On Wednesday, the Federal Reserve announced that it will “raise” interest rates faster than previously planned in order to “fight” worsening inflation.
In a press conference, Fed Chairman Jerome Powell tried to assure investors and the public that the Fed is, “not trying to induce a recession now. Let’s be clear about that.” As the Wall Street Journal reported, Powell “still believes [the Federal Reserve] can cool the economy and bring down inflation while engineering a so-called soft landing in which the economy and labor market continue to grow.”
On Thursday, President Biden was similarly hopeful, telling the Associated Press that a recession is “not inevitable.”
That same day, investors splashed cold water on Biden and Powell’s hopes. After the Fed’s announcement, markets briefly rallied before tumbling yet again.
Yet it’s not just traders who beg to differ with the rosy optimism emanating from the White House and the Fed, but economic reality itself. Biden and Powell are in denial. A soft landing is impossible, a recession is inevitable, and it is their own policies that made it so.
The Untold Story
Media reports tend to leave out why the Fed thinks raising interest rates will fight inflation in the first place. First of all, it is grossly misleading to say that the Fed “raises” interest rates or “fights” inflation.
Imagine a bully pins down one of his victims. If the bully eases up, allowing the victim to stand up on his own, you wouldn’t say that the bully “raised” up his victim. Yet that is basically what the Fed is doing with regard to interest rates. The Fed has been holding down interest rates, and now it’s relenting a bit to allow them to rise somewhat.
And imagine an arsonist pumps gasoline on a fire. If the arsonist eases up on the pump, allowing the fire to die down a bit, you wouldn’t say that the arsonist is “fighting” the fire. Yet that is basically what the Fed is doing with inflation. The Fed has been driving up inflation, and now it’s relenting a bit to allow prices to moderate somewhat.
The way the Fed holds down interest rates is by “quantitative easing,” a euphemism for flooding the banking system with newly created dollars. The Fed has been holding interest rates down to near zero by injecting trillions of new dollars into the banks.
More money chasing the same amount of goods will tend to bid up prices. Federal Reserve bureaucrats are at least economically literate enough to be aware of that, so they know their money pumping is fueling the flames of inflation. And the inflation conflagration is getting dangerous enough to back them into a corner. They feel they have no other choice but to ease up on the pump, even if it means allowing interest rates to rise.
Fed policymakers are highly reluctant to do so, because the main reason they have been holding interest rates down has been to “stimulate” the economy, especially in the face of COVID and the lockdowns. Many investors and economists fear that an economy with less monetary stimulus will crash and fall into a recession.
The Unknown Truth
But what almost nobody understands is what crashes and recessions even are and why they happen. And they have no excuse, because that was clarified way back in 1912 by the great Austrian economist Ludwig von Mises.
As Mises explained, crashes and recessions are made inevitable by monetary stimulus. Money pumping can only stimulate the economy by overextending it.
The extra money sloshing around the banking system lowers the interest rate by boosting investor demand for resources to use in new and expanded production projects. This means more investment opportunities, higher profits, more jobs, and higher wages: i.e., a “stimulated” economy.
New and expanded production projects would be fine and great if they were matched by new and expanded resources to support them—made available by higher savings. That’s what a natural drop in the interest rate would signify. But the infusion of new money only expands production; it does nothing to reduce present consumption and thus to increase saving. So it results in an over-committment of available resources.
It’s the simple logic of scarcity: we have (1) the same finite stock of resources, (2) more production demands for resources, and (3) the same (if not more) consumption demands for resources.
Eventually, something’s gotta give.
The Fed’s money pumping only “stimulates” the economy by deluding investors into behaving as if there are more available resources in the economy than there actually are. At some point, that delusion must run headlong into economic reality.
Generally, that happens when the Fed finally eases up on pumping money into the banking system. With less new money pumping it up, the effective demand of investors for resources collapses back down to a level compatible with consumer demand and the actual rate of saving. Deluded less by monetary stimulus, market actors start reckoning with economic reality. The interest rate spikes, stock prices collapse, and throughout the economy, production projects that looked like profitable winners are revealed to be unaffordable losers (“malinvestments”).
That is what a crash is.
Entrepreneurs then scale back or liquidate the loser projects, reallocating resources (including human resources) to uses that are more compatible with the now clearer economic reality. That reallocation can only happen through a mass change of partners throughout the economy. This means many painful “break-ups” of impractical economic relationships: lay-offs, contract cancellations, bankruptcies, etc.
That is what a recession is.
Those break-ups are prerequisite to the formation of new, more practical economic relationships: new jobs being filled, new contracts being signed, and new businesses being started.
That is what a recovery is. The result is a healthier economy. And the only path from an unhealthy economy to a healthier one is through a recession.
That is why Biden and Powell are wrong. A recession is inevitable. It’s also necessary. It was made inevitable and necessary by their own policies: by Biden (as well as President Trump before him) crippling the economy with lockdowns and other destructive policies, and by Powell “stimulating” the crippled economy into a distorted, overextended, and unsustainable condition.
The only way to heal that condition is to let the economy heal itself through a recession. And the sooner that Biden and Powell let that happen, the better.
Dan Sanchez is the Director of Content at the Foundation for Economic Education (FEE) and the editor-in chief of FEE.org.