Steve Hanke: The Fed’s Policies Are Making the Credit Crunch Worse

Mon, Sep 16, 2013 - 4:12pm

Although Federal Reserve policy is often blamed for blowing bubbles in the stock market, to Steve Hanke, professor of Applied Economics at John Hopkins University, it’s actually doing much more than that: it’s also hurting the real economy.

The Fed and policymakers, he says, have completely misdiagnosed the situation by focusing on the wrong valve. To understand the problem, Professor Hanke breaks down the total amount of money circulating through the economy into two categories: “State money”, which is high-powered money supplied by the Fed, and “bank money”, which is money or deposits created through private banks.

The Fed’s contribution to the total money supply is only 15%, whereas 85% is created through the wider banking system. If we think of these as two valves, the Fed has opened up the floodgates of “State money”, which mainly helps the financial markets, while squeezing "bank money" created through the interbank lending market—the exact place where the overwhelming majority of loans are actually created. The net result has been a booming stock market but a very slow economy.

To fix the problem, Professor Hanke argues that the Fed needs to allow interest rates to rise so that banks will begin to lend to the wider economy again.

When that happens, the interbank lending market should begin to function normally, opening up a much needed relief valve to small and medium-sized businesses, which also drive half of the jobs in the U.S.

The question for investors then is whether a Fed taper is a cause for worry or a chance to rejoice? If Professor Hanke is right, as interest rates rise back to normal levels, those looking for a job may have a brighter future ahead.

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