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The Greenspan Myth

April 5, 2001

Ever since the ominous fall in stock prices and the economic slowdown in recent months many Greenspan fans have turned into bitter critics who censure the master for having hiked interest rates unnecessarily in 2000. Millions of investors have lost most of their savings in only twelve months as four trillion dollars in wealth vanished when Nasdaq prices fell by 70 percent, 80 percent, even 90 percent.

They now fault the Fed for not having lowered the rates quickly and sizably since the downturn came in sight. "The Fed is asleep at the wheel," they are moaning. They are clamoring for big interest rate cuts "in order to save the economy." The loud hustle and bustle for lower interest rates do not diminish the cult of the Fed.

All eyes continue to be on the Fed. If only its critics could hold and wield its controls, they would slash the rates which would revive the economy. At least, that is the talk of today, the explanation given by nearly every analyst, fund manager, and news commentator.

A few economists of the Austrian School view the Greenspan Fed in an entirely different light. They perceive it as the very cause of instability and not the solution. They fault it for having fostered the biggest and longest bull market in history, the most speculative market with the greatest public participation, the largest volume of trade and the greatest overvaluation of corporate stocks. And they censure it for laboring to avert corrections and readjustments. While public opinion applauds the Fed for averting the financial crises, these economists deplore all such Fed efforts for being counterproductive, aggravating, and prolonging the readjustment pains. Booms and recessions do not spring from the nature of the market order, they contend.

Central banks and many financial institutions with central-bank backing and support create them by issuing fiat money and credit which falsify interest rates and distort the market structure. Low-interest fiat credit in particular misleads producers in their entrepreneurial decisions. Led astray, many embark upon uneconomic construction which in time is bound to inflict losses. When many businesses expunge the losses through correction and contraction we speak of a recession. The projects that looked so promising during the boom must now be written off as entrepreneurial errors.

Cuts in interest rates obviously cannot correct the mistakes made in the past. Once the readjustment has begun interest rate cuts tend to make little difference. Every Fed chairman since the recession of 1924 has tried to prevent the decline by lowering interest rates. After the stock market crash of 1929 and during the Great Depression the Fed lowered its rates eight times. During the recession of 1973 to 1975 it lowered rates six times. It lowered rates in 1945, 1953, 1970, and 1990, and yet the economy continued to slump. The same can be said about the reductions of 2001.

All eyes, nevertheless, are on the Fed, the guardian of liquidity, defender of stability, and protector of prosperity. Even if its governors should fail and disappoint, it remains the focal point of hope on which all aspirations converge. And it is the object of formidable financial and political pressures for easy money and credit. Most Wall Street analysts and strategists who in recent months have become the target of much public denunciation and anger long and wait for early rescue by the Fed. Ever eager to sell stocks, their very economic existence depends on a bull market which the Fed will hopefully restore.

Numerous major publicly-trade companies with debts in excess of assets are dangerously close to bankruptcy. In a recession their creditors and especially their bankers may be dragged down by them. Banks across the country are holding more than a trillion dollars in commercial and industrial loans much of which may go bad in a recession. They all look to the Fed for prompt deliverance. An important pillar of the economic boom of the 1990s was debt, the greatest edifice of debt in American history. Individuals, corporations, states, and communities incurred mountains of debt. Consumers' savings even turned negative, that is, they spent more than they earned.

According to In-ChargeInstitute, a provider of credit counseling services, the average credit card debt per household now amounts to some $8,000. Altogether, consumer debt is at a record high, totaling $1.52 trillion. In a recession much of this debt may default, which would cast a shadow on many financial institutions. They look to the Fed for support so that they may endure a recession.

Few politicians and government officials, if any, can visualize an economic order without a central bank that manages the people's money. Surely, they are not interested in financial freedom. They need the Fed to guide and supervise the financial structure they created. The banking system with its fractional reserves undoubtedly needs a central bank with legal tender powers to come to its rescue whenever it is found to be overextended and insolvent. The Fed is the appointed supervisory authority and lender of last resort. It is also the primary credit agent of the U.S. Treasury, facilitating the ready financing of any size deficits the Treasury may incur.

The federal debt of some $5.5 trillion would be inconceivable in an unhampered market order functioning smoothly with commodity money. The classical gold standard would have been an insurmountable obstacle to such heedless spending of the people's savings. This is why politicians and officials passionately disparage and decry it as a relic of the distant past. Their deus ex machina which resolves any financial difficulty is the Fed.

The great popularity of the Fed rests not only on its multifarious functions as economic regulator and lender of last resort but also on thorough public indoctrination by the academic community. To inquire into the history of any institution is to search for the doctrines and theories that guide the policy makers. Ideas control the world, and monetary ideas shape monetary institutions. Most American colleges teach various systems of economic thought which place the Federal Reserve System in the center of their economic universe.

