Does the Fed set interest rates?

The short answer to this question is "no".  Listen to this episode for details.

The Federal Reserve Bank (the "Fed") stands as an example of the collateral messiness, and the distortions, that inevitably accompany intelligent design projects.  In this episode, Rik from Planet Vulcan explains why the Fed has always failed, and always will fail, in its mandate to stabilize prices; and why, rather than containing systemic risk, the Fed has itself been a major SOURCE of systemic risk.

Transcript

The Federal Reserve – Who Needs It?

 Good day to you, and welcome to Fascinating!  I am your host Rik, from Planet Vulcan.  My ongoing mission on Planet Earth:  to plant seeds of a way of thinking, a way that is based on an understanding of evolutionary processes, with the ultimate aim of helping to sustain and increase the momentum of Earth’s long arc towards prosperous and happy societies, based on ideals of liberty and justice.

 I read yet another news story recently which stated that the Federal Reserve had “raised interest rates in an effort to fight inflation”.  Stories about the Fed raising and lowering interest rates abound in the popular press.

 Interest rates are the price of credit (not to be confused with the price of money), and the price of credit, like any price, is determined by supply and demand, and not by anyone in a position of authority.

 Why then do Fed economists claim to be “setting” interest rates?

 Let’s take a step back, take the Vulcan’s-eye view, and put America’s Federal Reserve Bank (the “Fed”) in perspective.  This exercise should shed some light on why Earthlings are routinely told that the Fed “sets interest rates”; and some light on other things as well.

 The Federal Reserve System is part of an elaborate intelligent design scheme.  The Fed was created as a national central bank by act of congress in 1913, with the intention of “doing something” to mitigate financial panics, following the Panic of 1907.  The hope was that a central bank would help to provide a more stable economic framework.

 The original legislative mandate gave the Fed limited abilities to increase or reduce the growth rate of the money supply; to supervise banks; and to act as a “lender of last resort” to banks which have a healthy balance sheet, but which become technically insolvent, i.e., short on liquidity, due to bank runs.

 The current mandate gives the Fed broader abilities to increase or reduce the growth rate of the money supply, with several occasionally-conflicting guidelines:  1) to promote full employment; 2) to stabilize prices; and 3) to “contain” systemic risk.

 We should note that the US did not have a central bank during most of the 19th century, dating back to Andrew Jackson’s refusal to renew the charter of the Second Bank of the United States in 1832, so no one can argue that having a central national bank is an absolute necessity.

 Surprisingly to many, but not surprising to anyone with a deep understanding of natural processes, it was mostly order and not much chaos which emerged following the cessation of the bank’s operations in 1836.  Economic growth overall when there was no central bank was robust.

 There were, however, a number of serious but short-lived financial panics during the period from 1836 to 1907.  The average duration of these panics was six to twelve months, typically accompanied by economic dislocations that would take a few more years to settle.

 And although you can find many facile explanations of the causes of these panics, most of these explanations make little sense.  Earthlings in general did not then, nor do they now, have a convincing explanation for business cycles.  

 Most earlier explanations of booms and busts focused on speculation as a major cause, which was pure ecnarongi, because speculation in general routinely contributes to stability and efficiency, because it means that risk is borne by those most capable of bearing it, and provides those who are more risk-averse with the opportunity to offload risk by hedging.

 Ecnarongi is “ignorance” spelt backwards, and refers to believing things that are not so.

 The panics were always accompanied by bank runs, a genuine problem, which can disrupt the operations of even the sound banks, due to insufficient liquidity of the typical bank’s assets.  

 Insufficient liquidity is always a potential problem for any business when you have long-term assets, mortgages in the case of banks, financed by short-term liabilities, such as deposits in the case of banks, which can be withdrawn on demand.

 The Federal Reserve Act of 1913 instructed the Fed to act as a lender of last resort, but following the stock market crash of 1929, they failed to do so and thereby allowed hundreds of sound banks to fail.  

