It's an Economy, Not a Machine

Sheldon Richman

The Dow dropped almost 150 points on a single day a few months ago at indications that the Federal Reserve, the nation's central bank, may raise interest rates if the economy doesn't "slow down." Concerned officials there had been expecting a slowdown, but they couldn't discern the hoped-for signs. The Wall Street Journal said that "Fed officials are beginning to prepare markets for a Fed move to brake the economy-unless it slows on its own soon."
This is all perfect buncombe.
Memo to the Fed: It's an economy, stupid!
An economy is not a vehicle speeding downhill or a machine overheating. It's an economy, a network of markets. An economy is people-human beings planning and acting to improve their lot. They transform resources from less useful to more useful forms and exchange with each other. If they think they are moving too fast, they will slow themselves down or rest. If they get overheated, they will switch on the air conditioning or take a shower. There's no need for the government to fret.
Words like "slow," "fast," "brakes," "overheating' " and "cooling down" are out of place when we talk about economic matters. Such thinking lends support to the central-planning mentality. Vehicles have drivers. Machines have operators. But an economy does not have-and cannot have - either a driver or an operator. I'd have thought we'd learned that by now.
Central planning in the U.S. economy? Where? Leaving aside the Antitrust Division, which is intent on centrally planning the computer software industry, and a few other government agencies, the biggest would-be central planner in the U.S. economy is the Fed. Central banking is the central planning of money. Isn't it odd that a country which, rhetorically at least, condemns economic planning as socialism engages in monetary socialism?
The government controls the means of production of money, a rather important element in the marketplace. Believing that a few people can determine the proper interest rate is like believing they can determine the proper price for bread or cheese. An interest rate is a price for the use of someone else's money Left to the market, it reflects the intensity of people's preference for having money now versus having it in the future. Since people prefer having things now, if you want to borrow money, you must be prepared to pay a lender something extra in the future. How much more depends on people's time preferences. Supply and demand set an economy wide rate of interest.
In a truly free market, no one decrees an interest rate, because the money supply is not controlled by government. The market itself generates money; it might be gold or a combination of things that is stable and valued generally. We would expect competition among currencies. In the approaching world of electronic commerce, there will be monetary innovations no one has yet dreamed of.
The best money is the one the market comes up with, because it will be convenient and responsive to people's preferences. That's the nature of entrepreneurship. Government currency is always subject to political manipulation, which means disruptive inflation or deflation. The Fed over the last several years has largely, but not always, kept the growth of the money supply tight. But we can never rest while any political institution controls the printing-press switch.
Why the fear that the economy is "moving too fast"? The standard reply is that too vigorous an economy will bring inflation, a general rise in prices. But only the government causes such inflation. It does so by expanding the supply of money or credit, as it has done recently. If the expansion occurs at a faster rate than the increase in goods, prices will rise. More dollars are chasing a relatively "too small" supply of goods. The price rise is not likely to be uniform. Since the new money and credit will enter the marketplace at particular points, some prices will be bid up sooner or more intensively than others.
The policymakers prefer to blame us, instead of themselves, for inflation. They think inflation can result from rising consumer demand, which translates into a higher demand for workers and higher wages. But that can't lead to a general rise in prices. If there is no increase in the amount of money, consumers can't afford to spend more across the board. They will have to cut their purchases of some things just to maintain their former level of consumption of other things. That will cause some prices to fall.
Moreover, rising wages wouldn't perforce cause prices to rise because a business's costs do not determine what it charges at the cash register. A consumer doesn't care what an item costs its manufacturer or retailer. He cares about only one thing: is the item worth what he has to give up to obtain it? If $10 is asked for necktie, it's not $ 10 that a buyer ultimately gives up, but whatever else he would have spent the money on. Competition among sellers prods each of them to keep prices down. Potential competition does the same for those sellers who have no actual competitors at a given time.
The upshot is that inflation is a creature of the state. In a system of free banking, competition would tend to restrain the unjustified expansion of currency. We get distracted from the real issue if we go off looking for culprits in the private marketplace.
It's time the Fed and its advocates dropped their pretensions. Central bankers do not know what the interest rate should be. Further, the bank cannot control economic activity by manipulating the interest rate. Oh, it can mess things up if it were to engage in wild and erratic conduct. But it is wrong to think that it can "steer" the economy by changing interest rates. Today's markets are sophisticated and fast. Information travels at the speed of light 24 hours a day, seven days a week. Money watchers, having learned from experience, glimpse the signs of policy changes early and translate them quickly, if imperfectly, into price adjustments. Capital can flee countries as never before. The Fed can't predict the effects of its policies on people, each of whom alone knows his peculiar circumstances, needs, and aspirations. As economists J.W, Henry Watson and Ida Walters write, the Fed is like a child with a toy steering wheel on his car seat. There is an illusion of control "but the steering wheel is not connected to the drive train."
Henry David Thoreau wrote that "government has never furthered any enterprise but by the alacrity with which it got out of the way." The Fed may have behaved well for much of the recent past. But it is an intrinsically interventionist creature, and Fed chairmen come and go. The same Fed that can avoid inflation can also set off a great depression. It would be better if our economic wellbeing were not dependent on a particular person in a particular office.

At the time of the original publication, Sheldon Richman was editor of The Freeman.

Reprinted with permission from The Freeman, a publication of The Foundation for Economic Education, Inc., September 1998, Vol. 48, No. 9.