The Daily Switch

The Federal Reserve: How it Hurts You-Part 5

Posted by Ender on March 25, 2009

This is Part 4 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. In Part 3, we discussed the Austrian Business Cycle. In Part 4, we discussed the Tech Stock Bubble.

Moral Hazard

What is Moral Hazard?  Wikipedia has the following definition “Moral Hazard is the prospect that a party insulated from risk may behave differently from the way it would behave if it were fully exposed to the risk. Moral hazard arises because an individual or institution does not bear the full consequences of its actions, and therefore has a tendency to act less carefully than it otherwise would, leaving another party to bear some responsibility for the consequences of those actions.”  If you threw a party without your parents’ knowledge in high school you probably experienced moral hazard.  The kids that you invited over most likely did not treat your house like you did.  They broke vases or windows or any other cliché object in the house because they knew they would not bear the responsibility for their actions.  For all those nerds out there who never threw a party like this just watch Can’t Hardly Wait or any other teen movie for an example.

Risky? Sure, but no Moral Hazard

Risky? Sure, but no Moral Hazard

How does the Fed create a Moral Hazard?  The answer lies in a term you may have heard before, which is “lender of last resort.”  A lender of last resort will lend to banks or institutions that cannot find a lender on the open market.  The first problem with this is that the Fed can be lender of last resort and not absorb any of the cost associated with it.  They can just print money in order to finance these bailouts.  The Fed does not have to act like a normal business and borrow money to give to the bankrupting companies.   

The second problem with this is that having a lender of last resort encourages risky behaviors by banks and other businesses.  These banks know that the Fed will be there to bail them out if things go sour.  They can ignore sound business practices to an extent because they are not taking the full burden of the risk.  Hulsmann writes, “To sum up, bailouts through monetary policy socialize the costs of bad investment decisions. This creates a moral hazard on the side of all the beneficiaries. Financial agents can worry less about risk and concentrate on possible profits. They become exuberant and turn to excessively risky business practices such as reducing the equity ratio.”  This sounds remarkably similar to what we have been hearing about AIG, Fannie Mae, et al during this financial crisis. 

Some probably doubt that Moral Hazard exists, but how can this be?  The Fed has a long history of bailing out companies in trouble.  If you recall, in Part 4 we discussed how the gpvernment bailed out LTCM during the Tech Boom.  More recently, they bailed out AIG.  The Fed has proven over and over that it will rescue companies and ultimately make the taxpayer pay for their mistakes. 

Price Fixing

If you ask any Free Market advocate if we should just fix the oil price at $1.75 per gallon they would invariably look at you like you were crazy and scream NO!  You would likely get the same answer with any good from cheese to cars.  However, for a reason I cannot comprehend, some of these same “Free Market advocates” will argue FOR the Fed to fix the interest rates and discount rates.  Why would this ever work?  It seems to me that they do not understand they are actually arguing that we need to socialize part of the Free Market in order for it to work.

The Bliss of Price Fixing

The Bliss of Price Fixing

Ron Paul writes “One of the primary means the Federal Reserve uses to stimulate the economy is manipulation of the federal funds rate and the discount rates, which are used as benchmark rates throughout the economy. The interest rate is the price of time, as the value of a dollar today and the value of a dollar one year from now are not the same. Just like any price in the market, interest rates have an important informational signaling purpose. Government price fixing of the interest rate has the same deleterious effects as price controls in other areas.”  We have discussed these effects in nearly every part of this series on the Federal Reserve. 

What people need to understand is that Money itself is a good, perhaps the most important good, in the Free Market.  We allow (for the most part) the market to determine prices of other goods, so why not money?  Why allow the Fed to fix interest rates so insanely low that it hurts the economy and the individual? 

Paul goes on to say, “Under Chairman Greenspan’s tenure, the federal funds rate was so low that the real interest rate (that is the nominal interest rate minus inflation) was negative. With a negative real interest rate, someone who saves money will literally lose the value of that money.”  This destroys the effort of the individual to save money for the future.  The Fed’s price fixing is not the answer to whatever problem people think it might be stopping. 

Conclusion

The Fed, as argued throughout these articles, is an immoral force in the Free Market system.  It steals from the individual through inflation, it causes misery through booms and busts, it encourages companies to engage in overly risky behavior and is unaccountable to the American people.

A lot of research went into this series, here are some of the sources and further reading for those interested.
Inflation
Postrel, Fed Up
Coster, Socialist Man
Williams, Counterfeiting vs Monetary Policy
White, Inflation
Hazlitt, What you should know about inflation
Mises, Economic Freedom and Interventionism
Paul, The Inflation Tax
Busts
Thorton, Economics of Housing Bubbles
Karlsson, Yes, Greenspan Did It
Englund, The Fed and Housing
Other
Sowell, Bailout
North, Moral Hazard
Hulsmann, Moral Hazard

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One Response to “The Federal Reserve: How it Hurts You-Part 5”

  1. […] In Part 5, we will wrap up and take a look at a few odds and ends. […]

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