In a capitalist economy there is one market which is more important than any other — the market for capital. What can be more vital than the efficiency of the process by which the price of capital in all its various financial forms is determined — whether long or medium-term fixed-rate loans or equity?
And it is an axiom of economic freedom that market forces undistorted by monetary instability and drawing power from de-centralized information-gathering do a more efficient job than a control command center. Yet that is exactly what we find operating at the heart of the U.S. and global financial system.
The Federal Reserve System, since its creation almost a century ago, has meddled in the free market for capital and never to a greater extent in modern times than under the chairmanship of Ben Bernanke.
To grasp how much it is involved in price-fixing, look back at monetary systems that were the polar opposite of the current day Fed: the classical gold standard in the decades prior to World War 1 and the monetarist regimes found in Germany and Switzerland from the early 1970s to the mid-1980s.
In these, money market rates fluctuated, sometimes wildly, as part of the day-to-day process by which the market for non-interest bearing reserves cleared. In Germany the central bank did peg the overnight rate but changed this frequently in line with the objective of achieving its target for the growth of monetary base. The Bundesbank absolutely did not consider its pegging of the short-term rate as an instrument for influencing longer term rates or the price of equity capital.
Fast forward to the Greenspan Fed in the early mid-2000s which sought to manipulate market expectations of future short-term interest rates up to several years from the present. In his subsequent protestations of innocence for the bubble Greenspan has stubbornly blamed inappropriately low long-term interest rates on excess savings in Asia. He does not countenance the possibility that the low level reflected his determination to hold the rise in short-term rates to a glacial pace amidst his and (then) Bernanke's dire warnings about the need to avoid "Japan-style" deflation.
Bernanke has taken the manipulation of longer term interest rates to a new pitch. By exhorting Congress in late 2008 to pass legislation allowing the Fed to pay interest on reserves, monetary base has been displaced effectively from the pivot of the monetary system.
Short-term money rates are fixed in accordance with how Bernanke and his colleagues view the present and futures state of the economy. They are not inhibited by modesty from mapping out the path for short-term rates stretching into the medium term to achieve its so-called "dual mandate."
In part towards impressing the market-place that this path will remain flat as far as the eye can see, there have been two campaigns of quantitative easing. Now we have "operation twist" to influence downwards the market determination of long-term interest rates. One wider purpose has been to generate such a famine of interest earning opportunity as to drive investors into equities and lower the so-called equity risk premium.
Driving capital market rates away from the hypothetical equilibrium level (economists describe this as "neutral level"), which in principle markets have a better chance of discovering than Federal Reserve officials, is an enterprise strewn with danger. The hazards should be only too obvious to contemporaries who have witnessed the global credit bubble of the last decade and more recently the Fed-magnified speculative temperature rise across the emerging market and commodity market universe. Contemporaries have re-learnt the famous observation of J.S. Mill so fondly repeated by Milton Friedman that, "if the machinery of money gets out of control it becomes the monkey-wrench in all the other machinery of the economy."
J.S. Mill had more in mind than Bernanke's inflation target being missed! Rather a key symptom of monetary disorder is the extent of irrational exuberance present across a spectrum of credit and asset markets. In fact J.S. Mill would never have recommended inflation targeting or have endorsed the deflation phobia which has gripped modern central bankers. Fluctuations of the price level through time both downwards and upwards along a long-run flat trend are an essential mechanism of the economy achieving and re-achieving economic balance through time.
U.S. monetary reform and the future of the Fed loom large in the 2012 election campaign. It would be a great pity if the U.S. squandered this historical opportunity to have a true reckoning with the failures of its monetary past and to appreciate the economic renaissance which could flourish once the money and capital rate fixers are banished from their control towers.
Brendan Brown, author of The Global Curse of the Federal Reserve, is executive director and head of economic research at Mitsubishi UFJ Securities International plc, in London.
