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There's an old joke where the first guy says, "What's the difference between drapes and toilet paper?" The second guy says, "I don't know, what?" Then the first guy responds, "You are not allowed in my house!"

After watching the "expert" economists debate our financial crisis during the past year, I realize that we can modify the joke. Today I would ask the econobloggers and op-ed writers, "What's the difference between monetary policy and interest rates?" If an economist answered, "I don't know, what?" then he is not allowed to advise the government. Any "expert" who confuses money and interest is eventually going to give horrible recommendations under certain conditions, as we'll see below.

Money and Interest Are Different Things

Although the public has been desensitized into believing that a rising money supply is the same thing as lowered interest rates, these are actually quite distinct things. In fact, the apparently obvious connection between monetary growth and interest rates is largely an accident of the way central banks developed historically. In an economy truly based on private property, the gold miners — i.e., the producers of new money — would have no direct connection to interest rates at all. A decision by the gold miners to boost production would have very little direct impact on interest rates.

Central banks quite arbitrarily inject new money into the economy via the credit markets. Let's suppose for the sake of argument that the government should control the "money industry." Further suppose we are in a situation where the government determines that an injection of new money is needed to help the market snap out of its laissez-faire funk. Even so, there is no reason the central bank needs to choose debt securities as the point of entry for new money.

This is a crucial point so let's think it through. Right now, when the Federal Reserve engages in "open-market operations," Bernanke goes into the market and buys, say, $10 million worth of US Treasuries from a bond dealer. How does Bernanke pay for this? Why, he simply writes them a check written on the Federal Reserve.

When the bond dealer deposits the $10 million check, his bank credits his checking account with $10 million. Then the bank itself turns the check over to the Fed. Get ready, here's the fun part: when the Fed receives a check — written on itself — from Acme Bank, the Fed processes the check and increases Acme's checking balance with the Fed by $10 million. But there is no corresponding debit to any other checking balance! The total amount of member-bank reserves, held on deposit with the Fed, has magically increased by $10 million.

As everyone who didn't skip the relevant college lecture will recall, the fractional-reserve nature of our banking system means that the injection of $10 million in new reserves will actually allow up to $100 million in new money to enter the economy. But that pyramid effect is not what I want to focus on.

Instead, I want to focus on the fact that the Fed chooses bond dealers to be the first recipients of the new money. That has an enormous impact on the way the economy operates. But we don't even see this aspect of the situation, because we have come to believe it is natural.

In fact, it is horribly unnatural and causes the business cycle itself. Suppose that instead of entering the bond market, when Bernanke wanted to increase the money supply, he started adding SUVs to the Fed's balance sheet. Can you imagine how much this would disrupt the car market?

The SUV Fed

It is not unusual for the Fed's balance sheet to increase by $5 billion in a given 12-month period. (In this article I'm not even going to start to deal with the astronomical increase in Fed holdings during 2008.) That means that in the course of a year, it is entirely possible that the Fed could go on a spending spree and bulk up with $5 billion in extra bonds issued by Uncle Sam. Then, down the road, it may dump those holdings just as quickly, and not according to any predictable formula but instead largely at the whim of one man.

Now imagine if the Fed stocked up on SUVs, rather than bonds, when conducting its open market operations. It would approach car dealerships and write checks (backed up by the infinite supply of Fed electronic reserves stored in the Bernanke Phantom Zone). Then the dealership would really sell an actual vehicle to the Fed. A private customer who had had his eye on that particular SUV would have to find another vehicle, because the one he wanted was being loaded on a truck headed for the New York vault.

However, the customer could actually decide to postpone buying, hoping that the Fed would adopt a tight monetary policy. In this case — when the Fed wanted to suck money back out of the economy to contain price inflation — it would dump SUVs back on the market. When the car dealerships bought them off the auction block, they would write checks to the Fed, drawn on their commercial checking accounts, and in the process would ultimately send some of the total reserves in the banking system back to the Phantom Zone.

Although our hypothetical system would introduce extreme volatility in SUV prices, it's still obvious that the car manufacturers would love the arrangement, so long as the government generally acted as a net purchaser of SUVs. That is, as long as the government's stockpile of SUVs tended to grow over time, the manufacturers would effectively receive a roundabout subsidy, even if the government never dealt directly with the manufacturers and always bought SUVs from third-party dealerships.

The actual and potential consumers of SUVs, of course, would suffer. Not only would they pay higher prices but they would also be less certain of the availability and price of vehicles down the road, due to the sudden jumping in and out of the market by the central bank.

Bond Prices and Interest Rates

Similar distortions occur in the real world, but we don't notice them anymore. When the Fed "cuts interest rates," what it's really doing is creating money out of thin air and handing it over to bond manufacturers. And what is a bond manufacturer? It's simply a fancy term for a borrower.

The most privileged bond producer is of course the US Treasury. Now I'm sure it was just a pure coincidence that when the government established the Federal Reserve — the entity that in a sense controls the dollar printing press — the government required, either explicitly or implicitly, that the Fed could generally only inject that new money by buying bonds issued by the Treasury. (This pattern has changed recently, of course.) This ensures that whenever the Fed injects new money into the system, it pushes up the price of Treasury bonds. Since the Treasury is selling those newly issued bonds, the Treasury obviously benefits from this.

