Fed in a Bind

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Alan Greenspan may have come to believe the media when they say he has extraordinary, even magical, power to steer the economy. Like the captain of a ship, the metaphor goes, his job is to navigate the massive economy toward prosperity, keeping it away from rocks and storms. Miraculously, he does this using only a handful of tools, like the discount rate and the ability to buy and sell federal debt.

But now he has a very serious problem that should remind him that some forces are even more powerful than his Zeus-like self. If he reduces interest rates further to avoid recession, that releases more credit into the banking system, risking inflation. The recent report on wholesale prices, showing an annualized one-month increase in the double digits, suggests he can’t take that risk. But fighting inflation might cause the economy to nosedive.

What to do? The core problem he now faces is known as "economic law." What is that? These are the fixed, gravity-like rules that govern the world of exchange and production, money and prices, investment and the business cycle. The laws of supply and demand are the foundation. If you try to fix prices, for example, you can distort the operation of these laws, but you can’t make them go away.

An example might be fixing the price of a dozen eggs at $10 in order to help the egg industry. The trouble is that people make rational choices, so instead of buying the same quantity, they will be buy far less, and they will shift into substitutes. (Law: people buy more of a good at a lower price than at a higher price, all things being equal). The result is not high profits for the egg industry but rather a massive egg surplus (and huge black markets popping up).

It works in the reverse too. Fix the price too low to "help" consumers and you create a massive egg shortage. Keep it up long enough and you bankrupt the industry. As only one example of how dangerous fixing prices is (that is, an attempting to get around economic law), consider the California electricity mess. Much of the problem was caused by a attempt to control the retail price of electricity.

Alan Greenspan’s job is to be a price fixer. He doesn’t fiddle with the price of eggs or electricity. Rather he deals in an area far more dangerous and momentous: the price of credit. He and his buddies gather together on the Open Market Committee and decide what rate the Fed should charge on short-term loans, an action that can create credit and money out of thin air. How does he know what price to charge? He doesn’t know. There is no magical formula available to him.

Fed policy in an age of financial deregulation is such that he can’t even know for sure just how much money and credit a small action by the Fed will create. It depends on the lending decisions of banks, the borrowing decisions of consumers and investors, and a hundred other factors. The only way to know for sure is to examine the money supply after the fact, and even that is rather difficult to do because there are many different ways to measure it.

A hard job? You bet. All central planning is hard because central planners are attempting to do what is impossible. They are operating outside the free market and therefore lack the basic signals like profit and loss that guide the decisions of private entrepreneurs.

What happens if Greenspan and his friends create too much credit? It enters the economy through the capital markets and spurs production in a way that would otherwise be unjustifiable. This creates an unsustainable economic boom that begins in a few sectors and then spreads to create a kind of euphoria. It happens again and again: just as the punditry class is convinced that a New Era has arrived, the downturn seems to begin.

During the 1990s, the Fed had come to believe in its own infallibility. The Fed orchestrated three major bailouts without causing much damage (so it seemed), and otherwise appeared to be ushering in a new age of perpetual prosperity. We all know investors who became heady in the 1990s, attributing their massive profits to their own personal savvy instead of the phenomenal bull market. Well, the Fed, including Greenspan, enjoyed the same free ride.

No more. If the data coming out over the next few weeks suggest the return of price inflation-a consequence of way too much credit creation from 1996 to early 2000-the Fed will have a serious problem. It can’t use credit creation to both forestall recession and avoid inflation. Taming one encourages the other.

What’s the answer? Bite the bullet. Let the downturn happen, come what may, and cushion it with a massive tax and regulation firesale. That’s what economic law dictates. The long-term answer, however. is to restore a monetary system that is not vulnerable to manipulation by central planners at the Fed.

Llewellyn H. Rockwell, Jr., is president of the Ludwig von Mises Institute in Auburn, Alabama. He also edits a daily news site, LewRockwell.com.

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