Fed in a Bind
by Llewellyn H. Rockwell, Jr.
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.
February 23, 2001
Llewellyn H. Rockwell, Jr., is president of the Ludwig von Mises Institute in Auburn,
Alabama. He also edits a daily news site, LewRockwell.com.
Copyright © 2001 LewRockwell.com |
