Operation Twisted Logic – Why the Fed is the problem, not the solution

I wrote the following essay yesterday for TheStreet.com.

Yesterday the U.S. Federal Reserve delivered no real surprises. Its new policy was expected by the market and those members of the public who still follow the central bank’s every move with interest and, I can only assume, in the misguided belief that it has the answer to our problems. As part of “Operation Twist” the Fed will purchase $ 400 billion of long-dated government bonds and sell an equivalent number of short-dated securities from its extensive portfolio over the coming nine months. The operation is aimed at lowering long-term market rates and flattening the yield curve. In their infinite wisdom, the bureaucrats on the central bank’s policy-setting committee decided that here was another set of market prices that required their astute adjustment, or at least gentle guidance.

The Fed has recently acquired quite a taste for correcting market prices. Remember that the goal of the first round of debt monetization – euphemistically called “quantitative easing” – was to free bank balance sheets from the toxic waste accumulated during the boom and thus prevent banks from unloading unwanted mortgage securities in the market place at distressed prices, which would not only have burnt a considerable hole into their capital but would also have revealed the lack of true demand for these securities. This required the printing by the Fed of a brand new $ 1 trillion – give or take a few hundred billion – and provided a nice subsidy to the hard-pressed American financial system. The second round of debt monetization – QE2 – was squarely aimed at manipulating the prices of Treasury securities. Treasury yields were simply not in line with what the committee deemed appropriate for the planned recovery and had thus to be massaged to lower levels. Another $ 600 billion had to be printed for this initiative.

For the benefit of those Americans who were beginning by now to feel that monetary policy in the United States was acquiring a whiff of Weimar Germany, and who were still beholden to the quaint idea that the setting of asset prices and yields, just as any other price, should best be left to the market, Fed chairman Ben Bernanke, in an op-ed in the Washington Post in November 2010, spelled out the advantages of clever price manipulation by the central bank (I know, I know, you readers of the Schlichter files have read this quote already a few times. But it is simply too delicious to miss any opportunity to quote it again):

“Easier financial conditions will promote economic growth. For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment. And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.”

Well, the virtuous circle has not arrived yet. Defenders of this policy will argue that things would look even worse without it, and that for a while “quantitative easing” boosted equity markets and other risk assets. Hooray for that. Although it has to be said that the idea that we, the public, can easily be cajoled into feeling confident and behaving in more expansionary modes economically via the open manipulation of market prices strikes me as somewhat condescending and hubristic. But we are talking about a state agency here, so we shouldn’t be surprised.

The Fed’s entire policy program suffers from the same defect that all market interventions suffer from. The moment you stop intervening, the underlying problems come to the surface again. Just look at the short-lived results of QE2. Administrative price setting does not change economic reality, at least not for the better. The interventionist has to keep intervening and do so at an accelerating pace.

Surprisingly few people seem willing to ask what exactly the underlying economic problem is. As long as we avoid that question and simply talk superficially about slow growth, the risk of a ‘double-dip’ and the need for ‘stimulus’, I guess the Fed will continue to get away with portraying an image of, at worst, innocent bystander or, at best, a well-meaning and public-service minded bureaucracy that just keeps trying to fight the recession, diligently exploring all available policy tools. According to this popular view, our economic difficulties seem to have come over us like a bad harvest or an alien invasion. They appear to be entirely exogenous, and the Fed is our friend and partner helping us to get out of this mess.

The reality is different. Like all state bureaucracies, the Fed is in fact struggling with problems that are predominantly of its own making. The Fed is the reason we are in this crisis. Or, more specifically, the present economic crisis is the inevitable consequence of the political decision to adopt a system of unconstrained, constantly expanding fiat money, in which the central bank, in its role as lender-of-last-resort, systematically encourages bank lending and thereby the extension of credit on the basis of money printing rather than true savings. This system came into full bloom only in 1971, when Nixon severed the last link to gold and thus initiated, for the first time in history, a global system of unrestricted fiat money creation.

