Friday, October 31, 2008

Why rate cuts are failing

An interview with Frank Shostak six years ago provides some answers. At that time the Fed had just lowered the Federal Funds rate to 1.25 percent. This week, the Fed cut the same rate to 1 percent.

Shostak:
While the Fed is going to do its best to inflate the money, it can happen that money supply won’t increase - depending on the behavior of banks. If banks stop lending, due to tighter credit standards or fewer borrowers, the money supply will not respond. This is what happened in the 1930s.
And why doesn't the Fed reduce rates to zero? Shostak:
The worry is that this would produce panic. It would underscore the reality that the Fed is incapable of producing wealth from its printing press. It would show that the Fed is completely powerless, except to produce mis-signals that generate malinvestment. The only thing that might temporarily move is the stock market.
Yet some people say the Fed chairman is the most powerful man in the world. Isn't he supposed to have the ability to get the economy growing again? Shostak:
. . . this reminds us that this powerful man only has one tool at his disposal: printing money. And this tool only creates an illusion. One cannot create real wealth by printing money. If printing money could create wealth, there would not be poverty in the world today. Every third world country could print money and become rich. There would never be a recession. We would have perennial wealth creation with no effort.

You can pump all the money you want but it does not create anything; it only destroys. It creates a misallocation of resources, consumes capital, and makes everything much worse.
If the Fed is creating more money with its interest rates cuts, why haven't we seen a more dramatic rise in prices? Shostak:
Prices have not responded because businesses do not have pricing power. The reason is that people don’t have as much real income as they used to have. If you don’t have the means to spend, it is hard for business to raise prices.

There would be price inflation if people were spending at the same level as they used to. When production is falling, those who produce have less means of payment. We are looking at a snowball of downward pressure.

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