The Daily Switch

The Federal Reserve: How It Hurts You-Part 3

Posted by Ender on March 17, 2009

This is Part 3 of of a series on the Federal Reserve.   In Part 1, we discussed Money, Fractional Reserve Banking and a brief history of the Federal Reserve.  In Part 2, we discussed Inflation.

The Austrian Business Cycle

Ludwig von Mises

This Guy Had the Foresight, Will You Listen?

In order to understand how these Bubbles are created, one must understand some basic economic principles found in the Austrian Business Cycle.  Dan Mahoney gives a simple example of a man stranded on an island who must pick berries in order to survive.  The man in question needs 12 berries per day to survive.  So, he goes on picking them.  Then one day he decides that he is tired of picking them by hand and wants to find an easier way to pick more berries.  He devises a plan of knocking the berries down with a stick and catching them in a net.  What would the cost of this investment be?  The cost in this situation is the berry-picking time he loses by building his stick and net.  Said differently, if he estimated it would take a full day to build his tools, he would lose 12 berries.  So we have reached a point, in this scenerio, where the man must take into account his time preference.  “Time preference is the extent to which people value current consumption over future consumption.”  If the man values eating the 12 berries more than potentially eating more as a result of his stick and net method, he will not make the tools.  Relating to what we learned about the fractional reserve no amount of berry tickets (gold receipts) printed is going to change his value of current consumption.  If his time preference falls and he decides he will only eat 10 berries a day he can now save the extra 2 berries.  If he does this for 3 days he will have 6 berries in his “bank.”  He can now spend half a day working on the new tools and half picking berries by hand.

Mahoney writes,”This same process of using savings to fund current production for future consumption goes on in more complex economies.  At any given time, the individuals in society are engaged in production to meet some “level” of consumption needs. In order for more lengthy—and, hence, if they are to be maintained, more productive—processes to be entered into, it is necessary that some individuals have refrained from consumption in the past so that other individuals may be sustained and facilitated in assembling this new structure, during which they cannot produce—and thus, not consume—consumption goods with the methods of the old structure.”

This Guy Also Had the Foresight, Listening Yet?

This Guy Also Had the Foresight, Listening Yet?

How is this process distorted by the Fed?  Through inflation or more specifically credit inflation the Fed makes “it appear that more means exist for current production than are actually sustainable.”  Entrepreneurs and investors are led to believe that the consumer has more money available to buy more goods than they actually do.  Consider the man on the island. If he was completely content to eat 12 berries a day he would never save or invest in the tools.  For the sake of the illustration, imagine that there were two men on the island and they both picked 12 berries a day.  One day, man A makes a berry receipt for 12 berries and gives it to Man B.  Man B sees that Man A has saved enough berries for him to not pick berries for a day and to create the net and stick.  At the end of the day he goes to redeem the reciept only to find that there are no additional berries.  He dies of starvation over night.  Now, what would happen if Man A had actually saved 12 berries?  Man B would have worked to create the net, redeemed his receipt at the end of the day and aside from the obvious intestinal unpleasantness brought on by a berries only diet, would have slept soundly.

What would this look like in a complex economy such as ours?  When the Fed artificially lowers interest rates it signals a change in consumer demand from current consumption to future consumption.  Which means companies should shift their use of capital to future output instead of current output.  This causes companies to start investing (through borrowing from the bank) in new capital goods whether they be new machinery, tools, real estate, research etc.  Demand for anything needed to perform the capital investments increases. 

For a more applicable example, let’s look at a typical construction company. Contruction companies start getting work orders to build new buildings. Business is booming so they build a new location on expensive real estate because they think the demand is permanent and the new location will spur more business.  They order supplies for all the new projects they are doing.  Their suppliers are running out of materials and place orders for large replacements because their business is booming.  And so on and so on, all the way down to the employees of all the related businesses buying Starbucks coffee on their way to work instead of making their own because of the raises or bonuses they received due to the booming business.  This scenario just described is a (fiat, fake, phony) credit induced boom and started on a false promise of future consumption.  Inevitably, resources start getting scarce because there was no real decrease in time preference made by the consumer.  Prices start rising as more companies are competing for the same materials.  Eventually, to battle inflation, our hero (read villain) the Fed, increases the interest rates.  Now all the companies that were depending on cheap loans for their liquidity start having trouble making ends meet.  It turns out there was no real increase in demand.

These illustrations convey the main point of the Austrian Business Cycle: a savings induced boom is sustainable whereas a credit induced boom is not.  Initially, both an increase in savings at a bank and the central bank expansion of credit have the same effect.  It signifies a shift between current consumption value and future consumption value, which gives a signal to Investors that there are more loanable funds, thus more demand for future products than previously existed.  However, the outcomes are drastically different.  In a savings induced boom, the boom is backed by consumer preference to spend in the future.  In a credit induced boom, the boom is backed by an artificial interest rate, which in the end can only be sustained by printing more money or lowering the interest rate even further, to the detriment of individuals and the economy as a whole.

Theory is one thing, real life examples are another.  In Part 4, we will take an in depth look at the Tech-Stock Boom of the late 90s early 00s.


3 Responses to “The Federal Reserve: How It Hurts You-Part 3”

  1. […] As if prices rising and devaluation of your money isn’t enough, the Fed through inflation, also causes Booms, Busts and Bubbles.  Look forward to part 3… […]

  2. […] Reserve Banking and a brief history of the Federal Reserve.  In Part 2, we discussed Inflation.  In Part 3, we discussed the Austrian Business […]

  3. […] Reserve Banking and a brief history of the Federal Reserve. In Part 2, we discussed Inflation. In Part 3, we discussed the Austrian Business Cycle. In Part 4, we discussed the Tech Stock […]

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