DISCRETIONARY MONETARY POLICY: Towards an Explanation of the Sub-Prime Mortgage Crisis

Many economists agree that in the short run, an increase or decrease in the money supply has real effects on the economy. That’s how the fed raises and lowers the fed funds rate, buy buying and selling bonds and utilizing printed money to manipulate the money supply in such a way that the fed funds rate (determined by overnight borrowing between banks) remains at it’s target level.

So, if the federal reserve wants to try to stimulate economic activity, at least in the short run it can inject liquidity into the market by lowering its targeted fed funds rate. This is why many people agree that the fed should be able to conduct discretionary monetary policy. When markets are volatile the fed's action can calm tensions.

The problem is that the tensions that the fed may be trying to calm are a symptom of problems created by previous discretionary monetary episodes. The general consensus of the Austrian and Monetarist/Rational Expectations views of monetary policy (admitting in substance they actually differ in many ways) is that expanding the money supply when not fully anticipated can lead to an artificial expansion. Decisions are made based on conditions in the credit market that may not be supported by the true fundamentals of the market. I.e. credit is cheaper than it should be. People take on riskier projects, leveraging increases, and if it is anticipated that the fed may intervene when problems ensue, they take on more risks than otherwise. This creates a moral hazard and adverse selection problem, and a series of bad ‘mal-investments.’

Later, when there are problems with inflation, or risky plans start to fall through, this house of cards built on miscalculated expectations and easy credit begins to fall. It is expected that the Federal Reserve will take action to alleviate concerns at this point. However it is often the case that the fed will have inflation concerns and be reluctant to act. A monetary contraction may follow with a recession. Many economists believe that this ‘boom and bust’ scenario is characteristic of discretionary monetary policy and that most of the recessions (including the great depression in the 30’s) we have had are a direct result.