Central bankers, academics, and major financial players from around the world convene each year at the Federal Reserve’s Jackson Hole Economic Policy Symposium in late August. The theme of this year’s event—“Fostering a Dynamic Global Economy”—shows precisely how misguided the accepted perception of central bank power is.
Federal Reserve Chair Janet Yellen’s remarks at Jackson Hole began by reaffirming the importance of regulators in keeping the economy from experiencing crisis, and in limiting the severity of negative economic effects. Yellen implied that without the Federal Reserve and institutions like it, the economy would suffer more frequent and more severe downturns.
The notion that the Federal Reserve can enhance the growth of the economy is unsupported by any empirical evidence. The fallacy in the Fed’s thinking becomes clear when one recognizes that in prosperity, it credits the wise planning of regulators who supposedly guided us to wealth, yet in crisis insists even the best efforts of our laws and institutions could not prevent catastrophe. As Yellen said in recalling the events leading up to and including the financial crisis of 2008, “Despite the forceful policy responses by the Treasury, the Congress, the FDIC, and the Federal Reserve as well as authorities abroad, the crisis continued to intensify…”
Never in its history has the Federal Reserve correctly predicted an economic downturn. President of the Federal Reserve Bank of Minneapolis Neel Kashkari acknowledged this on Twitter. Yet, in Yellen’s speech, she stated, “The vulnerabilities within the financial system in the mid-2000s were numerous and, in hindsight, familiar from past financial panics.” If the Federal Reserve can’t correctly predict when the economy will enter recession even when the problems in the financial system are similar to those seen previously, how can it know how to prevent one?
Not to worry, however. Yellen assured the world that regulators will not allow the economy to fail in the same way again, saying: “In response, policymakers around the world have put in place measures to limit a future buildup of similar vulnerabilities.” Has anyone notified her of the unsustainable student loan and automobile loan buildups?
The Economy Is Not a Machine
Yellen continued her speech by again crediting regulators with creating conditions for a strong economy: “Because of the reforms that strengthened our financial system, and with support from monetary and other policies, credit is available on good terms, and lending has advanced broadly in line with economic activity in recent years, contributing to today’s strong economy.”
Yellen fails to recognize the role her institution and fellow regulators played in creating the conditions for economic crisis. The subprime mortgage bubble was a function of government action, not a lack of regulation. It’s specious to claim more regulations would’ve prevented a crisis that wouldn’t have existed if not for regulator involvement.
By guaranteeing loans through Fannie and Freddie, by pressuring rating agencies not to withhold loans from subprime borrowers in the name of diversity, and by holding interest rates artificially low for an extended period of time, regulators dug the pit into which irresponsible homeowners and corporations jumped.
Yellen says she expects “the financial system” to eventually fall prey to “the all-too-familiar risks of excessive optimism, leverage, and maturity transformation,” and her solution is more policy adaptation. The implication is that the default state of the economy is to become increasingly optimistic, eventually resulting in system failure due to speculation. The Fed believes economic growth can become “too hot” due to this optimism, and that too fast an increase in productivity could overheat the economy, resulting in an economic meltdown. The economy requires—using Yellen’s words—forceful policy responses to keep systemic stress levels in check.
But the economy isn’t a machine, and the Federal Reserve can’t control it any more than it can stop the sun from rising. When central banks cause mayhem by creating monetary inflation or attempting to reallocate resources, they burden market participants by forcing them to adapt to an unstable environment. The policy “tools” Yellen believes she has at her disposal—changing the value of the dollar, influencing interest rates, and setting artificial requirements on the amount of capital banks should retain—are not suited for fixing any problems. Fed regulators believe the perfect combination of their actions will optimize economic growth. This “Goldilocks” economic growth fallacy misunderstands how an economy grows.
An economy grows by allowing market incentives to direct savings to successful capital investments, leading to increases in productivity. When the Federal Reserve—or any central bank—manipulates the currency through monetary inflation, it devalues the future value of potential investments, making investing in economic growth less attractive. That is why every case of hyperinflation has led to extreme economic depression. Conversely, monetary deflation causes savings to become overly valuable, creating an undue burden on debtors and stunting incentives that encourage risk-takers to utilize capital.
Contrary to what Yellen and her colleagues believe, the strict regulations government has imposed, including Dodd-Frank, are the reason the economy has experienced subpar growth, full-time jobs replaced with part-time jobs, stagnant wage growth, and a new generation of millennials who are extremely risk averse.
We Deserve a Better Regulator
There is a valid role for regulation in officiating financial markets, but the Federal Reserve shouldn’t pretend to be the champion of economic stability. Sparing unsuccessful market participants from the pain of their mistakes removes a critical component of the free enterprise system. By punishing poor decisions, the free enterprise system is a better regulator than the Federal Reserve could ever be. Unwritten market regulations automatically transfer resources from unsuccessful participants to those more likely to succeed, a more effective and fair form of wealth transfer than any policy Bernie Sanders could concoct.
The Federal Reserve believes its role is to shield market participants from losses. This idea gained traction in 2008 due to large financial institutions supposedly “too big to fail.” Without propping them up, the Fed believed the total damage from their collapse would spread into other parts of the economy. By preventing resources from being taken from unsuccessful market participants, the Federal Reserve did the opposite of what it says its mission is, and ensured that another financial crisis is inevitable.
Yellen closed her speech at Jackson Hole by saying, “if we keep this lesson fresh in our memories–along with the painful cost that was exacted by the recent crisis–and act accordingly, we have reason to hope that the financial system and economy will experience fewer crises…”
The meaning of the phrase “act accordingly” is clear in the context of her speech: Yellen believes increased regulatory power will restrain overly optimistic markets. She hopes the markets will learn from the mistakes of 2008, but when will the Federal Reserve and their fellow regulators learn from their own?
To take just one example of unlearned lessons, the government guarantees student loans and offers loans directly to students. Many of these students have no business taking out the equivalent of a small mortgage to pay for a degree they will never use, with a future income that will barely afford them the ability to repay the loan over several decades. They are the equivalent of subprime home buyers, and they too are encouraged by government to seize the new American dream of a college education.
Yet when the problems resulting from financing 18-year-olds with no life experience and no financial savvy finally reach a boiling point, it will be Yellen—or another like her—who stands up to decry the over-optimism of universities, lending institutions, and students, while sadly missing the real lesson yet again.
