The world’s major central banks, led by the U.S. Federal Reserve, have always manipulated interest rates and money supplies. In recent years, however, the extent to which they intervene in the economy has increased dramatically—not only in degree, but also in kind. Central banks are no longer content merely to manipulate aspects of the economy; they now aim to own portions of the economy in the form of equities in major corporations. This is an ominous and seismic shift toward government ownership of the means of production. And, if we want to advocate and defend liberty and capitalism, we need to understand the nature of the problem, how it came to be, and what must be done to reverse the trend before it’s too late.
Toward that end, let us begin by reviewing what central banks traditionally have done and how their policies have evolved in recent years, in particular since the financial crisis of 2008. We’ll focus primarily on the actions and evolution of the U.S. Federal Reserve, not only because it sets monetary policy for the world’s largest economy, but also because it is in many ways the leader of practices for central banks worldwide.
Although central banks engage in both monetary policy and bank regulation, our concern here is with the former and related developments. The equally problematic regulatory actions of central banks are a subject for another day.
Traditional Monetary Policy
For decades, the objective of the Fed and other central banks, as articulated by their administrators and defenders, has been to “nudge” the economy to grow (or to slow) by setting short-term interest rates and managing the money supply. The primary means of nudging for growth has been “open-market operations,” which consist essentially in printing (or otherwise fabricating) new money with which to purchase government bonds.
For an indication of how this works, suppose the Federal Reserve Open Market Committee (FOMC)1 believes the economy is growing “too slowly.” Perhaps their forecasted growth rate is 1 or 2 percent, and they believe 3 or 4 percent would be “better.” After a long technical discussion, the FOMC votes to “boost” the economy by increasing the money supply and pushing interest rates downward. This is often called “loose” monetary policy, or “easy money.”
To implement easy money, the Fed buys a quantity of U.S. Treasury notes on the open market.2 This purchase increases demand for Treasury notes, pushing up their price and pushing down short-term interest rates.3
How does the Fed pay for this purchase? If, as is usually the case, the central bank does not have enough cash on hand, it pays for the Treasury notes with brand new money of its own creation. This new money is generated by fiat or bureaucratic decree—literally by a government employee making a few keystrokes or mouse clicks on a computer. This new money—technically known as “base money” or “reserves”—is deposited at the Federal Reserve Bank of New York in an account (similar to a checking account) for the commercial bank that handled the sale.
When the commercial bank loans these funds to a customer, the new money feeds into the economy and is spent on investments, land, houses, yachts, or whatever. All else being equal, an injection of money into the economy tends to decrease the value of money in circulation and thus to increase the price of goods and services. According to the theory of John Maynard Keynes—the theory embraced by all central banks—this new money and consequent spending “stimulates” economic growth.4
By contrast, if the Fed deems that the economy is growing “too fast,” it “tightens” monetary policy by reversing the procedure: It sells Treasury notes (thus taking money out of circulation), increases interest rates, and thereby slows economic growth. In practice, the Fed has been strongly biased toward expanding the money supply, tightening it only rarely.5
Central banks possess exclusive legal power to fabricate new money. Any other institution or individual who attempted to fabricate money would be arrested for counterfeiting. And, in the United States, as in most countries, there is no legal limit on the amount of money the central bank can create. As we will see, the Fed has in recent years taken advantage of this absence of limits on the fabrication of money, creating enormous quantities of fiat money, and laying the groundwork for new kinds of interference.
From Conventionalism to Activism
For most of the Fed’s history, open-market operations functioned essentially as described above. But beginning in the late 1990s, under Fed Chairman Alan Greenspan, the central bank took a more active role in the economy. For example, in 1998, the Fed orchestrated a bailout of the private hedge fund Long Term Capital Management; in 1999, it “provided liquidity” (i.e., fabricated extra money) in anticipation of a Y2K panic; and in the aftermath of the 2001 dot-com bust and ensuing recession, the Fed temporarily pushed key short-term rates to 1 percent, the lowest since World War II.6 Despite these aggressive moves, the Fed was still seen by most people as a benign facilitator. Americans on Wall Street as well as on Main Street by and large still believed free-market principles dominated the economy.
Many private-sector economists now think . . .