Gonzalo Macera's Scholarship Essay
-How has the Federal Reserve System helped or hurt the American economy?
Even though between the Federal Reserve System listed responsibilities one reads: “Maintaining the
stability of the financial system and containing systemic risk that may arise in financial markets.” It would
appear to be that unsound monetary policy from behalf of the FED has actually had the opposite effect in
more than one occasion. Between the various examples, a recent one was the 2008 crisis.
The explanation of what went wrong in the 2008 Financial Crisis by some authors was that the problem
could be traced back to a monetary policy that kept interest rates too low for too long (Diamond and Rajan
2009a; Dowd 2009; McKinnon 2010; Meltzer 2009; O’Driscoll 2011; Schwartz 2009; Taylor 2009), that it
could be argued that excess liquidity fueled by major central banks, among them the FED, generated an
accumulation of imbalances that led to the crisis.
To this respect, business cycle theories like the case of Real Business Cycle theories, fell short into
providing a comprehensive explanation of the crisis (Caballero, 2010; Ohanian,2010). There are various
references in this sense that point to an explanation of these events that is consistent with the Austrian cycle
theory (Borio and Disyatat 2011; Diamond and Rajan 2009b; Garrison 2009; Lal 2010; Leijonhufvud 2009;
O’Driscoll 2009; Young 2011)
Following Mises (1912,1949) and Hayek (1931,1937) on the view of the Austrian Business Cycle theory,
a boom artificially provoked by policy that lowers interest rates below equilibrium levels generates a
business cycle through misallocations of capital goods and factors of production, where the correction of
those misallocations can be very costly.
From this framework we can expand on the following concepts: Firstly, that since production consumes
different amounts of time, we can then take the production processes and divide them into different stages.
From the extraction of a natural resource, to manufacturing a certain product, to the retail sales, we can
differentiate from the earliest stage (extraction) to the final stage where products are ready for consumption.
To this regard this business cycle framework is associated with the concept that as more stages of production
are, the longer the average period of production will be. We can speak then of -more roundabout- of those
economic activities that are more capital intensive and more forward-looking relative to other -less
roundabout- ones (following Kirzner’s 2010 conceptual treatment).
Secondly, since more roundabout projects require of more time for production and are more capital
intensive, then they happen to be more sensitive to variations in the interest rates than their lesser
roundabout counterparts. When interest rates are lowered, the net present value of cash-flows of investment
projects that require more time and are relatively more capital intensive increase more than proportionately
compared to those that consume less time and are relatively less capital intensive. Therefore, being more
roundabout projects more sensitive to interest rate changes, in this scenario as their NPV increases they will
tend to outbid the less roundabout projects in the competition for factors and lead them out of the market,
reallocating then from less to more roundabout activities in the economy.
Third and finally, given the interest rates are lowered consumers will reduce their savings and increase
consumption since their time preference remains unchanged, which leads to inconsistencies between
production and consumption. Producers want to increase their investments but at the same time consumers
are unable to comply with the supply of savings since they are consuming more. Since interest rates cannot
be below equilibrium for ever, eventually the central bank has to increase them and at this point, the effect
in the opposite direction is set in motion. The more roundabout projects are affected negatively more than
proportionately than the less roundabout projects given the raise in interest rates; but now since the capital
structure was fitted to the previous scenario and given the heterogeneity of capital goods, these cannot be
reallocated so easily. The correction from a more to a less roundabout situation ends up being very costly,
and constitutes the bust phase of this process. The reallocation of capital goods and factors of production is
far from instantaneous and the costs of it manifest as a crisis.
Monetary policy and real factors played crucial causal roles in the housing boom and bust. Housing policy
and regulation of financial services also played important roles in the housing boom and bust, they
interacted with the monetary and other real factors to produce the financial crisis, which some have
considered as the Second Great Contraction. (Reinhart and Rogoff 2009). Whether in this crisis, or other
crisis and bubbles that preceded this one, unsound monetary policy carried out by the Federal Reserve has
played its part.
The unsound monetary policy and intervention on the equilibrium interest rates has perverse consequences
in the economy. Although it may be deemed seemingly innocuous in the immediate present, the process
which takes place and builds up into potential crisis takes time to develop. Some of the effects on the capital
structure and functioning of the economy may be observable, other effects not so directly, and some remain
particularly unseen until the crisis and final adjustments have to take place in the economy. The varying
channels which through these distortions make their way into the economy shape and impact the particular
circumstances into which the different crisis end up manifesting. The symptoms in each case and the
adjustments needed can look different but the roots of the problem remain the same, and meanwhile the
American economy is hurt.