Alan Greenspan is playing with fire. His recent lowering of the federal funds rate by half a point suggests that he is unwilling to allow the economy to settle into a recession, liquidating unwarranted investment.
There’s only one problem with this strategy: sometimes, and probably this time, a recession cannot be stopped. In any event, attempting to forestall one creates even more problems that can end in utter calamity.
If Greenspan had any sense or guts, he would hold the line on interest rates, and permit the economy and the stock market to tank. The screams would appear unbearable, but in 12 to 18 months the economy would be back on a solid footing and prepared for real growth in the future. This would also teach an important lesson to investors: that they can’t count on the Fed’s printing presses to bail them out.
But prodded by political considerations and deluded into believing that he really is the Master of the Universe, Greenspan appears to be pulling wildly at every lever at his disposal. He has the power to create money, and right now he is using that power. What’s more, this is not doing himself, George W., or the economy any good.
Wall Street responded to the half point decrease in the federal funds rate by selling stocks at lower and lower prices — the opposite of what was supposed to happen. A financial sector addicted to cheap credit is screaming at him that he is not going far enough. Print money, they say, regardless of the consequences.
Those calling for more money expansion point to some very bleak signs. Consumer and mortgage delinquencies are growing, as are corporate bond defaults. Industrial production is falling. And, most pressingly, $4.7 trillion has been lost on the stock market during the past year. Investors, assured by their brokers and media commentators that stocks are not risky and anyone who keeps a passbook savings account is a boob, are shell shocked.
But if you think that printing money is the answer, here’s something else to consider. Consumer prices in February rose at a rate well above that forecasted. This follows reports that wholesale prices are also starting to rise. And these increases are not just in one or two sectors but across the board. If Greenspan keeps it up, this is going to get worse and worse. A return of roaring inflation seems like a remote possibility now — but so did a stock market crash one year ago.
A quick inflation primer: why do artificially lower interest rates create inflation? Here’s how it works. The Fed lowers the rate it charges its member banks for overnight loans, which then permits banks themselves to lower rates for borrowers.
If banks find takers for the money, the effect is to create credit that is unjustified by the pool of savings. Assuming no other changes, this new money waters down the purchasing power of all existing money. The banks and their connected interests are able to spend the money before prices rise, while the consuming public gets stuck with the bill down the line.
The effects of inflation are deadly for long-term growth. Inflationary expectations can quickly take hold. Instead of saving, then, consumers began to realize that they are far better off spending, that is, getting rid of their cash before its purchasing power decreases. These spending patterns further increase prices until a spiraling upward begins to take effect.
What will the Fed do at that point? It can either slam on the brakes and prompt a dramatic economic downturn, or it can guide us into a hyper-inflationary environment. It turns out, however, that inflation is the last thing anyone cares about right now.
Saving America’s mutual funds from further calamity is apparently more important than forestalling wholesale robbery via inflation of what is left of American savings. There are even signs of growing inflation vogue. The Financial Times of London has called on the Bank of Japan, for example, to pursue policies that "take the risk" of "hyperinflation."
This is a shortsighted view, one that is as popular now as in the 1920s, when the business press couldn’t get enough of low interest rates. Ludwig von Mises in 1928 identified this as a "mania for low interest rates." "Every single fluctuation in general business conditions — the upswing to the peak of the wave and the decline into the trough which follows — is prompted by the attempt of the banks of issue to reduce the loan rate and thus expand the volume of circulation credit," he wrote.
Mises noted that people widely deplore both inflation and depression, but very few see the connection between those events and the actions of the central bank. That is why inflationist policies, such as those being pushed by Greenspan, keep coming back again and again. But as Mises said, if your prescription for downturns amounts to nothing but printing money, the end result will always be "crisis and depression."
Recessions are not natural disasters. They are the flipside to an unwarranted economic boom brought about by unwise monetary policy that feeds overinvestment in capital-goods industries. The thing to do is grit your teeth and get through recessions, and, above all, resist the temptation to pile error on top of error.
They didn’t listen to Mises in 1928. But Greenspan has the chance now to reverse himself, let the economy swallow a downturn, and get on a sound footing for the future. Forget the boom times. Any Fed chairman looks good when stocks are rising. Now is the time of testing.