On the other hand, private-sector buyers of Treasury and other bonds lose out. If they had entered the market with the intention of buying a bond yielding $10,000 in ten years, they will now have to pay a higher price because of the Fed's muscling into the picture with its Phantom Zone checkbook.

Another name for private-sector buyers of debt is savers. Thus the Fed's decision to stockpile debt instruments — rather than sport-utility vehicles — subsidizes the borrowers and penalizes the savers. Its actions also cause people to save less or borrow more than they would have in a free bond market. Perhaps more serious, the Fed's behavior sets in motion the boom-bust cycle that mysteriously plagues market economies.

The Fed's One-Two Punch to the Economy

What people often overlook is that the Fed distorts the economy in two separate ways: first, it destroys the value of the dollar by expanding the supply of dollars year after year. But beyond raising prices in general, the Fed's actions also cause distortions because they pull up bond prices first, so that they are temporarily higher compared to other prices.

If the Fed doubles the money supply, in the long run, that will roughly double the prices of all goods and services. But if the Fed restricts the injection of new money into only the hands of a few privileged recipients, those people will be at a fantastic (albeit temporary) advantage relative to everyone else in the economy. They will get their hands on the billions in new dollars, while prices still reflect the old reality. The new money will then flow from sector to sector, pushing up prices as it ripples throughout the economy. But the last people in line receiving the new influx of twenty- and hundred-dollar bills will be much poorer than others, once prices settle down. Their paycheck was the last to rise, while they watched helplessly as more and more prices began doubling.

A Deadly Combination

Now what happens when the economy is in a situation where (a) it "needs" more money, and (b) it "needs" higher interest rates? (I'm using "needs" loosely to mean "required by economic efficiency.") For example, maybe a country that was previously economically isolated has now joined the world market. Its people originally traded among themselves with their own domestic currency, but now they want to use the international money.

Under a truly free money market, gold would probably be the world commodity money. That means tons of extra gold (in the form of bars and coins) would flow into the developing country, to be added to the cash balances of its people.

But at the same time, because these people would recognize the immense jump in standard of living they would soon experience, they would also try to borrow against their future income. In other words, now that their nation was open to international trade, their productivity would multiply by a factor of ten within a few years. The switch wouldn't be overnight however, because it would take time for multinational companies to come in and build state-of-the-art factories, or to begin large-scale extraction of mineral resources.

From the point of view of the natives, they would realize that their average annual income would jump from, say, $500 to $5,000 in two years, where it would stay until their retirement. In that situation, they would naturally borrow a lot of money. Their increased demand for loans would raise interest rates, calling forth new savings from the rest of the world and rationing the available funds among other potential borrowers.

That is how a truly free market would handle a scenario where the market needs more money and higher interest rates. The rising world price of gold would induce gold miners to boost output, while the rising price of borrowing would induce savers to boost their "output." There is no reason that the actions of the gold miners would conflict with the actions of the savers.

But what happens with a central bank such as our Federal Reserve? When it tries to increase the money supply, it necessarily has to push down interest rates, at least relative to what they otherwise would have been. Therefore, in a scenario where people want to hold more cash and where they are in desperate need of more savings, the Fed can cater to one crisis only by exacerbating the other.

This is exactly where we stand during today's crisis. The tremendous uncertainty in financial markets — itself caused largely by government policies — has led everyone to seek higher cash balances. People have no idea what their income stream will be like in 6 or 12 months, and so they are trying to expand their command of very liquid assets.

At the same time, the bursting of the housing and stock bubbles revealed that many wealthy people all over the globe had not been saving nearly as much as they thought they were. The alarm needed to flood through the world: "Save more! Save more! This is an emergency! The entire structure of capital is at risk if we don't plug these holes soon!"

Tragically, the setup of central banks in today's world only allowed the governments to solve one problem. They chose to flood the markets with money, thereby pushing interest rates down to the nonsensical rate of practically zero.

Thus, at the single most crucial time in world history for interest rates to rise sharply, they were instead pushed down to zero. Just when extra saving is needed most critically, instead the governments of the world have caused lending itself to become almost pointless.

Conclusion

Interest rates are prices, and as such they convey real information about scarcity in the world. People talk of financial affairs spreading into the "real economy," as if the allocation of capital is some minor detail. On the contrary, the capital markets — guided by interest rates — are the single most important "governor" of the "real" market economy over time.

By flooding the credit markets with money created out of thin air, the central banks of the world are interfering with humans' attempts to communicate with each other after the housing bubble popped. It would be as if the governments used military aircraft to jam the radios of rescue workers in a region hit by an earthquake.

The politicians and bureaucrats talk as if the members of the private sector are aloof during the crisis. On the contrary, people the world over are concentrating on their finances more than ever. But the governments of the world keep drowning out the signals people are trying to send to each other.

Money and interest are distinct things. There are times when the "right" market response is an increase in the supply of money and an increase in interest rates. Because modern central banks typically inject new money only by lowering interest rates, they make financial panics much worse.