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Cleaning House

September 6, 1998

The Fed may be preparing to adopt exactly the wrong policy in response to falling stock prices, recessionary fears, and collapsed world currencies. Instead of allowing a much-needed market correction to run its course, it may attempt to head it off by driving interest rates lower. Some financial pundits even suggest the Fed should intervene to save the stock market, as if a portfolio that grows in double digits has become a middle-class entitlement.

If the Fed follows this advice, or anything like it, it will prolong suffering and cause more debacles. Look at the Bank of Japan, which, during the last three years of recession, has pushed some interest rates to below 1percent. Far from encouraging broad-based borrowing—people are not idiots, after all—the policy has only worked to salvage illiquid financial institutions and to insulate whole sectors from coming to terms with the downturn.

Such short-sighted attempts to shore up failure assume that recessions serve no real economic purpose. They are exogenous shocks to the economic system that hit as randomly as lightning. Currency speculators then take advantage of recessions to make a killing off the misery of others. The job of central bankers, in this scenario, is to fight off recession and speculation with looser money.

But the theory that booms can last forever, and that any economic trend can be reversed by a central bank, is false. Instead of recovery, for instance, Japan is falling further behind. A similar process, on a different level, is playing itself out in Russia.

For the nineties, the U.S. has been in the boom phase of the cycle. Beginning soon after the 1992 election, Bill Clinton made his peace with the bond market and Alan Greenspan rewarded the administration with a federal funds rate of 3 percent. Greenspan sat next to Hillary Clinton at the State of the Union address, and investors got the message. The most conspicuous sign of the nineties boom has been the explosive inflation in stock prices, and the U.S. has enjoyed the free ride of having the dollar become the de facto world standard.

The problem with economic booms is this: it is never obvious to observers, no matter how sophisticated, which sectors of the economy are being artificially propped up by exorbitant lending (and to what extent), and which are being sustained on their economic merits alone. Booms obscure what is real and what is credit-created mirage.

The economic function of recessions is precisely to sort out this difference. Recessions are not random; they are induced by prior economic errors. They correct the effects of "irrational exuberance," in Greenspan's famous phrase. They purge the economy of unwarranted projects undertaken during the boom, and represent macroeconomic honesty after a time of fibs. In this sense, we should think of recessions as difficult but necessary and even good.

As economist Murray Rothbard showed in America's Great Depression, the Great Depression might have been the Short Recession if politicians hadn't intervened to prevent the working out of economic law. They should have seen the stock market crash as a rebuke for prior credit expansion, letting banks and businesses fail and begin anew on a sound basis. Instead, they propped up wages and prices, and instituted central planning.

Today, the Fed has lent its support to the bailouts of whole governments and their banking systems in Mexico, Indonesia, and South Korea. It has lobbied on behalf of the IMF's growing role as the global lender of last result.

It's not only old-line Keynesians like MIT's Paul Krugman who cheer Fed intervention. The Wall Street Journal is also advising Greenspan to head off a supposed deflation by gunning the money supply. Both sides of the debate believe that the Fed's primary job is to guarantee stability, either of prices or the macroeconomy.

But the Fed cannot achieve the unachievable. A market economy cannot be "stable" in any statistical sense: it is a dynamic process driven simultaneously by risk-taking and security seeking, profits and losses, successes and failures. When failures and losses occur in clusters, it is for a reason and it serves a purposes.

The Fed has been a quiet conspirator in an unwarranted boom; anything it does to try to prevent the bust can only make matters worse.

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Llewellyn H. Rockwell, Jr., is president of the Ludwig von Mises Institute in Auburn, Alabama.


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