Another related view:
Paul L. Kasriel, "Is Alan Greenspan a Closet Austrian?"
on the web at:
ntrs.com
From the article:
"In his recent Humphrey-Hawkins testimony, Alan Greenspan said excess aggregate demand exists in the US economy now because people wanted to consume currently goods and services that will only be available for consumption at some future date. This predicament sounds similar to the business-cycle explanation espoused by the Austrian school of economics, whose luminaries included Friedrich Hayek, a Nobel laureate. It is ironic that Greenspan, the chairman of the US central bank, would make this Austrian-like argument. Why? Because one of the major tenets of Austrian economics is that business cycles result from the actions of the central bank.
Let's briefly go over the Austrian explanation of the business cycle. Suppose that some new technology comes along that holds the prospect of reaping above-normal profits for those entrepreneurs who employ it. It will take some time, however, to build new plant and equipment complementary to the use of this new technology. Therefore, it will take some time before goods produced from this new technology will be available for consumption. In order to build the necessary new plant and equipment, entrepreneurs will have to bid some resources away from their current use in the production of goods and services. This implies some decrease in the amount of goods and services immediately available for consumption. In order to pay for these resources, entrepreneurs will have to raise capital, either in the equity or debt markets. This increased demand for capital will put upward pressure on interest rates, which would induce people to save more. Presumably the expected return on equity invested in these new enterprises would rise, also inducing more saving. Saving means cutting back on current consumption in the hopes of being able to consume even more in the future. So, the rise in interest rates and the higher expected return on equity induces people to cut back on their demand for current consumption, which frees up the resources needed to produce more future consumable goods and services.
So far, no problem, no business cycle. Now, enter the Fed, which is pegging interest rates at the level prevailing just prior to the technological breakthrough. Thus, interest rates will not be allowed to rise with the entrepreneurs' increased demand for capital. How does the Fed accomplish this pegging? By creating an increase in the supply of credit to match the increased demand for capital from the entrepreneurs. By pegging the interest rate, the Fed is controlling a price -- the price of current versus future consumption. The rise in interest rates, before the Fed entered the picture, represented an increase in the price of current consumption relative to future consumption. This was a signal to consumers to save more, i.e., cut back on their current spending. By the Fed preventing the rise in interest rates, consumers have no inducement to cut back on their current spending. Moreover, with the cost of capital being held down by the Fed, entrepreneurs have the incentive to start even larger projects employing this new technology.
Now we do have the ingredients for a business cycle. Although resources are being re-allocated away from the production of current consumable goods toward the production of future consumable goods, the demand for current consumption has not decreased. Thus, a situation of excess demand has been created by the Fed. This is the boom phase of the business cycle. This excess demand, if it persists, will ultimately lead to higher inflation. The higher inflation, or the forecast of higher inflation, will motivate the Fed to start raising interest rates, i.e., to start "destroying" the extra credit it had previously created to hold down rates. The higher rates will induce consumers to cut back on their current consumption, thus reducing excess aggregate demand. But the higher interest rates also will render some of the investment projects based on the new technology unprofitable. Therefore, some of these projects will be abandoned. This is the bust part of the business cycle.
Greenspan's explanation for the current boom was a bit different than the standard Austrian explanation. But, at the heart of his explanation, the Fed still emerges as the perpetrator of the "crime," just as in the Austrian case. Greenspan is arguing that the rise in stock prices, which represents future profits and future production from the employment of new technologies, is inducing people to try to consume today what will only be produced tomorrow. In other words, people are cutting back on their saving. But, if there were no Fed pegging interest rates, this decrease in saving would cause interest to rise until the demand for current spending again equilibrated with the current supply of goods and services. But, by the Fed, through its pegging operations, preventing interest rates from rising to their new higher equilibrium level, a situation of excess demand is allowed to occur.
Is there any evidence that the Fed stepped up its credit creation as the demand for credit increased? The chart below speaks to this point. Plotted in the chart is the 2-year annualized growth in nonfinancial sector debt against the 2-year annualized growth in the monetary base. The monetary base consists of currency and cash reserves owned by depository institutions and held in accounts at the Federal Reserve. Because the credit created by the Fed takes the form of currency and depository institution reserves, the monetary base, then, represents the amount of credit created by the Fed. Notice that in about the middle of 1997, growth in nonfinancial debt started to trend higher. Notice also that at about the same time, growth in the monetary base took off. So, the data suggest that the Fed stepped up its creation of credit at about the same time that the demand for credit picked up. This had the effect of holding interest rates lower than they otherwise would have been in the face of the increased demand for credit. And, by preventing interest rates from seeking their higher equilibrium level, the Fed allowed excess aggregate demand to develop in the economy. (The sharp acceleration in monetary base growth toward the end of 1999 represents, in part, the Fed's accommodation of banks' and the public's Y2K-related increased demand for currency. Because Y2K was a non-event, the demand for currency is subsiding and so, too, will the growth in the monetary base.)
So, has Mr. Greenspan joined the Austrian school of economics? I doubt it. In his excess-demand argument, the chairman never once mentioned the Fed's excess creation of credit as being the proximate cause of excess aggregate demand. But I suppose that in the interest of national economic security it would not be wise to have our supreme monetary commander admit before Congress and the American people that he had erred. If such an admission had been forthcoming, who knows how far consumer confidence might have plunged? Of course it is irrelevant as to whether or not Greenspan has come over to the Austrian side. What is relevant, however, is his stated intention to raise interest rates in order to rein in aggregate demand. According to Austrian business-cycle theory, then, we should be about to enter the bust phase of the cycle. Hold on to your hats and cash. It could be a wild ride." |
