Attached is my term paper I wrote at the end of the fall semester.
Tuesday, January 6, 2015
An Argument against Open Market Operations in Equity Securities
An Argument against Open Market Operations in Equity Securities
Since 2008, many have argued that there needs to be more
regulation and intervention in financial markets. After witnessing the federal
government take over Fannie and Freddie as well as the insurance giant A.I.G.,
there has been a push to allow the Federal Reserve to also step in during times
of economic panic and carry out open market operations in equity securities of
private firms. While to many this may not seem like a bad idea on the surface,
many problems will arise if the Fed is allowed to conduct these purchases.
The most obvious problem that will arise is the problem
of moral hazard. There is an example of this currently in the courts that is
attempting to deal with what to do with the profits of Fannie and Freddie. Should
they be returned to the shareholders, or continue to be paid to the government?
The problem is that since the government bailed out the companies in the past,
there is now an explicit backing by the government, instead of the implicit
backing the companies had received prior to the financial crisis in 2008. This
means that if Fannie and Freddie were to fail in the future, the government has
established the precedent of bailing them out. If profits are to be returned to
the shareholders of Fannie and Freddie, the government would in effect be
condoning the combination private profits, paid only to the shareholders, and
socialized losses, paid for by the taxpayer. The same problem would arise if,
instead of the federal government, the Federal Reserve took part in the equity
purchases. The only difference is that the cost of the losses would be paid for
not by the taxpayer directly, but rather indirectly by anyone who held the U.S.
dollar. This is simply because in order to purchase securities in the troubled
firm, the Fed would need to expand its balance sheet, or in other words, more
money would need to be created. The new money would expand the existing stock,
therefore stealing purchasing power from the stock of money already in
existence.[1]
Therefore the firms would get all the benefit in times of prosperity, while in
times of hardship, the losses they would incur would be shared with holders of
the dollar. This strategy of privatizing profits and socializing losses is not
a political strategy that would last too long in the United States, especially
given the public response to the bailouts back in 2008.
Even with the problems associated with moral hazard, the
worst problem that will arise if the Fed were allowed to carry out open market
operations in equity securities is one that already exists today because of the
Fed; it is the problem of a misallocation of resources. When the Fed increases
its balance sheet, which it would need to do in order to make open market
purchases of equity securities, the interest rate is necessarily lowered below
the rate that would arise on the free market, or as Knut Wicksell states, the
interest rate is artificially lowered below the “natural” rate of interest.[2]
Interest is, as the great economist Ludwig von Mises defines it, “the
difference in the valuation of present goods and future goods; it is the
discount in the valuation of future goods as against that of present goods.”[3]
So why is it a problem if the interest rate is artificially lowered below the
natural rate? Because the market receives mixed signals about the time
preference preferred within the economy, in other words, resources are
misallocated. In a genuine free market, the interest rate is raised and lowered
by the amount of savings available to be lent out; the greater the amount of savings,
the lower the prevailing interest rate. Therefore, when there is a large amount
of savings and the interest rate is low, the market is essentially saying that
consumers are presently choosing to delay consumption until a further date upon
which they can consume more goods. This correlates with the production of
businesses, which will now to choose to invest in capital goods due to the
lower rate of interest. The increase in capital goods will bring about more
goods in the future, which will satisfy the future desires of consumers who are
planning to consume more in the future given their postponement of consumption
today. However, when the interest rate is artificially lowered, there are mixed
signals being shown in the market. It is not an increase in savings that
induces the fall in the interest rate. Therefore, consumers are not choosing to
postpone present consumption until the future, rather they are consuming in the
present. Meanwhile, because of the lower interest rates, businesses begin
investing more in capital goods, expecting that when they are producing more in
the future, there will be consumers ready to buy. While it is quite clear there
will be a problem in the future since there are no savings to purchase the
future goods, there is also a problem in the present. More resources are trying
to be used than are available in the economy since there is no increase in
savings. Because of this Mises states, “Credit expansion can bring a temporary
boom. But such fictitious prosperity must end in a general depression of
trade.”[4]
Given these two major problems, I do not think that the
Federal Reserve should be allowed to carry out open market operations in equity
securities. Following this argument to its logical conclusions, the Fed should
not be able to conduct any open market purchases, since doing so is the root
cause of the business cycle.[5]
[1] See,
What Has Government Done to Our Money?,
by Murray N. Rothbard.
[2] See,
Interest and Prices, by Knut
Wicksell.
[3]
Planning for Freedom, by Ludwig von Mises. pp. 187-88
[4] Planned Chaos, by Ludwig von Mises. p.
21
[5]
See, Economic Depressions: Their Cause
and Cure, by Murray N. Rothbard for more.
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