The Fed and its Role in the Economy: No Conspiracies, Just Bad Policy

In the comment section of my last post, one of my critics identified as JG made a point that I believe truly highlights the differences between Keynesians and the Austrians:

@ Anderson,"The Fed wants to drive money toward those assets by keeping their prices artificially high..."

Is that really what the Fed's goal is? To keep prices high? Do you really believe that QE is really a conspiracy to inflate MBS prices?

Someone less given to conspiracy theories would assume that the Fed was buying MBS to maintain liquidity in the financial system to faciliate lending during a time of weak demand.

True, the commenter was trying to lump me in with conspiracy theorists who seem to believe that the Fed principals conspire to wreck the economy and that they know exactly what they are doing and that is part of their dastardly plan. Now, I would agree that a bad economy in which an increasing number of people become dependent upon the government is good for President Obama in particular and the Democratic Party in general, especially if people come to believe that their state of dependence exists because the government is not taxing others enough or if businesses are conspiring to destroy the economy. We certainly see a lot of that from the Democrat/Keynesian camp, which is not without conspiracy theories of its own.

If I might use somewhat simplistic  models that I believe do reflect the differences in thinking between Keynesians and Austrians, the differences are portrayed as followed:

Keynesians: They believe that a market economy is internally flawed and will hurdle toward underconsumption at every turn. Their underconsumption lynchpin (wild swings in private investment, depending upon the "animal spirits" of investors) differs from that of the Marxists (capitalist profits suck the purchasing power from the proletariat, which leads to internal collapses of capitalist economies), but the results are similar.

For example, the housing boom and bust was a product of a pure, unregulated (by government) market in which none of the government agencies had anything to do with the crisis, except that the animalistic capitalist spirit so infected every regulatory agency that none of the regulatory agents -- even those who had perfect foresight (since most government agents are blessed with such foresight if they are performing under a regime run by the Democratic Party) -- did anything to stop it. The capitalists refused to read any price signals and led the economy into the abyss, as pure, unregulated capitalism always does. Had government agents been properly regulating the directing the housing market, it would have performed perfectly.

The Keynesians believe that capitalists do not respond to price signals (which are overblown, anyway, since an actual economy does not replicate the mathematical models of perfect competition), and that prices are useful mostly in their aggregation into various price indices, which themselves are statistics, not points of economic analysis.On the production side, market economies are prone to slide into the scourge of being overrun by monopolies, which create income inequality when then exacerbates the downward slide even more. Thus, without government oversight, and without the presence of a central bank like the Fed along with various government spending mechanisms, a market economy will implode into a miserable abyss of high unemployment and underconsumption. If there is deflation -- which always looms within a market economy -- then the system automatically will plunge into depression and stay there, since in the real world, entrepreneurs don't respond to price signals, anyway.

The important point here is that the Fed, along with the government agencies, exist in order to respond to private market failures, which the capitalists create on their own, with capitalist failures always being systematic. The Fed and the government, then, do not create conditions that lead to mass unemployment (unless someone at the Fed believes in Austrian theories that will make the central bank raise interest rates and choke off aggregate demand), but rather exists to offset those private market failures.

I believe this has been a fair interpretation of the Keynesian position. I now turn toward the Austrians.

Austrians: They believe that market economies are internally stable, and that government interventions, such as the ones made by the Fed, not only are counterproductive but actually help cause the downturns in the first place. No one is blessed at any time with "perfect information," but a price system actually sends the information that entrepreneurs and managers need to make production and exchange decisions regarding the future. Not all people respond properly to price signals, but the errors tend to be random, not systematic.

Intervention by government is harmful because it creates perverse incentives and directs production away from lines that are sustainable into those lines of production which are not. For example, far from being a free-market failure, the housing boom occurred because government in the form of the Federal Reserve System and the various government agencies that are tied to housing engaged in activities that directed investment and spending toward housing in amounts that could not be sustained. Not only did the Fed push down interest rates that encouraged more home buying and refinancing than what would happen in a normal market (without the intervention), but government agencies especially aimed their programs toward the "sub-prime" market in which were created vast amounts of mortgage securities that sold at prices well beyond what would have been the case had the government not been targeting housing in the first place.

Now, it was Wall Street, with its politically-connected banks and financial houses, that created many of these securities (Freddie and Fannie being the other two entities) but one must remember that these banks did not act within the structure of free markets. Instead, their principals acted knowing that the infamous Greenspan/Bernanke "Put" existed in the background, and that even though the mortgage securities certificates clearly stated that they were not guaranteed by the government, in essence that was a mere formality, for the government stood by to do just that: bail out Wall Street.

The point that Austrians emphasize is that without the government intervention and the promise of bailouts, the banks would have been much more likely to have followed the price signals that the markets were sending and not have marched over the cliff. Government here was not an entity that followed in the wake of private disasters in order to clean up the mess, but rather government was actively taking part in creating the mess in the first place.

As for the post-crisis mess, Austrians believe that since government interventions set the stage for the collapse, doing more of the same will not rescue the economy. In fact, it simply continues the same mistakes that occurred in the first place.

In response to the comment that I see Bernanke's purchases of mortgage securities as some sort of sinister plot to undermine the recovery, that is nonsense. My criticism is not of Bernanke's motives, but rather his actions. He is not "preserving liquidity" or anything like that; instead, he is propping up securities that markets already have rejected and continues to direct resources into lines of production that are unsustainable.

Keynesians counter with the "idle resources" argument that states that in a depressed economy such as ours, there are "idle resources" that are made idle by a lack of aggregate demand. When government resorts to what essentially are financial tricks such as the Fed purchasing securities, it is doing nothing more than engaging in unorthodox actions that are needed at this particular time because of very specific conditions that for the most part don't exist, i.e. the "liquidity trap." Without those actions, the economy will plunge into the abyss of a miserable, high-unemployment steady state in which we will be mired forever.

The Austrian response is that many of the "idle resources" are idle because they were malinvestments. The market does not support them because the patterns of purchasing and preferences shown by consumers do not and cannot keep those resources unemployed. Instead, entrepreneurs guided by price signals and interest rates (that follow a natural rate of interest, not something set by the Fed) will move resources from lower to higher-valued uses.

At the base of the thinking, I believe we can say the following: Keynesians believe that a market is not self-correcting in the event of a downturn, while Austrians believe that it is. There really is no middle ground between the two lines of thinking, which is why we see the kinds of responses we observe on this blog and elsewhere.