In today’s world, it is not generally markets which set the price of money – interest rates – nor the supply of money, which are closely connected. (In general, higher interest rates shrink the money supply and lower rates do the opposite.) Governments, especially those saddled with large debts, prefer an increasing money supply to create asset inflation, bring in higher tax revenues, and make it easier for them to service their debts. When governments control the price of borrowing and money supply, they will manage them at their benefit, often to the detriment of the larger economy.
In the past, the natural limit to government money creation was the supply of gold or silver, a traditional medium of exchange for thousands of years around the world. For its first hundred years or so after its independence, the only legal tender issued by the U.S. government were gold and silver coins. After its Civil War, the U.S. government allowed paper currency to be used as a medium of exchange, but the amount of “money” (paper bills) that could be created had to be convertible to gold or silver and limited to its supply. In this way, the increase in the money supply would be limited because currency was limited by the supply of gold and silver. (In general, gold supply increases 1%-2% per year, although it is often less is there is rising demand for gold and silver, such as from jewelry, which reducing available supply.) In other words, a million dollars of currency wouldn’t be printed unless there was an equivalent amount of gold or silver in circulation.
The backing of currency units by real money, ended in August, 1971, when the Nixon administration ended the Bretton Woods agreement, which ended dollar to gold convertibility. That in turn, allowed governments to print unbacked money, fiat currency, with abandon, which they’ve done over the past several decades. Below is a graph showing the money supply growth in the U.S. of over 15 times since 1971, the end of the gold standard in America.
A necessary tool to increase the money supply is interest rate policy. Whereas in the past, markets would set the price to borrow and lend, since the Federal Reserve was created, the Fed has taken upon itself to override natural market and economic forces. Not only does it set interest rates directly with key short-term interest rates such as the Fed Funds Rate (see chart below), but by directly intervening in the bond market - buying or selling bonds - or by giving “forward guidance” as to the direction of the economy or interest rates. With such tools, it can control the price of longer-term interest rates as well, and in turn, greatly influence and control the economy as a whole.
In the past, with market-driven interest rates, there were natural floors and ceilings for interest rates. Since the money supply was normally very stable, interest rates would fluctuate based on economic conditions, but would usually quickly revert to normal levels once a crisis or speculative episode ended. That has not generally been the case with the Fed in charge. Interest rate volatility caused extreme financial and economic stress during the 1970s and early 1980s. Since then, the Fed’s pushing of interest rates to below market and inflation rates have also led to at least three speculative episodes and financial dislocations since the mid-1990s. In the current manipulated market, interest rates have been held below natural market rates for close to a decade.
In a free market, one would not usually see very low interest rates over the long term when the money supply was strongly increasing. That’s because an increasing money supply usually leads to more economic activity. As economic activity increases the price of interest is bid higher as there are more feasible or attractive economic activities. In response to the higher borrowing demand interest rates will normally rise, which at a certain point, will in turn, choke off economic activity before economic, or speculative activity, gets too strong. This will then put a natural lid on interest rates. Clearly, nothing like this happened over the past eight or nine years as interest rates have hardly been allowed to increase at all. With the Fed managing interest rates, it errs on the side of low interest rates, higher inflation and greater levels of financial and economic speculation (and therefore financial, economic and asset bubbles). It is quicker to lower interest rates, keeps them lower longer, and is slower in raising them despite inflation or speculative pressures.
Another example of government market dislocation can be seen in 2009 and 2010, when the Federal Reserve spent more a trillion dollars buying nearly worthless mortgage-backed securities (paying prices far above the market) from the banks. The Fed still sits on these securities eight years later (has grown them, in fact: see chart below) rather than sell them to the marketplace, because it knows the free market wouldn’t absorb them. What were once called (by government rescuers) “distressed” securities can now be seen as a very large financial gift from the Federal Reserve (and by extension, citizens and taxpayers) to the banking industry that never has to be repaid.
In a free market, such bailouts of crony mega-banks wouldn’t exist. Nor would the near-trillion-dollar TARP slush fund. Nor would the government’s manipulation into the mortgage market (besides interest rates), by pushing lenders to alter their lending standards to risky borrowers. Nor would currency, stock, commodity and bond market manipulations. The incredible growth in the derivatives market since 2000, growing to over $700 trillion at the height of the financial crisis (see chart below), may reflect market “innovations” by the financial industry, but it should also be remembered that the Federal Reserve and other regulatory agencies explicitly praised them for contributing to the stability of the financial industry. (And regulated them as well: such derivatives have been highly regulated by government agencies for decades.)
