What The Fed Should Do Now——-Get Out Of The Way!

By RAND PAUL and MARK SPITZNAGEL for The Wall Street Journal

The recent tumult in U.S. equity markets has prompted many analysts to urge the Fed to postpone any increase in interest rates. This advice assumes that rock-bottom interest rates are balm for a weak economy, with the only possible side effect being price inflation. Yet it is the Fed’s artificially low interest rates that set up the economy for the 2008 crisis, not to mention previous crises.

The “doves” are right to point out that higher interest rates will lead to a repricing of many securities, aka a crash. But years of near-zero interest rates have made this inevitable. Continuing on the current course will only allow structural distortions caused by these interest rates to fester and an inevitable reckoning that will be much worse than seven years ago.

The master fallacy underlying so much economic commentary is to imagine that a handful of experts in Washington should be setting the price of borrowing money. Instead, the Fed should set markets free.

In their theory of business cycles, the Austrian economists Ludwig von Mises andFriedrich Hayek explained several decades ago that artificially cheap credit misleads entrepreneurs and investors into doing the wrong things—which in the current financial context includes making unsustainable, levered investments in risky assets, including companies loading up on debt to buy back and boost the price of their stock. Low interest rates may create an illusion of robust markets, but eventually rates spike, assets are suddenly revealed to be too highly priced, and debt unpayable. Many firms have to cut back production or shut down, unemployment rises and the boom goes bust.

The Austrian diagnosis leads to an unorthodox prescription: Rather than provide “stimulus” to boost demand during a slump, the Federal Reserve and Congress should stand aside. Recessions are a painful but necessary corrective process as resources—including labor—are guided toward more sustainable niches, in light of the errors made during the giddy boom period.

In 2000 the stock market, bloated by earlier Fed rate cuts, started falling when the tech bubble burst. Markets bottomed out in 2002, as the Fed slashed rates. Although people hailed then-chairman Alan Greenspan as “the Maestro” for providing a so-called soft landing, in hindsight he simply replaced the dot-com bubble with a housing bubble.

When the housing bubble eventually burst, the crisis was much worse than in 2000. When Lehman Brothers failed in September 2008, it seemed as if the whole financial infrastructure was in jeopardy. And Fed Chairman Ben Bernanke followed the same playbook: cut interest rates.

When near-zero-percent interest rates did not jump-start the economy, the Fed launched a series of “quantitative easing” (QE) programs, buying unprecedented amounts of Treasurys and mortgage-backed securities. The Fed has roughly quintupled its balance sheet, going from $905 billion in early September 2008 to almost $4.5 trillion today.

The U.S. stock market rose with each new wave of QE. Does this wealth represent genuine economic progress? Economic growth is still far below previous recoveries. Unfortunately, the performance of equities, as well as the unprecedented increase in public and private debt, may be another asset bubble in the making, leading to another inevitable crisis likely worse than in 2008.

At its core, the market economy is a homeostatic mechanism that self-corrects by cleansing mistakes from the system. When policy makers—in the Fed or Congress—try to spare us from all pain, they cripple that mechanism and ironically make the system vulnerable to a major crash.

Consider an analogy. When the U.S. Forest Service took a zero-tolerance approach to forest fires 100 years ago, what ultimately happened was a massive wildfire at Yellowstone National Park in 1988 that wiped out more than 30 times the acreage of any previously recorded fire. Paradoxically, by refusing to allow small fires to run their natural course, the forest managers made the entire park vulnerable to a giant inferno.

What is true of forests holds for the economy: When governments create a lie, whether it’s a fabricated ecology of no fires or a fabricated economy of no failures, the truth reveals itself even more violently than otherwise. Attempts to stop any dips in the stock market with monetary stimulus postpone the necessary adjustments to how and where resources and workers are deployed. Interest rates are a vital signal in the market; they must be allowed to do their job—that is, they must be allowed to be free.

The sooner Fed officials withdraw their artificial monetary injections and let interest rates rise to their natural level set by free markets rather than government decree, the sooner the economy can return to genuine, sustainable growth.

Mr. Paul is a U.S. senator from Kentucky and a Republican presidential candidate. Mr. Spitznagel is the chief investment officer of Universa Investments and an economic adviser to the Paul campaign.

Source: If Only the Fed Would Get Out of the Way – WSJ