The Federal Reserve and Interest Rates

Question - During the current recession, interest rates have been held at historically low rates by the Fed. They use the Keynesian argument that low interest rates "keep credit flowing freely." But it seems to me that the lower interest rates are, the less incentive banks have to give out loans. If this is correct, why is raising the interest rate (or at least leaving it alone) not the answer to getting credit flowing again?

Response - First, it is important to understand precisely what interest rates are. Interest rates are the price for borrowed money. However, this particular price works a little differently from the prices we encounter most frequently (for example, the price on a can of green beans at Wal-Mart, or the price of a gallon of petroleum at the gas station). Prices help allocate resources more efficiently by providing incentives for resources to flow from where they are plentiful to where they are scarce (from where prices are lowest to where prices are highest). As more goods flow in this manner, the price level begins to even out between the two locations.

Interest rates, however, help allocate resources more efficiently by providing incentives for resources to flow from one time period to another. The higher the interest rate, the more it pays to forego spending now in order to spend more in the future - so resources flow from the present into the future. The lower the interest rate, the more it pays to forego saving now in order to spend more now - so resources flow from the future into the present.

Let us assume that I am currently indifferent between $100 right now and $105 one year from now. My effective interest rate is 5%. In order to convince me to part with my $100 right now, you must offer me (at the very least) $105 a year from now. If, however, the majority of potential lenders is indifferent between $100 right now and $107 one year from now, the effective interest rate will be 7%. This is great from my point of view, because I was willing to lend at 5%. If I can get 7%, why should I settle for 5%, right?

This is how interest rates work. The Federal Reserve System does not set interest rates. The Federal Reserve System sets only the rate at which it charges banks for borrowing money from the Federal Reserve. Banks have the ability to borrow this money and then loan it out at interest. If the target rate set by the Federal Reserve is 2%, then the banks have to charge more than 2% interest when loaning out this money to borrowers in order to earn money. In this way, the Federal Reserve indirectly influences the overall interest rate offered by the banks.

However, it takes two to make an interest rate work. If I do not receive an offer of at least 5% (since I am indifferent between $100 now and $105 a year from now), then I will not be willing to part with my cash. I must receive a payment that satisfies the inconvenience of no longer having the cash in my possession as well as the risk I am taking that the loan will never be repaid. If I am not paid for this risk and inconvenience, then I will have no incentive to loan you my money.

Now, to your specific question. Why is raising the interest rate (or at least leaving it alone) not the answer to getting credit flowing again?

The higher the rate is that the Federal Reserve charges the banks for borrowed money, the higher the rate they will need to charge borrowers in order to make money. The higher the interest rate the banks charge potential borrowers, the fewer people will be willing to borrow. In this way, interest rates work just like every other price in the market. The higher the price (interest rate), the lower the quantity (of loans) demanded and the higher the quantity (of loans) supplied - at that price. The lower the price (interest rate), the higher the quantity (of loans) demanded and the lower the quantity (of loans) supplied - at that price. All other things being equal, of course.

Does this answer your question? Please feel free to ask any follow-up or clarifying questions you feel are necessary.

The FDIC

Question - Is the FDIC a good thing? Does its existence cause banks to take unnecessary risks since they know there is a parachute that can be used when they overextend?

Response - In all honesty, whether or not a particular policy passed into law or a particular bureaucratic entity created by the legislature is 'good' depends entirely upon one's personal preferences, agenda and ideology. However, permit me to take a leap of faith and assume that by 'good' you really mean 'efficient.'

Is the FDIC an efficient thing?

It depends.

Is it more efficient than having nothing of the sort in place while simultaneously keeping all the other characteristics of the national banking system intact? Yes.

Is it more efficient than having nothing of the sort in place while simultaneously culling the waste out of the current mess of banking regulations resulting in a free market for banking? No.

The FDIC (Federal Deposit Insurance Corporation) serves as a firewall for the national banking system. Since it guarantees a depositor's account up to $250,000, the incentive for account-holders to initiate a 'run' on the bank in times of economic contraction is severely muted (if not eliminated altogether).

