Risk-free profits short-circuit the system
The central bank’s open market operations that became the vogue in the early 1920’s are not just inefficient, they are contrary to purpose. Open market purchases of bonds by the central bank are supposed to have an inflationary effect. However, just the opposite is the case. The effect is highly deflationary as it is making bullish bond speculation risk-free. All the speculator has to do is to preempt the central bank. He buys the bonds first. The central bank is helpless. It has to buy the bonds at the higher price, thus rewarding speculators with risk-free profits.
In an unhampered market, risk free profit that may occur occasionally is ephemeral and has no consequences. Hawk-eyed speculators immediately take advantage of it with the result that the opportunity to make risk free profit is eliminated on the spot at the same instant. This is no longer true if the opportunity to make risk free profit is not an infrequent aberration but the consequence of deliberate and well-advertised official policy. Such is the case in the bond market, where the central bank uses open market purchases of bonds in order to expand the monetary base on a regular, ongoing basis. The “theoretical basis” to do this is Keynesian/Friedmanite economics. It is the most ill-conceived monetary policy that can be concocted to increase the stock of money. The Federal Reserve Act of 1913 disallowed such a policy and imposed stiff penalties on the Federal Reserve banks if their balance sheets showed that government bonds were used as reserves for creating Federal Reserve notes or Federal Reserve deposits. For a time, the Federal Reserve System used open market purchases of government bonds illegally, creating a fait accompli. As a result, Congress was forced to legalize the practice in 1935 when it amended the Act.
The monetary policy of open market operations is counter-productive and is responsible for much of the damage inflicted on the world economy during the Great Depression of the 1930’s, as it does right now. It could be seen in the failure of “quantitative easing”. Speculative purchases of bonds show up as a falling of the interest-rate structure, which it turn causes a fall in the price level, capital erosion, bankruptcies, and snow-balling unemployment. As long as interest rates are falling, the lethargy of businessmen will continue.