Is Ron Paul’s suggestion that the Federal Reserve be eliminated a “fringe position,” as Josh Barro suggested in the June 21 issue of National Review (“Mend the Fed”)?

It depends on what “fringe” means. If it means simply that a large majority disagrees, then Representative Paul’s position deserves that characterization. But if “fringe” is meant to imply that abolishing the Fed is a lunatic idea that is not supported by economic theory, then Paul’s position is far from it. In fact, a number of economists argue that the economy would operate more smoothly without a Federal Reserve.

Paul’s position is supported by Austrian business-cycle theory, an economic analysis that has its roots in the writings of Ludwig von Mises and Friedrich Hayek. This theory emphasizes the role of the interest rate in bringing together the plans of producers and consumers. The interest rate is the price of loanable funds — in effect, the price of money — and, like the price of any good or service, it gives producers information about consumers’ behavior and the actions of other producers. For example, if consumers wish to save — to put their money in banks, which lend it out — they will increase the supply of loanable funds, putting downward pressure on the interest rate. Producers can then borrow that money cheaply and invest in capital goods such as machinery, factories, and housing — which they can use to create goods for consumers to buy in the future with the money they have saved. Thus do producers and consumers arrive at the equilibrium interest rate, which matches producers’ plans to invest in capital goods with consumers’ desire to save.

Central banks, by artificially expanding the supply of loanable funds in order to generate a temporary boom, drive down the market interest rate and distort these signals. At a lower interest rate, producers are inclined to borrow money and invest it in capital goods, on the assumption that consumers are saving to purchase more goods and services in the future. In fact, consumers are not saving; they are continuing to consume goods in the present.

Those artificially low interest rates eventually must rise, usually when the government raises the interest rate to combat the inflation it created by lowering it. As a result, the cost of the labor and capital needed to produce capital goods rises beyond what producers expected, so they begin to lay off workers and abandon capital investments. The end result is that producers have used up resources in order to produce future goods for which there is not a sustainable demand. This is what Hayek calls “malinvestment,” and it is the fundamental cause of the boom-bust cycle.

The longer the boom is maintained, the worse the bust will be. Mises likened the process to a builder who designs a house thinking he has more bricks than he does. The longer he continues to build, the harder it will be for him to redesign the building once he discovers how many bricks he actually has.