The Berlin Wall in Economics

There are a few economic principles that almost all economists endorse. One of those principles is that prices are best set by markets, rather than by politicians or central planners. Yet, at the same time, many economists believe the Federal Reserve (Fed) should manipulate interest rates.

Curious, isn’t it? Interest rates are a linchpin price in any economy. If markets are the best determiner of prices, why would markets not be the best determiner of interest rates?

In the interview below, the always elegant and brilliant observer of the Fed, Jim Grant points out that the Fed has been “highly manipulative” and has suppressed the price mechanism:

The Fed seems bent on suppressing this most elegant thing we have called a price mechanism, the movement of price that determines all manner of things in a market economy. Yet the Fed seems bound and determined to superimpose its will in place of the price mechanism. Take the bond market for example, the Fed has hammered down yields directly and indirectly and in response people are throwing money at things like high-yield or junk bonds. These are the prices the Fed wants, but are they the right prices? No not necessarily.

So how do economists resolve the cognitive dissonance over the fact that they have two irreconcilable theories? Clearly the idea that the Fed should have the power to set interest rates cannot meet the idea that markets are the best judge of prices. So economists have built their own Berlin Wall where the two theories shall never meet: The idea that prices should be set by the market is studied in the field of microeconomics, and the idea that the Fed should manipulate interest rates is studied in the field of macroeconomics. And never the two fields of study shall meet.

The real Berlin Wall had two important functions: One was to keep East Germans from escaping to the West, and the other was to keep East Germans from experiencing the West. The latter was necessary to prevent cognitive dissonance. One day in the West and the delusion that East Germany was a socialist paradise would be shattered.

Splitting economics into micro and macroeconomics serves a similar function. Those who pronounce problematical macroeconomic theories do not want pesky micro economists reminding them of microeconomic principles. And they themselves do not have to experience the cognitive dissonance should two conflicting ideas meet.

Jim Grant is not an academic economist who relies on academic peers to publish his research. He has the freedom to tell the truth. The inherent conflict between micro- and macroeconomics has not been subject to mainstream academic debate. Of course Austrian economists (those who have studied the teachings of Friedrich Hayek and Ludwig von Mises) understand the inherent conflict. Despite having won a Nobel Prize, Hayek’s ideas are literally ignored in most PhD programs and are not covered in most economics classes.

When asked what the worst-case scenario is, Jim Grant foresees the possibility that the “collective actions of world’s central banks careen out of control.”

If that sorry day happens, not only the Fed but academic economists should be held accountable for the Berlin Wall that they constructed. They will generally agree that New York City officials should not be setting rents and that politicians should not be setting oil prices. But, they are guilty of malpractice if they don’t also agree that Ben Bernanke should not be manipulating interest rates.

Driving over the George Washington Bridge into New York City and then on to the Cross Bronx Expressway going toward Connecticut, you see first-hand the consequences of rent controls. After all these years of manipulating interest rates, we will soon “view” first-hand the consequences—the “view” will not be bucolic; it will be as ugly as the South Bronx.

One Response to The Berlin Wall in Economics

  1. Barry Brownstein says:

    Update: Charles Hugh Smith recently wrote:

    I would characterize Mr. Bernanke as a tipsy teen with his foot mashing the accelerator pedal to the floor, supremely confident in his ability to navigate the careening car.

    In Bernanke’s case, the intoxicant is hubris, and man, there is nothing like a hubris high.

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