23/11/2012 06:40 GMT | Updated 21/01/2013 05:12 GMT

The Curious Case of Benjamin Strong

Benjamin Strong was the first governor of the Federal Reserve from 1914 to 1928. He was also the first economist to use the interest rate to control the aggregate price of goods (the level of inflation), using credit based mechanisms called open market operations as the main tool to achieve his objective. An open market operation occurs when a central bank buys or sells government bonds on the open credit market.

The action increases or decreases the availability of credit affecting the price of debt, which sets the interest rate. The interest rate is the price of borrowing, when the supply increases the price (interest rate) falls and conversely when supply decreases the price (interest rate) rises. Strong's agenda of reaching aggregate price targets through using the interest rate impacts the functioning of the banking system and in turn the economy as a whole.

There are two main functions the banking system provides in an economy. The first is borrowing, which provides businesses with the funds needed to enable the means of production. This function of Capital Generation is required in an economy to create output and employment. Borrowing is also a necessity for potential homeowners who wish to enter the property market but do not have the means to do so on their own.

The second function of the banking system is lending, which provides an instalment of funds over a period of time in exchange for capital up front. This function of Social Security is required in an economy to pay an income to people who have worked in the past but are no longer capable of doing so. It is also a method of saving, which can provide capital for self funded initiatives or contingencies if employment or economic circumstances change.

The rate of interest which each potential investment offers either relates to the risk involved in the project, which will be higher when risk is greater to compensate for the potential loss the project could bring. Or to the demand for investment in the project, which will require a higher interest rate to attract potential investors and draw their attention away from other projects.

The banking system has two mechanisms that naturally set the price of debt (the interest rate), risk and opportunity cost. The interest rate is set by a natural equilibrium of demand and supply determined by these two factors. Any intervention by the central bank through open market operations or any other means will alter the natural price for debt and in turn impact on the two functions of the banking system.

If the price of debt is too high the funds will not get to businesses to enable the means of production and home ownership will become more expensive. The consequence of high interest rates is an increase in unemployment and property repossessions. If the price of debt is too low the income of the lenders will decrease and saving will become less attractive. The consequence of low interest rates is a decrease in pensioner income and a reduction in saving.

Central bank intervention has damaged the natural price equilibrium of the debt market through expanding or retracting credit. The increasing level of debt is the cost of maintaining 'price stability'. The natural balance of debt and the management of repaying the outstanding deficit have become secondary in priority after inflationary targets. Although inflationary targets may have been met over the last twenty to thirty years, at least according to central bank calculations, deficit targets in both the private and public sector have not.

The first question this raises is, 'Should inflationary targets be put in precedence of deficit targets?' The second and perhaps more important question this raises is, 'Have the inflationary targets created the deficits incurred in western nations?' Or even, 'Do inflationary targets require private and public deficits to operate?' The last question asked is very important as it suggests inflation targeting requires a certain level of risk to exist.

If this is true then it is worrying as it would indicate the current operations of macroeconomic policy create a level of risk in the economy, which could create more problems than the original action was supposed to solve. In fact there is evidence to suggest that the use of interest rates to manipulate inflationary targets has created enormous problems in the past for the economy and the banking system.

Benjamin Strong is a prime example of such a scenario. From the time of his tenure as Governor of the Federal Reserve from 1914 open market operations were used widely as a macroeconomic tool. Strong retired from his position in 1928 shortly before the largest economic catastrophe in history, the Great Depression, hit in September 1929. It is widely thought that the reason for the crash was an over expansion of the credit market and in particular the derivative market.

This would indicate the use of open market operations and the over use of risk elimination tools, such as financial derivatives triggered a contraction in the money supply which lasted for over a decade. The actions of the Federal Reserve prior to the Great Depression seemed to have been mirrored by the modern Monetarist economic movement over the last twenty to thirty years, which would indicate an equivalent period of economic contraction.

To me it does not seem that odd to expect economic woe. After all the long period of expanded credit has led to a large deficit that has to be paid back. This will have a long term impact on the economy. The new central bank policy of Quantitative Easing is merely compensation for the lost demand the high debt repayments have created. It is likely history will repeated itself and we will enter a new Great Depression.