 The Fed board of governors at that time was dominated by those who subscribed to the usual tired ecnarongi about the evils of speculation.  The simple, easy-to-understand narrative was that speculation had caused the crash and the crash caused the depression.

 The Fed’s failure to carry out the lending mandate clearly made what is now called the Great Depression far more severe and far lengthier than it would otherwise have been.

 So the first major challenge faced by the Fed resulted in less stability, and not more.  Far from containing systemic risk, Fed intervention was actually a source of systemic risk.

 The devastation of the banking industry was the second part of the double-whammy that devastated the US economy, the first wham being the passage of the Smoot-Hawley Tariff Act in 1930, another intervention that proved to be an enormous source of systemic risk.  It is likely that the expected imminent passage of this act played a major role in the 1929 stock market crash, due to anticipation of what the tariffs and the accompanying retaliation by foreigners would do to international trade.

 All things considered, the Fed has done probably as good a job as any central bank could reasonably be expected to do during its existence.  Faint praise I suppose, but accurate.

 The Fed has frequently failed in its mandate to stabilize prices, but that’s no surprise when the government faces continual temptation to spend lavishly and fund the spending with newly created money.

 Another serious blunder in the operation of the Fed, almost as serious as its failings in the 1930’s, was the initiation of the too-big-to-fail policy in the wake of the collapse of the Continental Illinois Bank in 1984 (for a deeper discussion of this topic, see the Season 1 episode, “Blame it on the Bankers”).  The fear was that the collapse of a large institution might cause ripple effects throughout the financial markets that might be damaging and destabilizing to the entire economic system.

 The effect of instituting this policy, far from creating greater stability in the financial markets, was to undermine natural market discipline and incentivize excessive risk-taking, which is the core reason why a financial market crisis occurred in 2008; which is not to say that there were not other policy mistakes which contributed to that shitstorm. 

 Anyone with a functioning brain ought to be able to see that telling the managers of financial institutions that you won’t let them fail fatally undermines the discipline that would naturally emerge in a market where the prospect of failure exists.  

 I suspect that some promoters of this policy were in truth aware of the perverse incentives they were creating, but they believed they could compensate for it by intelligently regulating the behavior of market participants. 

 I suspect that other promoters of this policy were never not in support of any policy that would expand their authority, and all they needed was an excuse.

 Incredibly, the Fed was able to avoid accountability for its near-catastrophic failure by blaming the crisis on the greediness of bankers, and not only to avoid accountability, but also to gain deeper and broader authority to regulate in the wake of the disaster they had caused! 

 A clear instance of one of those times when it is possible to fool all of the people some of the time.     

 The too-big-to-fail policy, still in effect and being ever more broadly applied, is intelligent-design thinking at its worst.  

 The expectation that this policy will be followed allows both financial managers and regulators to take a nonchalant attitude toward risk, as we witnessed recently with the failure of the Silicon Valley Bank in 2023.  And in that case we are witnessing the usual boring pro forma routine where they are trying to close the barn door after the horse is already out, by threatening the former managers of this bank with criminal prosecution.

 But enough about the shifting arrangements of the deck chairs.  

 There is a deep-seated problem that continues to haunt Earthlings, which is the commonly held belief that such intelligent-design projects can actually work, and for many a belief that there is no practical alternative to intelligent design.

 But what would have happened if the current incarnation of the US central bank had never been created?

 The biggest problem during the era without a central bank (1836 – 1913) was the financial panics and associated bank runs.  Could this problem have been dealt with by financial market evolution?

 It most certainly could have been dealt with, and much more rationally and effectively than it has been dealt with by oversight and intervention - with an evolved system of true deposit insurance, rather than what now exists, which is deposit guarantees, and the existence of which has preempted the evolution of such a market.  

