The mess we're in and how the Fed got us here


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The financial collapse of late-2008 has left many in the United States scratching their heads. How did something like this happen? What are the origins of this mess? What exactly can we do to fix it?

The U.S. government and the Federal Reserve appeared to have the answers, claiming it was a failure of the market that caused the crisis. Sweeping into action, they bailed out the banks, piled on the regulations, and began pumping new money into the market in order to jump-start the dying economy. However, when utilizing the lens of the Austrian business cycle theory as developed by Ludwig von Mises, it is easy see that the collapse was not a failure of the market: It was a failure of monetary policy.

A recession occurs when large sectors of the economy see drastically falling prices more or less at the same time. Money is the common connection between all prices, therefore monetary policy is the place to search for the problem. The Federal Reserve in particular is the entity in charge of monetary policy and upon closer inspection is arguably the biggest part of the problem.

The Fed has the ability to raise and lower interest-rates, which it does by decreasing or increasing the money supply, respectively. By doing so, the Fed sends signals to investors about the ratio between consumption and savings within the economy. By raising interest-rates, the Fed tells investors that consumers are interested in purchasing goods in the present, thus sending the signal to invest in consumer goods. By lowering interest-rates, the Fed is saying that consumers are more interested in investing in the future; thus signaling that saving is up and to go ahead and invest in higher-order goods, things like houses. This is risky, however, because the Fed can change interest-rates in ways that come into conflict with the economy's actual consumption to savings ratio. Trying to calculate what market interest-rates really are is frankly impossible due to the complexity of the marketplace. This is where problems begin to arise.

Austrian business cycle theory explains that if the Fed artificially lowers interest-rates below that of the actual market level, new money pours into the banks and is then used to make loans. Investors see all of the new money as increased savings on the part of the consumer, signaling them to invest in higher order goods. The investments are made and the money begins to trickle down to the consumer. When consumers receive all this new money, they go out and spend it at the actual consumption-to-savings ratio that is higher than the one the Fed signaled. Thus, the investments made in higher-order goods are unprofitable due to a lack of demand, making huge portions of the economy go under all at once. We now have a recession.

This same process is the cause of the recent recession and the reason more expansionary monetary policy will not be a cure. In response to the bursting of the dotcom bubble in the early 2000s, the Federal Reserve, under the direction of Chairman Alan Greenspan, slashed interest-rates to as low as 1 percent between June 2003 to June 2004 . This put into motion the malinvestment that led to the housing bubble that burst in 2007. Investors believed that the time was right to invest in higher-order goods, in this case, housing. However, when it came time to pay for all of the new housing, there just wasn't enough real consumer demand and prices began to fall drastically. The rest of the economy soon followed with the stock market crash in 2008. The crash in stocks was due to the fact that stocks are units of title to masses of capital or higher-order goods and the artificially low interest-rates fooled investors into thinking there would be adequate demand for such goods.

In response to the crisis, the Federal Reserve has called for two rounds of monetary expansion, labeled QE I and QE II, and has kept interest rates near 0 percent in an attempt to jump-start the economy. With real, U6, unemployment figures stagnate around 16% and few signs of economic improvement in the near future, this is clearly not working.

If the Federal Reserve and the U.S. government really want to end the recession and begin the recovery process, they must allow for the necessary liquidation of malinvestment and debt to occur. This was once the policy of the U.S. government toward recessions, and it worked. From 1920 to 1921, for example, the country was hit with recession. The government, with Warren G. Harding as president, stood aside, cut spending, and slashed taxes while the Federal Reserve did nothing as far as monetary stimulation was concerned. Recovery was painful, but quick, as the market recovered and found growth again in only one year. Unfortunately, shortly after this, the Federal Reserve began tinkering with the monetary base in 1923, setting up the bubble of the Roaring 20's that would later burst into the Great Depression. Instead of following its predecessor, however, the Hoover administration encouraged and adopted inflationary monetary policies very similar to those currently in practice by the Bernanke Fed and the Obama White House.

This must be changed, as these policies will only re-inflate the bubble, drag out the pain of recession, and set up the economy and the American people for even bigger trouble down the road.

Logan Depover is a student at the University of Iowa.

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