BOHANON & CUROTT: Fed’s heavy-handed tactics are threatening the economy

Friends of free markets take heed: Central banking is the new central planning. Since the economic crisis began in March, the Federal Reserve has injected trillions of dollars of newly created money into the economy.

Increasing the money supply is an appropriate step to prevent a collapse in spending that would make the economic downturn even worse. However, instead of merely injecting needed liquidity into the economy, the Fed is taking extraordinary measures to allocate credit to particular financial institutions. An alphabet soup of new credit facilities has been set up to make risky loans to big corporations, municipal governments and small businesses. In the process, the Fed has overstepped its bounds and embarked upon a form of market socialism that is detrimental to the long-run health of the economy.

First, by subsidizing distressed companies, the Fed is inadvertently fueling the persistence of so-called zombie companies, businesses so deeply in debt that they can never pay off the principal. These companies suck resources from healthy sectors of the economy and deter economic growth.

Second, the Federal Reserve is socializing credit risk. During recessions, private investors demand a risk premium due to the increased probability of defaults on corporate debt. The Federal Reserve has enabled highly leveraged companies to borrow at interest rates below those that reflect the true risks of default. This does not eliminate credit risk; it merely shifts it to future taxpayers.

Finally, the Fed’s new lending programs politicize the allocation of credit. By choosing to buy the bonds of certain corporations and municipalities but not others, the Fed is picking winners and losers. This jeopardizes the Fed’s political independence from Congress. One can easily imagine a future where Congress directs the Fed to pursue any and all political or social agendas through its credit facilities. For example, direct the Fed to buy bonds from firms that pay a minimum of $16 an hour.

Fed policymakers claim that its extraordinary measures are necessary given the weak state of the economy and that they will be unwound once the emergency is over. Perhaps, but new policy tools, once used, are almost always used again. History shows that, while the size and scope of the Fed’s intervention in the economy ramps up after each emergency and shrinks back some afterward, it never actually shrinks back to the original, pre-emergency level.

Restoring economic growth requires free financial markets, not central planning.•

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Bohanon and Curott are professors of economics at Ball State University. Send comments to ibjedit@ibj.com.