a lender charges a borrower in the private market.

Of course, central bankers, economists and politicians claim this form of rent control “stimulates” the economy or, if they deem the economy getting “overheated,” artificially prevents too much inflation by “cooling” economic activity. Make no mistake about what “cooling off” an economy means: deliberately causing businesses to lose sales and people to lose their jobs.

The whole exercise is preposterous and immensely harmful. Economies don’t “overheat,” nor do they need government suppression of interest rates to recover smartly from a recession.

Using the prevailing logic on interest rates, or the price lenders charge borrowers for credit, central banks should have the right to impose price controls on other products and services in order to guide the economy. The Fed could decree that auto dealers cut the prices of their vehicles by 50 percent, claiming that this would gin up the economy because buyers of cars and trucks would have more money to spend on other things. Why not mandate that prices for all services and products be slashed in half — that would really get the economy moving!

Put this way, even the most dim-witted of policymakers — except for Bernie Sanders and his ilk — would realize the foolishness of such an exercise. Former President Nixon tried such controls in the early 1970s and the results were disastrous, especially in the area of energy. When former President Reagan removed all controls on oil and gas immediately after taking office in 1981, energy prices plummeted and the nightmare of lines at gasoline stations ended forever.

In the real world, why are controls on interest rates any different than controls on the price of oil and gas or any other goods and services?

They aren’t.

The Fed has no more idea of what the price of money should be than the central planners in the Soviet Union did for their economy’s myriad products.

Rent controls, most people recognize, distort and harm housing markets. The financial markets are no different.

“But interest rates are different!” scream most economists. “Manipulating them is essential in combating a downturn à la 2008–09 or any other recession.” Nonsense.

This is the Great Myth that emanated from the Great Depression. Previously, central banks set their discount rates  —remember, that’s the interest rate central banks charge banks that wish to borrow from them — in order to keep their currencies stable in value vis-à-vis gold. They never used them to guide the activities of their economies. This happened only in the aftermath of that 1930s catastrophe. The Great Depression was caused by the disastrous Smoot-Hawley Tariff, which destroyed global trade. Countries then made things worse by enacting massive tax increases as their economies cratered. Artificially trying to change the price of credit would have had no effect in stopping that disaster.

The same holds true for today. It’s structural deficiencies — high taxes, rigid labor markets and a never-ending array of suffocating rules and regulations — that are holding economies back. And we must also add current monetary policies.

Look at what the Fed has done since 2009. Zero interest rates, quantitative easing and the hyper-regulation of banks have woefully deformed our credit markets. The result? Artificially directing credit to bonds at the expense of loans to small and new businesses and households. As noted economist David Malpass points out, “53% of total credit is in the form of bonds, up from 39% ten years ago. [This is] a dramatic swing in the allocation of credit in the economy toward big, well-established entities and away from growth.”

Apple, for instance, has more than $230 billion in cash, yet it has issued tens of billions of dollars in bonds. Why? Because the cost was so low. After all, the interest Apple pays on this long-term debt is often less than the yield on its stock. Apple buys back stock and raises its dividend. The company plans to do more of this financial engineering. Exxon Mobil Corp. recently issued $12 billion in bonds for similar purposes. Other large corporations have done the same. Bonds are instruments for established companies, not for the countless small startup companies, and for financing inventories or raising loans for expansions. No wonder the number of new businesses has plummeted.

What the Federal Reserve and other central banks have done is to starve the most dynamic actors in their economies of credit.

Have price controls on interest rates helped in the past? No. The great boom of the 1980s and 1990s, for example, began with structural reforms in the U.S., primarily the enormous cuts in the income tax rates that Reagan pushed through. Numerous other countries followed our example. And other countries, led by Margaret Thatcher in Great Britain, engaged in major privatizations, which also spurred growth. Interest rate manipulation had little to do with these kinds of reform.

“But,” economists persist, “shouldn’t central banks suppress interest rates in order to hasten recovery and prevent downturns from spiraling into depressions?” The best answer is to ask another question: Would the economy be helped if the government dictated the prices of everything we buy and sell?

Such a query exposes the central banks’ interest rate fallacy. Prices are supposed to provide critical information to would-be buyers and sellers. They enable markets to function efficiently. Most economists acknowledge that government interference in prices makes for malfunctioning markets. Financial markets are no different. By garbling the message between borrowers and lenders, the Federal Reserve et. al., hinder, not help, economies.

The clear and constructive course for the Fed and other such institutions is for them to cease their Soviet-style central planning policy of interest rate manipulation and let the marketplace set all interest rates.

Forbes is chairman and editor in chief of Forbes Media. His latest book is “Reviving America: How Repealing Obamacare, Replacing the Tax Code and Reforming The Fed will Restore Hope and Prosperity.”