Our present problems are excessive levels of debt, now mainly public sector debt, weak financial institutions and distorted asset markets. On their present scale these problems would be inconceivable without a system of fully elastic fiat money and persistent periods of artificially low interest rates. Abandoning the gold anchor allowed the Fed, and other central banks, to cheapen credit and encourage borrowing for periods of unprecedented length. Today the Fed is promising us a way out of the crisis by providing monetary policy accommodation. This is hardly original. The Fed has practically always provided policy accommodation. Policy accommodation was the raison d’etre for the Fed. The Fed was founded in 1913 to support the banks’ money and credit creation and to avoid credit corrections. Hard and inflexible commodity money has now everywhere been replaced with elastic fiat money under central bank control so that the level of interest rates and the availability of credit in the economy are no longer constrained by the extent of voluntary saving but can be determined administratively by the central bank for the purpose of extra growth.

When Nixon took the dollar off gold internationally, the monetary base and bank reserves in the U.S., that is, the part of the overall money supply that the Fed controls directly, was $69.8 billion. Ten years later it was $147 billion, another ten years later it was $319.7 billion, another ten years later it was $645.1 billion, and last month, exactly 40 years after the dollar was ‘freed’ from gold, it was $2,679.5 billion. Like all interventionists, the Fed has to run ever faster to prevent the laws of economics to catch up with the unintended consequences of its interventions.

“Operation Twist” is another attempt to keep interest rates low and to encourage borrowing when the present crisis is in fact the result of low interest rates and excessive borrowing. The only solution to our problems is to stop printing ever larger quantities of money and to finally allow the market to set interest rates and to cleanse the economy of its accumulated dislocations.

Read more from Detlev at Paper Money Collapse.


  • Toby Baxendale says:

    Good Afternoon Detlev,

    I would be interested to know your thoughts concerning those people who consider themselves to be economists and influenced by the Austrian School, but not Austrian School economists , such as Larry White and George Selgin, who would say that Hayek says let money accommodate a demand shock (caused by past excess credit ramping up) by more loanable funds being pushed forth by banks from the new money balances of savers in these circumstances . Ideally they would like this done by fractionally reserved free banks who could issue new liabilities .

    I supply two quotes from Hayek that say that this is impossible, one from his book Price and Production and the other written at the back end of his career from Denationalisation of money. I supply these quotes as I am well aware of the quotes where he does seem to say that to prevent a secondary deflation we should look at money velocity adjustments, its just they never seem to be matched to these quotes which say the opposite. I for one can only conclude Hayek was inconsistent of this and perhaps in the thick of the late 1930’s felt he should be seen to be “doing something!”

    Hayek, Prices and Production:

    “..in order to eliminate all monetary influences on the formation of prices and the structure of production, it would not be sufficient merely quantitatively to adapt the supply of money to these changes in demand, it would be necessary also to see that it came into the hands of those who actually require it, i.e., to that part of the system where that change in business organization or the habits of payment had taken place. It is conceivable that this could be managed in the case of an increase of demand. It is clear that it would be still more difficult in the case of a reduction. But quite apart from this particular difficulty which, from the point of view of pure theory, may not prove insuperable, it should be clear that only to satisfy the legitimate demand for money in this sense, and otherwise to leave the amount of the circulation unchanged, can never be a practical maxim of currency policy.”