The system of fractional reserve banking is perhaps also one originally set by the free market, but has since been nearly universally regulated by governments, and hugely distorting to the financial industry, greatly magnifying its risk. With fractional reserve banking a bank is only required to hold a fraction of the money (often 5% to 10%, but sometimes lower, depending on the asset or location) deposited by its customers. The rest it may lend out or otherwise invest. With this, if a customer deposits $10,000 in a bank checking account, with a 10% reserve requirement, the bank only has to keep 10%, or $1,000, and can then lend out or invest the other $9,000. Some of this lent money will then also wind up in banks who can then leverage this as well, keeping a fraction of the $9,000 and lending the rest. This then becomes a very effective way for the money supply to increase even faster, and also for banks to fatten profits. While they pretend to serve customers, deposits from banking customers are a means to an end and fractional reserve banking is the leverage. The banks use fractional reserve banking to leverage their deposits into assets ten or twenty times higher, and then depending on the type of investments purchased with customer money, can leverage upon leverage.
However, the economic distortions and dislocations of the fiat currency and money printing systems you can place right at the hands of the government and central banks. Going off the gold standard in 1971 gave a green light to money creation, and trillions of extra dollars every year to slosh around the financial system. It also gave the all clear for governments to spend and overspend. In the past, government overspending generally meant they had to raise its citizens’ taxes, a risky business for those wanting to be reelected. Federal governments could also sell bonds to cover budget deficits, but it had to do so in a limited way to avoid upsetting bond market traders, and sending interest rates higher. But especially since the early 1990s the Federal Reserve has learned how to borrow and print, while at the same time keeping interest rates artificially low through rate-setting and jawboning. The interest rates structure, in general, has not been a “free market”, or one from a capitalistic model, in a very long time. The Feds’ manipulations of interest rates was a proximate cause of the 1990s dot-com bubble, the real estate and credit bubble of the mid-2000s and the current one that has resulted in more than $60 trillion in new global debt since the last financial crisis, and perhaps set up an even larger one to come.
With such a fundamentally distorted financial system, with fractional reserve banking, abandonment of hard currency and interest rate manipulation (among other embedded financial industry distortions), you cannot then give a green light to the financial industry to do whatever it wishes, particularly when it is playing with house money where big finance keeps the gains and taxpayers pay for the losses. The financial system is now so managed and regulated, it is difficult and dangerous to allow it to engage in “free market” activities that have the potential to bring down the industry and the economy. If the government and Fed is going to take control of a system they’d better know how to manage and regulate it well. The evidence shows they don’t.
Regarding the 2008 financial panic, many commentators like to point to the 1999 repeal of the Glass-Steagall Act, as directly contributing to the financial crash. That act, originally passed in the early 1930s in the wake of the depression and banking crisis, was designed to separate traditional banking from investment banking. It is sometimes remarked that the repeal of that act drove the financial industry on a free-market binge, with the inevitable crash, with the resulting harm done to the U.S. and world economies. But aside from the fact that the banking industry wasn’t a model of capitalism before the repeal (and, in fact, in 1998, before the repeal, the banking giant Citibank was allowed to merge with investment banker Solomon Smith Barney, with full approval of government and Fed regulators), this ignores the tremendous distortions that have existed for decades within the financial industry. The financial industry has not been a free market for many decades, but a manipulated and distorted one, heavily regulated by government agencies and at the mercy of a corrupt financial system. Perhaps the real lesson of the financial industry’s involvement in the 2008 collapse (along with others at different times and around the world), is not that we “need a regulated financial system”, but that we need one that is well-regulated.
Whether one believes in capitalism, communism, socialism, or a quasi-capitalistic government controlled one, it is not correct to look at the 2008 financial crisis as an example of why capitalism, or the free market, failed. Capitalism didn’t exist in the U.S. then, it doesn’t now, and it hasn’t for many decades. Particularly, when the heart of the financial stress was centered in the government controlled and connected financial system, the “failure of the free market” should be seen as the failure of an economic-government system that pretends to be a free market.