 Deposit guarantees have been effective in ending bank runs, but there have been unintended consequences, which there always are when you systematically deny reality.  The risk that is covered by deposit guarantees does not just vanish – that’s impossible – it is just shifted to others, i.e,  taxpayers.

 True deposit insurance would be priced based on risk, and would work even better in the long run than the deposit guarantees now in effect, in which risk is dealt with by magic-wand waving and pious pronouncements.

 And we ought to reiterate that price stability was an outcome that was actually achieved during the era without a central bank, under the gold standard, and that the general price level in America under the management of the Fed has continuously, and sometimes quite rapidly, increased.

 American Earthlings have a system that is held together with Scotch tape, chewing gum and baling wire; it ought to be obvious that it is not sustainable, and that an evolutionary approach to meeting the challenge of instability will be more effective than this intelligent design approach.

 It's difficult to imagine a smooth transition to what eventually must be, which is an end to central banking.  

 A promising solution, at least from a technical point of view, is what are referred to as cryptocurrencies which are under no one’s control, and which have an automatic feedback loop which limits the creation of new money, such as in Bitcoin mining, in conjunction with blockchain technology.  

 This solution is not quite so promising from a political point of view, due to desperate authoritarian measures the operators of the current system will no doubt resort to, and are beginning to discuss, in an effort to hang on to their outmoded roles.

 The stakes are high from the point of view of interveners and intelligent designers.  Let us not forget that the power to create money from thin air allows governments to support spending without having to collect taxes.  

 If you or I did this, we would be legally guilty of the crime of counterfeiting.  When the Fed does it, it is still counterfeiting – it is just not a crime.

 I would like to spend a little more time discussing the goings on in the world of a government-operated central banking system, and the role of Keynesian economists in advising policymakers.

 Let’s return to the news stories about the Fed “setting interest rates”.  Why don’t the news stories talk about what the Fed actually does, which is to control the growth rate of the supply of fiat money?  They can slow it down, speed it up, or hold it steady.  And that’s it.

 It seems that the Keynesian economists who serve as advisors and administrators of Fed policy think of themselves as a kind of priesthood.  They believe that their knowledge is so esoteric that just plain folk need to have it digested for them and regurgitated in a form their inferior intellects can handle.

 They excuse what might reasonably be taken for obfuscation and misdirection in their words by saying things like, interest rates are more tangible and relatable for the non-experts; if we tell them what is really happening they won’t understand it.

 I don’t suppose the true reason might be that they are trying to project an aura of power and control by claiming to have abilities that are actually beyond them - beyond anyone, for that matter.

 If asked, they will actually tell you things like, “If we were to tell the public how truly limited our influence is, and how ineffectual we actually are, it might lead to a lack of confidence”.

 Saying "the Fed sets interest rates" creates the impression of control and decisiveness, which supports the narrative of the Fed as a powerful institution effectively managing the economy. Discussing the complexities of credit markets and money supply could undermine this perception.

 As if “confidence”, in the abstract, is an unalloyed good, and it doesn’t matter whether the confidence is justified or realistic!  In the eyes of policy makers, it is something that just floats free.  In their world, an ounce of image is worth a pound of performance.

 If the public were told explicitly that the Fed merely "tinkers" with tools like the money supply, or influences rates indirectly, it could raise doubts about the Fed’s ability to manage inflation, stabilize the economy, or address crises.

 Smoke and mirrors, in other words.

 Furthermore, obfuscating the Fed’s role in the credit system helps avoid scrutiny of the larger financial system and the Fed’s relationship with private banks. If the public fully understood how money creation benefits banks or how policy often upsets financial markets, it might lead to demands for reform, or alternative systems.  Indeed!

 Good luck, Earthlings.  You’re going to need it.

 I invite you to have a listen to the next Fascinating! podcast and a look at the next video on our YouTube channel.  You can find access to all podcasts and videos on our web page, fascinatingpodcast.com.

 Please recommend Fascinating! to your friends if you find the lessons from nature in these essays personally valuable.

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