Free market capitalism is under assault. Framed as the culprit for the global financial crisis by the popular media, politicians and ideological opportunists alike, who expediently blame the United States for igniting the crisis. The irony is that we haven’t had true free market capitalism in the U.S. for a very long time. Plagued with recurring financial panics, recessions and downright depressions, the real culprit is the federal government management of money and credit that is quite antithetical to free markets.
Article I, Section 8 of the U.S. Constitution clearly gives Congress the enumerated right “To coin money, regulate the value thereof…” But in 1913, Congress decided to outsource monetary management to the Federal Reserve Banking System. And it did so for purely political reasons [1-4]: to charter an ‘independent’ body with the power to print paper money when the needs of government or special interests arose. More to the point: to finance government debt and perpetuate government spending habits; to rescue banks that become illiquid and insolvent due to risk mismanagement and/or instabilities in a fractional reserve banking system; and most insidiously, to inject inflation into the economy when prices fall below a certain point (price controls). None of these actions belong to free market measures in a capitalist society.
The stark reality is that the U.S. abandoned free market principles when it adopted fiat currency manipulation strategies and promoted a fractional reserve banking system that lends out many more dollars than exist in real deposits. A fiat currency (e.g., U.S. Dollar, Euro, Sterling, Yen) by itself is not the problem; it is the abusive government regulation of the value of the fiat currency that is anti-free market. Purposefully driving interest rates to zero instead of allowing for market determination of rates is anti-free market manipulation. Likewise, lending money created from thin air instead of from a rational measure of deposits undermines the supply and demand of resources that are natural to a free market and distorts healthy business cycles, not to mention the high risk of high leverage if loans default. The U.S. did not invent this brand of money and credit misregulation – it was adopted from millennia of central banking history in Britain and Europe [1,5,6]. The U.S. has become perhaps uniquely addicted to the easy money and credit binges promoted by our central bank, the Fed – especially since demand for Treasurys by foreign creditors (i.e., China and Japan) is limited. Runaway government spending, off-balance sheet entitlement liabilities and easy credit promises made to voters have throttled this modus operandi. And the crony capitalism of government welfare (bailouts, “subsides”) to large corporations and financial institutions has only made the addiction worse.
Consider the following basic examples to further illustrate. In a free market, interest rates are set by the supply and demand of the market, not artificially by a central bank. “When the Fed lowers rates artificially, they no longer reflect the true state of consumer demand and economic conditions in general. People have not actually increased their savings or indicated a desire to lower their present consumption. These artificially low interest rates mislead investors. They make investment decisions suddenly appear profitable that under normal conditions would be correctly assessed as unprofitable. From the point of view of the economy as a whole, irrational investment decisions are made and investment activity is distorted” . Artificially low rates are used to “stimulate” the consumer driven economy and interest rate sensitive investments, but the damage is borne in a misallocation of resources and a distortion of healthy free market driven business cycles. Consumers save less and consume more resources, and businesses that choose to invest will not only find resources limited and even more expensive as time progresses, but lending supply limited unless banks relax their reserve requirements. Modern fractional reserve banking answers this problem: banks lend from checkable demand deposits as well as timed deposits (such as CDs). Money that is lent can be multiplied by lending out on a basis of fractional reserves – for every dollar in checkable deposits, a dollar lent is deposited in checking and loaned again, up to the legal reserve limit. In a loose monetary environment, credit expansion means greater risk, as we have seen just recently in the credit boom of the last decade. In the worst case, artificially low rates and the artificial growth in lending supply (credit expansion though the creation of money in fractional banking) end in a business recession or depression: businesses cannot complete all of the invested projects due to the scarcity and/or inflationary expense of specific resources, and consumers cannot continue to spend what they don’t have. Natural supply and demand of the business cycle is disrupted.
As  succinctly points out, “The interest rate coordinates production across time.” And as far as the growth in the money supply caused by the artificial credit expansion, the effect on the fiat currency is profound: it further drives up prices of specific resources. When the system becomes unstable, banks run into liquidity and/or insolvency problems. And the central bank (the Fed) exists to reliquify banks that hit the instability curve. “Although interbank clearing mechanisms and continuous public supervision would tend to limit credit expansion in a fractional-reserve free-banking system, they would be unable to prevent it completely, and bank crises and economic recessions would inevitably arise. There is no doubt that crises and recessions provide politicians and technocrats with an ideal opportunity to orchestrate central bank intervention…Until traditional legal principles are reestablished, along with a 100-percent reserve requirement in banking, it will be practically inconceivable for the central bank to disappear” . In short, the free market and healthy business cycles are held hostage by the Fed.
The interplay between the savings rate, interest rates and lending, as they affect business cycles and consumer spending habits, are central to Austrian business cycle theory, founded by Ludwig von Mises. The Austrian economics school , led by Mises, his student Friedrich Hayek, and a range of economics scholars including Murray Rothbard and Henry Hazlitt, propose a different route to promote a free market economy – one based on a commodity-backed currency or standard that cannot be easily manipulated, banking and credit institutions that do not rely on an unstable fractional reserve practice for lending, and the lack of a need for a central bank that intervenes in markets with planning and control to undermine them.