The FDIC was created by legislation signed into law by Franklin Roosevelt in 1933 in response to the massive number of bank collapses during the initial years of the Great Depression. These bank closings created enormous deflationary pressures on the national economy due to the resulting evaporation of available credit. Since banks hold only a fraction of their deposits on hand as reserves to cover withdrawals, the remainder is available to loan out at interest. This, in effect, adds to the available money supply since the depositors are writing checks upon their accounts at the same time their cash is being loaned out. As a result of this fact (called fractional reserve banking), whenever a bank failed, not only did its account-holders lose their funds, but the credit that the bank had extended (effectively adding to the nation's money supply) disappeared. From 1929 to 1933, the money supply in the United States declined by 1/3. The FDIC was an effort by the Federal Government to limit any future threat of similar deflationary pressures in the banking sector.

You may be surprised to discover that not a single bank failed in Canada throughout the Great Depression (and Canada offered absolutely no government deposit insurance). Canada certainly suffered (as the entire world suffered) from the Great Depression, but not the way the United States did. The explanation is rather interesting as well as simple to understand.

Canada's banks had thousands of branches spread throughout the country. So, if the agricultural sector was hit hard, liquid assets from industrial and commercial sector-concentrated branches could be shifted to agricultural sector-concentrated branches and any threat was thus mitigated.

The United States possessed many local and state regulations controlling the number of branches big out-of-town or out-of-state banks could open within certain regions. The goal was to protect smaller community banks from the 'big boys.' The result was the unfortunate (and unintended) consequence of having more banks (than would have otherwise) having all of their eggs in just one basket. So, when a community suffered, the banks felt the pinch and had few opportunities for relief.

If these kinds of regulations were eliminated and the United States banking system were to grow in a similar fashion to the Canadian banking system, then the FDIC would be unnecessary because the banks would be able to take care of themselves in similar times of overall economic distress.

Now, on to the second portion of your question. Does the existence of the FDIC permit banks to take risks they otherwise wouldn't take because they don't have to worry about their depositors losing their money?

No, because whether or not a bank stays in business has to do entirely with its profitability. The bank (as any business) cares about its bottom-line first. If a bank is profitable, then naturally its account-holders will not have anything to worry about anyway.

The only way a bank can be consistently profitable (in a free market, absent government largesse) is if its decisions regarding loan extensions and investments are productive, efficient decisions. Risks must be effectively hedged and managed. Losses will be suffered for inefficient investments and profits will be gained when investments turn out to have been sound. As a result, the 'best' banks will earn the most money, be the most solvent, and attract the most account-holders.

Does this adequately answer your questions? If not, feel free to ask as many follow-up questions as you feel you need to.

The Problem of Increasing Entitlements

Question - Which would more effectively address the problem of increasing entitlement rolls? Should we address making welfare less attractive, ceteris paribus (all other things being equal), or making gains greater?

Response - Government bureaus may do both. Welfare may be made less attractive by decreasing benefits (like limits on what the money may be spent on) and adding costs (like job-hunting requirements). Gains may be made greater by some combination of industry deregulation and subsidized education/vocational training.

Making welfare less attractive is most likely the easiest goal to accomplish.

Deregulation will help improve gains by lowering the cost of entry into a wide variety of fields. However, these fields are currently vested interests for many and, as a result, any attempt to liberate these careers will most likely meet very strong and very vocal opposition. As far as subsidized education/vocational training go, I would much rather see this sort of activity on as local a basis as possible.

Welfare Recipients and The Law of Diminishing Marginal Utility

Question - Are welfare recipients more sensitive to the Law of Diminishing Marginal Utility than the general populace?

Response - I don't believe any one person is necessarily more or less sensitive to the Law of Diminishing Marginal Utility than any other person. The application of the law towards the observation of human behavior (in order to determine what one is doing and why) is not so much an issue of degree of influence as it is one of simple cause-and-effect.

First, I will provide a brief explanation for those unfamiliar with the Law of Diminishing Marginal Utility, or the Law of Diminishing Marginal Returns.

This law states that a person will only consume a good, seek a service or engage in an activity until his utility (satisfaction) is maximized. Once he is sated, he will seek out other avenues to gain more utility. Also, with each unit of the good consumed, he gains less utility than he did from the unit consumed before. For example, if you've been outside on a hot summer day performing yard work, when you come inside and have a cold glass of water, it is refreshing and provides you with a lot of satisfaction. You may desire a second glass, but the second glass does not provide you the same satisfaction as the first. You will stop drinking glasses of water once your thirst is sated. Your utility will have been maximized at that moment with regard to thirst.

Before I directly address the application of the Law of Diminishing Marginal Returns on welfare recipients, I feel I must explain some assumptions economists make about human nature and why people work.

