Quoting from How an economy grows and why it crashes : In addition to distorting the credit market by passing laws that favor certain types of loans and certain types of borrowers, government also influences the flow of credit in a more fundamental manner: through its control of interest rates. For almost 100 years, the federal reserve (in theory a private bank, but in practice an extension of the Treasury Department), has set the base level for interest rates upon which the entire rate structure rests. By setting its federal funds rate higher or lower, the Fed (as the bank is known) does not dictate the particular rate any bank offers for every loan, but it does move the entire market up or down. Banks will always charge a higher rate to the public than they pay the Fed to borrow money. So when the Fed raises or lowers its rates, businesses and individuals will pay more, or less, to borrow. The Fed was given this authority in order to keep the economy running smoothly in good times and bad. The theory goes that the collective wisdom of Fed economists could help keep the economy on track by determining the optimal interest rate for any particular moment in time. For instance, the Fed tries to boost a struggling economy by lowering interest rates to the point where businesses and consumers would be more inclined to borrow. In very good times, when overconfidence often leads to foolishness, the Fed is supposed to do the opposite and raise rates so that people will think twice about taking out loans. This system has two massive flaws. First, it assumes that a small group of people at the Fed can make better decisions than millions of people making independent decisions (also known as the marketplace) about the proper level of interest rates. But, the Fed has no skin in the game, as the saying goes. It does not generate the savings and will not suffer if loans go bad. The people saved the money and the banks profits depend on its wise stewardship. Without this connection, lending is inherently inefficient. Second, the Feds decisions are always determined by political, rather than economic, considerations. As low rates tend to make the economy appear better on the surface, push down the cost of servicing mortgages and other loans, and help financial firms make money, there are a great many people who want lower rates. Presidents seeking reelection will always bang the drum for lower rates, and they will pressure the Fed to help out. On their part, Fed policy makers naturally want to be seen as the good guys who help the economy, not the tight-fisted scrooges who push it into recession. The members of society who would favor high rates, most notably the servers, have no well-organized interest group. Their voices are never heard. As a result, there is a consistent bias toward holding rates too low, rather than too high. Remember, low rates encourage borrowing and discourage saving, Not surprisingly, the United States has been transformed from a nation of savers to a nation of borrowers. -Peter Schiff
Posted on: Mon, 30 Jun 2014 01:38:44 +0000
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