Rothbard - The Case Against The Fed key question

Economics Economics Questions
1

So I just finished reading Rothbard’s “The Case Against The Fed” and I thought it was good in many ways but lacking in a few areas. There was much more history than I was expecting (which was good) and much less talk about destructive business cycles and their causes than I was expecting and hoping for.

There is one thing in particular that I am confused about and I hope that we can answer it here. So I understand that the austrian theory of the business cycle essentially says that if central bank interest rates are held down below where the market would naturally set them an artificial boom and a bubble will develop. The longer the interest rate is held artificially low - the longer the boom will last and the larger the potential bubble will be. This obviously leads to the inevitable bust that is the cure for the malinvestment that was made during the boom.

My question comes here. Rothbard, after hardly mentioning the austrian theory of the business cycle in his book, says on page 144 that “in addition to reserve requirements and open market operations, there is the Fed’s discount rate, interest rate charged on its loans to the banks. Always of far more symbolic than substantive importance, this control instrument has become trivial, now that banks almost never borrow from the Fed. Instead, they borrow reserves from each other in the overnight “federal funds” market.”

This is the only time that he mentions the interest rate that is set by the Fed. Is it not this “discount rate” that causes the boom and bust cycle of the Fed? Was it not this rate being set too long during the early 2000s that caused the housing bubble? Why does Rothbard brush aside this key interest rate that I thought was of such great importance to the boom bust cycle? Am I misunderstanding something here?

Any thoughts?

2

I believe you are talking about the federal funds rate, which is the rate banks charge each other for loans. The Fed buys bonds from banks, banks have more money, va la lower federal funds rate.

The Discount rate is what the Federal Reserve charges banks for loans directly from the Federal Reserve. It isn’t used that much anymore because (in my opinion) its harder to control the U.S debt that way, and the money supply, since banks don’t have to take the bait, in addition the Fed discourages perpetual indebtness to itself. With open market ops, the Fed can buy/sell bonds and can manage the Money supply and the banks easier.

3

Ahh, ok. Thanks for replying. It’s making more sense to me. So when many austrians and free market economists discuss “historically low interest rates set by the fed that inflated the housing bubble” they are refering to the federal funds rate? So the Fed does not actually set this rate directly, correct? It sets the interest rate indirectly by buying bonds and giving banks more money and therefore indirectly causing banks to lower interest rates?

4

right, they have interest rate ‘targets’ that they try to achieve by the manipulations mentioned previously.

5

James,

Here is my version of it:

The mere existence of the Fed enables the banks to practice Fractional Reserve Banking, whereby the banks can lend out many times over the amount of real savings that have been deposited by individuals. If the reserve requirement is 10%, then the supply of credit available by the banks is 10X the real savings. The interest rate that is set by the banks is then according to the supply of artificial credit which is 10X the savings. Obviously, the interest will be lower.

To further exacerbate the problem, the Fed also pumps money into the system by the various methods that Rothbard describes in the book: discount rate, open market transactions, and reserve requirements. This money is then used as new reserves for the banks for which they can again pyramid on top. In this way, the Fed (or any other central bank) can continue the credit expansion for much longer.

Greenspan lowered the discount rate to 1%. I assume that this means that the Fed pumped in a lot of money into the system. Whether it was the discount rate per se, or open market operations, is not very important. The 1% means that money was pumped into the system.

I would think that this is why Austrians like Peter Schiff and Ron Paul point to the Fed’s interest rate.

I would think that because the public is ignorant, explaining the real reason why the interest rates are artificially lower is futile. Also, many people (including economists) simply refuse to understand or accept that credit must only come from real savings. It’s as if they think that individual time preference is not important or something. They never stop to realize how absurd all of this is. If you can create credit out of thin air, then why do we have to save at all?

6

I think there might be one piece of the puzzle that you are missing.

This might refer to the federal funds rate, but it could also refer to the fact that the federal reserve indirectly lowers interest rates through its Open Market Operations. When the Fed buys T-bills from the banks, this increases the banks supply of money thus decreasing the price for interbank lending (i.e., fed funds rate goes down) but it also creates extra money for the banks to loan out to its customers. In order to reach more customers, the bank must lower its interest rate, its lending standards or both.

So Austrians may be referring to the historically low 30 year conventional mortgage rates (just above 5% i believe) that resulted from the 1% federal funds rate.

Hope this helps a little.

7

I just finished the same book, just today. I found it complementary to some of his other works.

I think if you go back to the beginning of the work, you may find that inflation is the cause of harsh cycles.What is the Optimum Quantity of Money?

Here is the rest of that footnote…

"Thus the Fed has the well-nigh absolute power to determine the money supply if it so wishes.* *Traditionally, money and banking textbooks list three forms of Fed control over the reserves, and hence the credit, of the commercial banks:…

"

The works I have read that fit in with this book are…

Wall Street, Banks, and American Foreign Policy

A History of Money and Banking in the United States: The Colonial Era to World War II

America’s Great Depression

What Has Government Done to Our Money

I’m about to start The Mystery of Banking.

I am sure that if you continue to read more, you will find that government creates many deprivations on society.

I hope that you don’t become discouraged.

“All booms must end in busts”

Kind regards

Post Script: I forget to mention that interest is just when it is free. There should be no fixed rates determined or cartelized, by government or churches, etc. The rate of interest is the value placed on goods today verses goods in the future.