From Adam Smith (Division of Labor) to Ludwig von Mises (Disutility of Labor), the history of economic theory has been founded upon a handful of generally accepted assumptions regarding people. The most important in this case is the assumption that a person will generally seek the most benefit for the least possible effort. Economists believe this is an important motivator for innovation. Every time an easier (more efficient) way of doing things is discovered, wealth is created. Time and energy are liberated from the prior task and now made available for other tasks. One of these available tasks is leisure.

Why do we work? Work must be done for life to be maintained. At the very least, we need food and water, along with clothing and shelter to protect us from the elements. Where does all of this come from? It does not get presented to us from a benevolent Spirit or kind Mother Nature. All of this must be created, built, and/or harvested by the labor of man. Work is necessary. However, if we could be provided for without having to labor, would that be preferable? Generally, yes. Each individual possesses physical needs (food, shelter, clothing, water, air) and physical, emotional and psychological desires. The degree to which that individual wishes his needs and desires met influences how hard he is willing to work and how much time he is willing to devote (school, on-the-job training, apprenticeship, etc.) to learn how to best obtain what he needs and desires. So, we've reached a subjective fork in our road. What does the individual want? And, how hard is he willing to work for what he wants? How much does he value leisure versus the potential fruits of his labor? If he feels the price of obtaining what he desires is too high, he may only be willing to work as hard as he needs to in order to obtain what he needs to survive and then devote the rest of his time and energy towards leisure.

So, what does this have to do with welfare? Allow me to present a simple example.

Let us suppose that the most efficient labor I am able to provide to any employer is $8 of wealth-productive capacity per hour. There is no incentive for any employer to pay me more than $8 per hour for this task - if he did, he would be losing money. Let us suppose I am being paid $7.75 per hour for my labor. I am receiving $7.75 for my time (8 hours per day, 5 days per week), my physical energy and my mental effort.

Now, let us suppose I lose my job during a recession. I apply for welfare and receive what amounts to $6 per hour, with no requirement to find new work. I am now being paid for leisure nearly 78% what I was previously being paid to work. I may decide my time, my physical energy, and my effort are worth more applied towards leisure than towards the extra $1.75 I might command in the market. If the value of the work I used to provide has declined due to a decrease in demand for the good or service I used to provide, I might even find that I am receiving more in leisure than I could command in the market.

I will only have an incentive to leave welfare and reenter the market if I deem the return on my investment of time, energy and effort is worth their expenditure. 

Even if the market improves and I can command a higher wage now than I did before, I will only have an incentive to leave welfare and reenter the market if I value some combination of desired goods and services I can obtain through higher wages earned more than I do my current state of leisure.

This does not make me greedy, stupid or lazy. It makes me human.

If ever a politician truly desires to slim the rolls of entitlement projects, he must seek to make welfare less attractive than working. He must seek to make the return gained from leisure less attractive than the potential return gained from earning wages.

Does this adequately answer your question? Please feel free to ask any follow-up questions or clarifying questions you desire.

Concerning the Proper Role of Government Regarding Fossil Fuel Use, Pollution, and the Threat of Climate Change

Question: As a free market capitalist, where do you draw the line with regards to the exploitation of resources specifically when exploitation of said resources affects the rights of others?  One might argue that since the combustion of fossil fuels drives global warming, it affects us all negatively and is therefore something that should be regulated heavily and alternatives should be incentivized.  What are your thoughts?

Response:  This is a very complicated question, so I'm going to break up my response into different sections.

First, the scarcest of all resources is knowledge. This foundational fact of reality helps justify free markets since free markets are the only mechanisms where those with the most knowledge about their desires, circumstances and abilities can act on that knowledge when engaging with producers who necessarily lack that knowledge. I know what I want. Corporations do not. I tell them what I want through my purchasing behavior. If enough consumers share my tastes, preferences and desires, then the products and services I purchase will continue to be provided. If I'm relatively alone in my desire, then the product or service will be discontinued because the market will have demonstrated that there are not enough consumers with similar tastes both able and willing to pay the necessary prices in order to cover the costs of that good's production or that service's provision.