    And from Denationalisation of Money by Hayek

    “‘Neutral money’ fictitious
    My impression is that economists have become somewhat over-ambitious concerning the degree of stability that is either achievable or even desirable under any conceivable economic order, and that they have unfortunately encouraged political demands concerning the certainty of employment at a hoped- for wage which in the long run no government can satisfy. That perfect matching or correspondence of the individual plans, which the theoretical model of a perfect market equilibrium derives on the assumption that the money required to make indirect exchange possible has no influence on relative prices, is a wholly fictitious picture to which nothing in the real world can ever correspond. Although I have myself given currency to the expression ‘neutral money’ (which, as I discovered later, I had unconsciously borrowed from Wicksell), it was intended to describe this almost universally made assumption of theoreticalanalysis and to raise the question whether any real money could ever possess this property, and not as a model to be aimed at by monetary policy.1 I have long since come to the conclusion that no real money can ever be neutral inthis sense, and that we must be content with a system that rapidly corrects the inevitable errors. The nearest approach to such a condition which we can hope to achieve would appear to me to be one in which the average prices of the ‘original factors of production’ were kept constant. But as the average price of land and labour is hardly something for which we can find a statistical measure, the nearest practicable approximation would seem to be precisely that stability of raw material and perhaps other wholesale prices which we couldhope com- petitively issued currencies would secure.

    I will readily admit that such a provisional solution (on which the experimentation of competition might gradually improve), though giving us an infinitely better money and much more general economic stability than we have ever had, leaves open various questions to which I have no ready answer. But it seems to meet the most urgent needs much better than any prospects that seemed to exist while one did notcontem- plate the abolition ofthe monopoly ofthe issue ofmoney and the freeadmission of competition into the business of providing currency.”

    When demand changes and people hold larger cash balances are they saying in effect, “we are not prepared to pay the current higher prices for these goods and services offered by the market and when we are comfortable that they are correctly priced and what we want, we will send again,” or something else?

    Thus it would seem strange that free market economists can be seen to advocate accommodation to keep prices neutral when it is just those prices that need to be paired back for the market to function. I certainly know you are not saying this, but others do that are notionally Austrian and I would like to know your considered opinion on the matter.

  • Deltev, I agree –as per your last paragraph – that interest rates should be set by market forces. One of the many daft aspects of regulating economies via interest rates is that it involves boosting just those households and firms that are reliant on variable rate loans. We might as well boost economies via households and firms whose names begin with the letters A-L while ignoring the “M-Zs”.

    Toby, Re your 2nd last paragraph and cash hoarding, this is actually happening in the US according to Prof. David Beckworth. See:


    In your 2nd last paragraph, you ask whether when people hoard cash, they are in effect objecting to high prices. There is a bit of a tautology here. That is, a fall in all prices or average prices is ipso facto a rise in the value of the stock of money.

    Speaking as a wicked evil Keynsian, I don’t like the idea of waiting for prices to fall. This is exactly what is being attempted in Euro periphery countries, and look that the disastrous consequences. I’d rather expand the stock of money (in nominal terms), when people want to expand their stock of money. The downside is probably more inflation than would otherwise be the case, but I prefer 2 or 3 percent inflation to excess unemployment as per Greece.

  • Detlev Schlichter says:


    I am not very familiar with the writings of White and Selgin but I agree with you that Hayek was either confused on this point, or changed his mind a couple of times. Although I owe a huge debt to Hayek as it was his writings that got me involved with the Austrian School in the first place, I have to admit that I now struggle to follow him on many of his intellectual excursions and frequent ideological zigzags, and that I find it difficult to agree with him. From his first book in 1928 (Geldtheorie und Konjunkturpolitik) up to Prices and Production in 1933 he worked mainly in the Misesian tradition, with some departures already notable in PaP. From the 1940s up to his death in 1992 he developed his own research program, and this was largely outside the Austrian School. Admirers of Hayek – and they are numerous – may find this unfair. Why is only von Mises a “proper” Austrian? Well, if the term “Austrian School” is to denote a specific methodology and epistemology, based on the pioneering work of Menger and Boehm-Bawerk, then it was Mises who built on these foundations and developed them into a distinct, unique and (in my opinion) vastly superior intellectual structure, while Hayek lost interest in this project and moved in a different direction (theory of knowledge, law and legislation, theory of complex phenomena). “Constitution of Liberty” is mainly a social-democratic tract, appealing equally to Margaret Thatcher and German Social Democrats, and “Denationalization of Money”is – this is my honest opinion- vastly overrated. Interestingly, Hayek received his Nobel for the work he did between 1928 to 1933 (under the influence of Mises), not his massive output of later years. (Not that this matters much – now they give the Nobel to Stiglitz and Krugman – it is worth nothing). My point is that you cannot quote Hayek and say that this must be “Austrian” because Hayek said it.

