The Fed's Con Game

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The Federal Reserve and Wall Street agree that the stock market needs a big confidence boost. Fed policy, and brokers around the country, are trying to provide it, with their exhortations to stay calm and keep holding stocks. The idea is that if we all work together, we can keep the ship afloat. Just don’t notice those huge holes in the hull!

Implicit in this view is a grave falsehood that nothing in the real world is responsible for falling stock prices. The business cycle, in this view, reflects nothing but waves of emotion that sweep through markets. Not only stock analysts but also many economists have bought into this convenient error.

Where does this leave the Fed? Instead of doing what it can do, which is refraining from manipulating the money supply and interest rates, it is playing psychological games with the public. As Pace University economics professor Joseph Salerno argues, Fed policy is nowadays dealing not with concrete reality but with “the meta-economy of impressions, anxieties, perceptions and anticipations.”

Underneath it all, the Fed appears to be pursuing an outrageously reckless policy. It is attempting to push through the impending recession by printing as much money as possible. The latest numbers from the Fed show monthly money increases reaching as high as 20 percent per annum (as measured by MZM).

But the Fed can’t win at this game. We’ve already seen how dramatic attempts to gin up the market by lowering interest rates have been greeted with a huge ho-hum from investors. At best, the effect is short term. The Fed seems to have learned nothing from the Japanese experience, where even interest rates of zero failed to bring back the boom. Lower rates also threaten to revive serious price inflation, which is already looming.

Salerno further argues that Alan Greenspan, a legendary lover of data, has lost sight of the underlying relationship between cause and effect in economic events. The cause of the business cycle is not mysterious or emotional. It is economic imbalances that correct themselves during sell-offs, imbalances brought about by misguided Fed policy to begin with.

If we seek an explanation for the stock sell-off, we must first explain how it is that valuations became so wildly out of line. Looking back, it is clear that Greenspan need look no further than his own monetary policy. He enjoys a reputation as a hard-money man, but that is far from the case.

The problem began in the early days of the Clinton presidency, when the Federal Reserve gunned the money supply in late 1992 under the belief that this was the only way to get us out of the Bush recession. Also, Greenspan, contrary to the idea that Fed chairmen are “independent” of politics, was cozying up to the Clinton administration, ostentatiously escorting Hillary to the State of the Union speech.

In a modern economy, newly created money enters the economy through the credit system, so it is borrowers who end up receiving the initial blessings. They invest in projects that would be too expensive in the absence of the newly created money. These investments may lead the economy to new heights, but they tend to be unviable over the long term.

In the following two years, through 1994 and early 1995, the Fed reversed itself and held money flat. But beginning in mid 1995, the Fed began taking us on a wild ride. Money supply increases were between 7 and 9 percent for 1996 and 1997. Beginning in 1998, they shot up to 10 percent, and reached an astonishing 15 percent annual rate in early 1999.

All told, between 1996 and last year, the Federal Reserve worked with the banking system to inject more than $100 billion in new money (as measured by M2) into the economy. So much for Greenspan the tight-money man!

Now, $100 billion would have distorting effects with or without a stock market, new technologies, and complex new financing techniques. Replicate this same monetary policy in any time period, injecting new money through credit markets at double-digit rates, and you can create amazing investment imbalances.

Indeed it did. Real private investment soared from 12 percent of GDP in 1991 to a remarkable 20 percent of GDP by last year, with a pause in the increases taking place in the tight money years of late 1993 through early 1995. It so happened that all this new money hit at a time of extraordinary technological gains, particularly as related to the Internet. And it was the dot-coms and information technologies that were left holding the bag.

Why haven’t you heard about the spectacular monetary inflation of the late 1990s? One reason is that most people think there’s nothing to worry about so long as overall prices are not rising. But stable prices can often conceal underlying rot, and they did in the 1990s as they did in the 1920s. Besides, looking at money supply numbers has been distinctly unfashionable for many years.

A few economists warned about underlying problems, most of whom are associated with the Austrian School. Some incredulous stock analysts were rightly skeptical that any company with a P-E ratio of zero should be able to sell stocks to anyone. But most others were too busy marveling at the amazing performance of the stock market and the GDP and couldn’t be bothered to look at the fundamentals.

As in any economic boom, housewives and gardeners, to say nothing of run-of-the-mill brokers, began to believe that they were stock-picking geniuses. Millions of workers across America would forego lunch to dabble in day trading. Kids in high school would go to their school libraries to join in the fun, and dispense stock advice to their teachers and fellow students. Workers didn’t want wages; they wanted stock options!

The scene, comparable to something out of Charles MacKay’s “Extraordinary Popular Delusions and the Madness of Crowds,” looks absurd in retrospect. But at the time, otherwise sensible people threw caution to the wind to announce the repeal of economic law and the transformation of human nature. It’s incredible how a couple of years of money growth can affect the human psyche!

The whole thing was doomed to collapse no matter what the Fed did. But it so happened that Greenspan began slamming on the brakes again in mid to late 1999. Throughout the year and 2000, the money supply collapsed dramatically. And to many analysts, this collapse is the reason for the Wall Street meltdown and the current recessionary environment. Thus the supply-siders at the Wall Street Journal counsel Greenspan to open wide the money spigots.

But let’s be clear. The problem isn’t that Greenspan slammed on the brakes. That was only the precipitating event. The problem was the massive monetary expansion that caused the outrageous run-up in the first place. It created a fantastic amount of artificiality in the system that needed to be purged. In this sense, the present economic environment is a much-needed one.

But the story is not over yet. Since the beginning of the year, Greenspan has reversed course again. The latest numbers coming out of the Fed show that the same mistake is being repeated again. In the first quarter, the money supply soared again at a rate of more than 10 percent as measured by M2 and 20 percent as measured by MZM. But it doesn’t seem to be working — yet. If a “recovery” does take place, it is only setting the stage for another artificial boom to be followed by another bust. It is late 1992 all over again.

For now, the Bush administration isn’t panicking over the economic situation because it helps create a political environment favorable to the Bush tax-cut plan. But what happens after the small cuts take place and yet they have no noticeable effect on the macroeconomy? That’s when the Bush administration will turn to the Fed to manufacture another boom. Then the trouble really begins.

Oh, for the days of the gold standard, when money wasn’t the property of a central bank to manipulate according to the political winds! If we really want to end this nonsense, let’s make the dollar as good as gold again, and send the Fed chairman out to earn an honest living.

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

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