A corollary of this exists with regard to how property should be used. In a free market, the property owner has free reign to do as he wishes with his property. However, free markets do not often exist in anarchy. One of the chief roles of any government is the protection of life, liberty and property from any activities of neighbors that might cause harm. This is why governments establish judiciaries to handle breaches of contract, bankruptcies, and a variety of other common-law issues. This is also why an economic case can be made for the government handling of the problem of pollution. If my neighbor pollutes the air because he has built an industrial factory next to my land, he is not the sole bearer of the cost of that pollution. I also suffer. It is not unreasonable for bureaucrats to establish rules with regard to the pollution being created, in order to shift as much of the cost as possible back to the polluter and away from the bystander.

This argument works very well with pollution that can be easily identified, quantified, and possesses consequences which can be readily explained, understood and justified. The specter of global warming or climate change, however, poses numerous problems that must be solved before anyone's liberties can be justifiably limited.

This brings us to the second section of the answer: the problems with anthropogenic climate change.

The first problem – how do we prove it is taking place? How do we effectively observe and measure 'global climate?' How do we take an almost infinitely complex, organic, planetary system and determine within an acceptable margin of statistical error that human beings are altering the way the planet handles greenhouse gasses in the atmosphere? How do we identify and adequately account for every variable that may skew the numbers we're searching for? How do we know what we're looking for and how do we know that there aren't things we don't know that would destroy the whole model and render useless the conclusion we reach?

This is a pretty big problem.

Let us assume we've solved it.

The second problem – once we've determined anthropogenic climate change is taking place, how do we determine what the solution is? How do we effectively measure the reaction to the policy or policies we seek to implement? How do we adequately predict the results to make sure we don't unintentionally make the problem worse? Are we prepared to choose inaction if inaction is determined to be the solution that results in the least overall harm to the climate versus every other option currently on the table? How do we prove that we understand the nature of the problem well enough to develop a solution to that problem? How do we implement the solution well enough to avoid any side effects that might make most of us worse off than before? How do we adequately predict all of the side effects to the solution we wish to implement? How do we adequately account for the fact the planet is an extremely dynamic – not a static – system? How do we attune the solution to handle this dynamism?

This is also a pretty big problem.

Let us assume we've solved it, too.

The third problem – how do we convince everyone to go along? How do we convince every nation, every people, and every society to go along with the solution? Can we come up with a solution that will work if only the West goes along with it? If China, India et al decide to go their own way and put the economic interests of their people ahead of the survival interests of the rest of the globe, what then? How do we convince our fellow citizens to go along? How do we convince the wealth creators, industrialists and multi-national corporations not to move to the countries that aren't going along with us? How do we guarantee that we aren't unilaterally destroying our standard of living for no reason?

The fourth problem – what's the time limit for solving the previous three problems?

Since knowledge is the scarcest of all resources, as an economist I am extremely hesitant to support the taking of any action to solve a 'problem' that does not possess a solid foundation in demonstrable fact.

Lastly, I'll address what appears to be the third portion of your question regarding the exploitation of resources.

From an economic perspective, resources should be exploited as much as the owners of those resources wish to exploit them. Once third parties are permitted the privilege of dictating what others may or may not do with their personal property, we no longer live in a society conceived in liberty - and liberty is vital for economic growth. Personal liberty is absolutely vital for economic growth.

I hope you find this response adequate. If not, or if you have any follow-up questions, please feel free to ask them.

Rules of the Game

When I address economic issues here, I am going to try my very best to leave moral arguments to the side. My goal is to focus only on economics. I define the subject of economics as the study of the efficient allocation of scarce resources which have alternative uses. Efficiency is vital for the creation of wealth and the creation of wealth is vital for the improvement of the standards of life for everyone.

Whether or not something is 'ethical,' 'good,' 'right,' or 'moral' has everything to do with an individual's perspective of what, precisely, those things are. I love discussing philosophy, morality and theology, but I want to keep the discussions here focused with laser-like intensity on economics and only economics. Maybe I'll expand the discussions into other fields later. Probably not, though.

Question: What is a good intro book for the layperson on economics?

Response: I highly recommend Economics in One Lesson, by Henry Hazlitt. It is affordable, not very long, and very easy to read. Once you have read Hazlitt, I recommend reading anything you can find by Frederic Bastiat. He's also very easy to read.

If you're interested in digging into bigger books (but still focused perfect for the layman), I suggest Basic Economics, by Thomas Sowell. Sowell has also written Applied Economics, and The Housing Boom and Bust. They're both excellent.

All of these books will provide you with a very solid foundation.

There's tons more good stuff out there, of course, but these will be enough to start with. ;)