    The Austrian business cycle theory explains the crisis as the inevitable consequence of imbalances that result from elastic money (fractional-reserve banking and easy monetary policy). Once these imbalances exist, the recession is the painful but unavoidable process of cleansing. Resource allocation and PRICES must be allowed to get back in line with underlying preferences. If this means that some aggregate of prices has to drop – so be it. It cannot be avoided.

    In the recession, the demand for money may rise. This will put further deflationary pressures on the system. This cannot be avoided by the “free FRBs” or an expansionary central bank without disrupting the very process of re-balancing. Why?

    Banks are not in the business of providing money but in the business of making loans. Money is a byproduct. Nobody (or pretty much nobody) who has a higher demand for money goes to a bank and takes out a loan and pays interest and then sits on the larger cash balance. The person who borrows has not a high demand for money but a high demand for goods and services. (This demand is indeed so urgent that the person is willing to incur interest expenses!)The borrower spends the money right away. People who experience a rising demand for money SELL goods and services or reduce their money outlays and try to accumulate cash balances that way. A rising demand for money does NOT lead to a rising demand for loans (and thus more fractional-reserve banking) but to a rise in the purchasing power of the monetary unit (deflation)! This is the proper way (the only way!) in which this demand is satisfied in a free market.

    If the central bank runs an easy monetary policy to avoid deflation, it pumps the new money first through the credit money (it cannot reach those who have a higher demand for money directly, but only those who can be encouraged with low rates to borrow again.) It thus goes first to people who do not have a higher demand for money. Before it reaches those who do, it will, in the process, encourage again borrowing and investment that is funded by elastic money, and will thus obstruct the re-balancing process that the economy needs.

  • Detlev Schlichter says:

    sorry…little correction. In the last paragraph I meant “pumps the new money first through the credit MARKET”, not credit money.

  • Deltev, Re your point that “Nobody …. goes to a bank and takes out a loan and pays interest and then sits on the larger cash balance” you might be amused to learn that George Selgin does not seem to understand this point. See first two paragraphs on page 97 here:


    This paper of Selgin’s promotes fractional reserve banking. What Selgin is saying on p. 97 is as clear as mud, but one interpretation of what he is saying is that people borrow money from banks in order (in his words) to “hold” it.

    He also does not seem to understand that a full reserve system can be set up under a fiat money regime (top of page 99). Laugh out loud.

    • Thank you Detlev , this is pretty much how I see it as well.

    • Ralph , Selgin is no mug, I do not believe he says this. He says that if a prior increase in the demand to hold cash balances is just met by a new issues of new money , then this will keep a deflation from happening and not cause a boom / bust as ATBC says, but just keep the economy steady. Re what I have said in the above, I know of virtually no bank who lends in these situations, they panic , rabbits in the head lights and do not lend. The people demanding loanable funds are the least credit worthy, so they will not get any money anyway, with these new mediated funds and the people who hold the money do not demand any more. I do not see the policy proposal of allowing FRFB’s and its ability to accommodate, with new money when a demand for money rises, to be an option.

    • Rob Thorpe says:

      Selgin understands perfectly well that people borrow money in order to spend it, not in order to hold it. He has expressed that view to me several times and it’s in his books. His theory of how the money supply meets money demand is related to bank reserve requirements, not loans. If you read one of his books he explains it all in great detail.

      And he doesn’t think that fiat money precludes 100% reserves either, nor does he say that on p.99 of that paper.

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