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Affluent Investor | March 23, 2017

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The Fed is Flummoxed – Austrian Economics Has the Cure

Washington D.C. - Federal Reserve

Washington D.C. – Federal Reserve

Late last month the Wall Street Journal printed a report card of Fed activity for the new millennium. The writers think the Fed failed most of its curriculum.

“In the past decade Federal Reserve officials have been flummoxed by a housing bubble that cratered the financial system, a long stretch of slow growth they failed to foresee and inflation persistently undershooting their goal.”

Part of the Fed’s problem is that it believed the media’s hyperbole about former Fed chairman Greenspan, referring to him as the maestro during the “Great Moderation” of the decade of the 1990s. Fed officials didn’t comprehend that the mainstream media is very socialist and will grossly exaggerate every apparent success by a government agency. The Fed and most mainstream economists took the praise from the media to heart and began to believe they were invincible. They even announced that they had slain the dragon of business cycles. Meanwhile, Austrian economists warned that the corpse resembled a wind mill more than a dragon.

Now the Fed is slightly humbled so this could be a teachable moment. Just kidding. You can’t teach old dogs, bankers or economists new tricks. You just have to wait for them to die and hope the new generation will be more teachable. But in a fantasy world in which scientism had not disfigured field and made economists immune to reason, the Fed would consider the following points:

Ditch Ferbus. Ferbus (FRB/US) is the nickname for the Dynamic Stochastic General Equilibrium model the Fed employs as a Greek oracle to explain the economy and predict its future gyrations. But Ferbus has no connection to reality. Olivier Blanchard wrote a very mild critique of such models recently with the title “Do DSGE Models Have a Future?” The criticism is so mild that it could be seen as merely a backhanded compliment. The Fed knows the models are horribly wrong.

The WSJ article mentioned above said of the model, concerning the debut of the latest recession, “The model showed the economy could weather a 20% drop in home prices with small increases in unemployment and modest cuts in interest rates.” Wrong. Still, the Fed clings to their models as some of us cling to our guns and God, to paraphrase POTUS.

What’s really wrong with Ferbus is that she lacks an understanding of the variety of capital and any concept of the passing of time. Her fathers have kept her a virgin by hiding from her the existence of entrepreneurs. She has no grasp of microeconomics in spite of the charade that her inventors try to keep up. The only thing she can tell her devotees is that interest rates, employment and GDP have vague relations with each other in the long run.

Another suggestion for the Fed: buy yourself a good business cycle theory. Exogenous shocks knocking an economy out of equilibrium like a linebacker blitzing a rookie quarterback just doesn’t get the job done anymore. Austrian economists have a good one that has served us well for 150 years.

Look at history. The UK and US economies recovered from depressions quickly before the birth of the Fed with no help from a central bank or stimuli from the state. Mainstream economics says that’s impossible, but history is stranger than economic theory. Even the Bank of England had to admit in its 2011 paper, “Reform of the International Monetary and Financial System,” that the gold standard era before the Great Depression had far fewer financial crises than the current floating exchange rate regime.

Study the recessions of 1981-82. They were just six months apart and should be considered one, in which case it would have been as severe as the recent “Great Recession.” The Fed never lowered interest rates and Reagan offered no help from the feds, yet the recovery that followed was one of the most robust in history.

The Fed is confident it can keep the US out of a ditch like that Japan has trudged through for the past generation. But that confidence doesn’t come from any insight, tools and wisdom. It’s just plain arrogance. American economists always think they can succeed where everyone else has failed because, well, they’re Americans. But the next recession will extend zero interest rate policy a decade longer.

Hayek demonstrated in his book, Profits, Interest and Investment (1939) that if the central bank kept rates artificially low during an expansion then profits would do the work of interest rates. Peak profits last year initiated the end of the boom and it’s only a matter of time before the stock market catches on.

Originally published on ABCT Investing.

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