Many think of the economy as being like a space ship, which occasionally slips from the path of stable economic growth and stable prices and has to be steered back by the “experts” in monetary policy. When economic activity slows down and falls below the path of stable economic growth and stable prices, it is the duty of the central bank to give the economy a push, which will place it back onto the right path.

This “push” is done through expansionary monetary policy—the artificial lowering of the interest rates by the expansion of money and credit. Conversely, when economic activity is perceived to be “overheating” (i.e., price inflation gets too high and/or there is a risk of monetary debasement) it is the duty of the central bank to “cool off” the economy through tightening monetary policy. This amounts to raising interest rates and slowing down monetary injections. The goal would be to counterbalance the effects of the previous expansionary monetary stance.

A Tight Monetary Stance Cannot Undo the Effects of an Easy Stance

The misallocation of resources due to an expansionary monetary policy cannot be reversed by a tighter stance. According to Percy L. Greaves, Jr. in The Causes of the Economic Crisis and Other Essays Before the Great Depression,

Mises also refers to the fact that deflation can never repair the damage of a priori inflation. In his seminar, he often likened such a process to an auto driver who had run over a person and then tried to remedy the situation by backing over the victim in reverse. Inflation so scrambles the changes in wealth and income that it becomes impossible to undo the effects. Then too, deflationary manipulations of the quantity of money are just as destructive of market processes, guided by unhampered market prices, wage rates and interest rates, as are such inflationary manipulations of the quantity of money.

By freeing the economy from central bank interference in the money supply and interest rates, the process of wealth destruction is likely to be arrested. This will strengthen the process of wealth generation. With a greater pool of wealth, it will be much easier to absorb various misallocated resources. The Fed’s tampering with these market signals undermines the process of wealth generation, thereby exerting an upward pressure on individuals’ time preferences and pushing the market interest rate in an upward direction.

Can Central Bank Policies Keep the Economy on A Path of Stable Growth?

Most experts are of the view that a major obstacle to the attainment of stable economic growth are the deviations of the federal funds rate from the neutral interest rate. The neutral interest rate, it is held, is the one that is consistent with stable prices and a balanced economy. What is required then is for Fed policymakers to successfully target the federal funds rate towards this neutral interest rate.

In this way of thinking, the neutral interest rate is established at the intersection of the aggregate supply and aggregate demand curves. If the market interest rate falls below the neutral interest rate, investment will exceed savings, implying that the quantity demanded will exceed the quantity supplied. Assuming that the excess demand is financed by the expansion in bank loans, this leads to the generation of new money, which, in turn, pushes prices up. Conversely, if the market interest rate rises above the neutral interest rate, savings will exceed investment, aggregate supply will exceed the aggregate demand, bank loans and the stock of money will contract, and prices will fall. Hence, whenever the market interest rate is in line with the neutral interest rate, the economy is in a state of equilibrium and there is neither upward nor downward pressures on the price level.

The main problem with all this is that the so-called neutral interest rate cannot be observed. How can one tell whether the market interest rate is above or below the neutral interest rate? However, many economists are of the view that it could be estimated by various indirect means. In order to ascertain the unobservable neutral interest rate, economists now employ various sophisticated mathematical methods. However, does all of this make much sense?

In the process of attempting to establish a stable growth path, economists assume the existence of aggregate supply and aggregate demand curves. The intersection of these curves generates the so-called equilibrium that supposedly corresponds to the neutral interest rate, and thus, to the growth rate of economic stability.

The supply and demand curves, as presented by mainstream economics, does not originate from the facts of reality but rather from the imaginary constructs of economists based on faulty assumptions. None of the figures that underpin the supply and demand curves originate from the real world—they are purely imaginary. According to Mises, “It is important to realize that we do not have any knowledge or experience concerning the shape of such curves.” Yet economists heatedly debate the various properties of these unseen curves and their implications regarding government and central bank policies.

Why General Equilibrium Is a Fiction

The existence of a “general equilibrium”—as depicted by the intersection between the overall economy supply curve with the overall economy demand curve—is questionable at best. The economy as such does not exist apart from individuals. Hence, something that does not exist cannot strive to some kind of general equilibrium. The concept of equilibrium is only relevant to individuals in a dynamic, ever-changing economy that is the result of countless subjective decisions.

Equilibrium in the context of an individuals’ conscious and purposeful behavior has nothing to do with the imaginary equilibrium as depicted by popular economics. Equilibrium is established when individuals’ ends are met. When a supplier is successful in selling his supply at a price that yields profit, he is said to have reached an equilibrium. Similarly, consumers who bought this supply have done so in order to meet their goals. Every individual in his own context achieves a sort of equilibrium whenever he reaches his goal.

In the absence of central bank interference, the market interest rate will be in line with individuals’ goals, not the wishes of central bank planners. Thus, some individuals might discover that the interest rate they would have to pay is much lower than what they are ready to pay. For some other individuals, the free-market interest rate may turn out to be far too high. Consequently, they will be out of the market.

Once policies are implemented to achieve the neutral interest rate—which supposedly reflects the so-called general equilibrium as established by the mathematical models—this will be in contradiction to what the free market would have established. As a result, this will generate a misallocation of resources and the weakening of the wealth-generation process. (By setting the federal funds target rate, Federal Reserve policymakers are pretending that they have the numerical information of the interest rate that corresponds to stable economic growth and stable prices).

The failure of various centrally-planned economies, such as the former Soviet Union, is a testimony that central authorities that attempt to push the economy towards a growth trajectory, as dictated by government bureaucrats, results in an economic disaster.

Conclusion

The notion that the economy can be regarded as a space ship is erroneous since the economy is about many acting human beings that interact with each other. Individuals are consciously engaged in the pursuance of their various goals by employing various means. The damage caused by inflationary policy of the central bank cannot be neutralized by a deflationary policy. The deflationary policy is a policy of intervention and, in this sense, it sets in motion a different form of the misallocation of resources. In other words, it attempts to fight prior distortions with new distortions.