Ever since its establishment, the Federal Reserve System, the markers and the economy have been radically transformed. The aftermath of a semi-private organization having exclusive control of the money supply and interest rates has had both positive and (mostly) negative outcomes on the US economy.
Economic damage of the Fed has been widespread and continues to drag down the US economy. Ills that can be directly correlated to the Fed are income inequality, higher rates of inflation asset bubbles generated through cheap money, and the creation of a monetary support mechanism for large deficit spending. It is no coincidence that these societal trends accelerated since the mid-1980’s, when political pressures against Paul Volcker forced monetary loosening. The result was a thirty year trend of relatively continuous monetary easing which has seen interest rates decline from 16% to 0.25% since 1981, and the US money supply increase by over a multiple of 6.5.
Before the Federal Reserve System was established, the US dollar gained 10% in value since 1776. Since 1913, the purchasing power has gone down 98%. Currency debasement became a tool to fund the two World Wars, the Vietnam War, welfare programs such as the Great Society, Medicare, and many other government programs that taxes could pay for without rates that would trigger rebellion. Instead, the US government (and most countries internationally have done the same thing to different degrees) places a secret regressive inflation tax on Americans, which erodes savings and real wages at the expense of current asset holders. For those who were fortunate to have cash to buy businesses or real estate when the currency was strong or those who can get cheaper loans before the money circulation started due to political connections, benefitted greatly. Everyone else, on the other hand, loses through higher living costs and having to pay more for the same assets when investing. That is why the current system favors the existing wealthy and older generations while hurting the lower and middle classes along with younger people looking to build their own wealth bases. As a consequence the “top 1%” income continues to increase, not because of free markets or low taxes.
Outside of domestic inflation and income inequality, the Federal Reserve has caused other global imbalances such as the large differences in balance of payments between creditor exporting nations and debt burdened importers and civil unrest generated indirectly though higher food and energy prices in developing nations. The most recent example of Fed unintended consequences was QE2 triggering high food prices that lead to the Arab spring rebellions. Asset bubbles have also wiped out the fortunes of millions of individuals and businesses.
The only silver lining I have seen from the Federal Reserve System is the fact that speculative bubbles in certain asset classes have lead to creating increased innovation and infrastructure within the speculative sector, which in long term allows for cheaper prices and further developments. Examples of this include the fiber optic broadband connections, which have allowed for the massive expansion of uses for the Internet after the tech bubble and lower food prices and higher yields after the commodities bubble in the 1970’s. The same would have likely happened for housing if the Fed did not start reflating that bubble before it truly bottomed out.
Overall, the Federal Reserve and other central bank’s policies have done more harm than good in the long run. In order to protect the creditworthiness of their parent government and to create illusory growth that helps re-election chances, central banks deliberately hold interest rates below markets levels. By using the printing press to finance wars and social problems, the Fed has caused the economic imbalances that lead to the need for the wars and social programs in the first place. As shown by the Great Depression, the decade of 10%+ inflation in the 1970’s and the 2008 financial crisis, this behavior is not sustainable. Whether tapering happens or not, the Fed will once again lose control of bond market. As a consequence, other deflationary or inflationary crisis may happen. With the current degree of economic imbalances, the bust is likely to happen sooner rather than later. To make things worse, the Fed’s bubble is so big this time that the current monetary system may not survive to the see the recovery.
For investors this means being cautious towards overvalued equities in Western markets as emerging market equities seemed to have already priced in either a taper or a bust from Fed over easing. Bonds (especially ones with duration greater than five years) should either be avoided entirely or sold short. Commodities could go either way, but I would lean towards buying due to negative sentiment and the likelihood of inflation.
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