Three schools of thought in particular have influenced and continue to guide public opinion and shape economic policy: the Keynesians, the Supply-Siders, and the Monetarists. The policies they shape tend to be heterogeneous and incongruous depending on their relative strength and influence and the compromises they are forced to make in the realm of politics.

Most professors of economics merely recite the doctrines and theories offered by the most famous and influential economist of the 20th century, John Maynard Keynes. Unemployment and depression, according to Keynes, are the result of inadequate effective demand. Therefore, government must apply monetary and fiscal policy to increase aggregate demand. The central bank must increase the nominal amount of money, which causes interest rates to fall, investments to increase, and income to rise. But in case monetary policy should prove to be ineffective because individual hoarding may counteract an increase in the quantity of money, Keynes recommended direct government investment through tax cutting and deficit spending.

Keynesian economists rarely propose to tap the capital market to finance deficit spending. They depend on only one source: the expansion of money and credit by the central bank and the banking system which it guides and controls. Their appeal to central bankers and deficit spenders has made their teaching rather influential the world over. It has given rise to the New Economics which has become the common everyday property both of the learned and of the laity, the mental furniture of businessmen, politicians, and professors. The Supply-Siders who readily accept the Keynesian framework enjoy great popularity with the public because they promise tax- cuts for all. Unfortunately, they obscure the fact that the real burden of government is not the weight of taxation, but the dead weight of government spending.

Taxation is merely one of several methods of public financing. Tax reductions without spending reductions merely shift the burden of government from taxpayers to the loan market where government crowds out business and consumes the people's savings. Government spending, thus financed, causes interest rates to rise, investments to decline, and economic conditions to deteriorate. Tax reductions without spending reductions are shams that may deceive the voters, but do not lower the burden of government.

Supply-Siders would not change the monetary system, but would manage it differently. They would use the Federal Reserve System to adopt a "price rule," that is, they would stabilize the value of the dollar by holding the price of gold at a certain point or within a certain range. When the price of gold rises to a maximum, the Fed would contract the total volume of credit to exert downward pressure on the price of gold. When the gold price falls to a minimum, the Fed would expand credit and send the price of gold back up. By stabilizing the gold price through Fed credit expansion or contraction, all other prices would be stabilized in the end.

It is unlikely that the Greenspan Fed was ever guided by a price rule for gold. But sooner or later it may be called upon to enter the gold market in order to come to the rescue of a few giant bullion banks, such as J.P. Morgan, Chase Manhattan, Citigroup, Goldman Sachs, and Deutsche Bank. Since the early 1990s these banks have borrowed large quantities of gold from various central banks at rates of one percent or less, then sold it for U.S. dollars and invested the proceeds in U.S. Treasuries at 6 percent or higher. Such transactions obviously are very profitable but rather risky and potentially ruinous if the price of gold should soar beyond the level at which it was sold, or the gold loan rate should rise and the Treasury rates should fall.

The fate of the bullion banks obviously rests in the hands of the Fed. Although the Monetarists are vocal critics of the Keynesians and the Supply-Siders they, too, rely on a federal monetary authority which would have direct responsibility for controlling the stock of money; but in contrast to the Keynesians, they would not bestow broad discretionary managerial powers, but would provide simple, definite rules laid down in legislation. Milton Friedman, the senior Monetarist, recommends a Constitutional amendment that would read as follows: "Congress shall have the power to authorize non-interest-bearing obligations of the government in the form of currency or book entries, provided that the total dollar amount outstanding increases by no more than five percent per year and no less than three percent."

Such an expansion of the stock of money not only presumes the existence of a monetary authority, a "Fed," to expand the stock, but also relies on legal tender for forcing its acceptance at par. The issue of "non-interest-bearing obligations" would not alter the nature of currency expansion; it would merely simplify its technique. The volume of these obligations is supposed to grow, year after year, without any obligation to repay, which supposedly changes their nature from being "obligations" to being mere government money.

Instead of the Federal Reserve creating funds and buying U.S. Treasury obligations, earning an interest thereon and then returning the interest to the Treasury as "miscellaneous receipts" (the present method), the Monetarists would have the Treasury issue non- interest-bearing U.S. notes, which would save the U.S. Treasury the interest it is now paying, and eliminate the "miscellaneous receipts" the Treasury is now receiving. Monetarists rejoice about the "dethroning of gold" which they believe "reduces the sensitivity of the stock of money to changes in external conditions." They refer to the imponderables of gold mining throughout the world and to political upheavals that may affect the flow of gold from country to country.

Actually, the abolition of the last vestiges of the gold standard in 1971, when the U.S. Government defaulted to redeem its currency in gold, did not bring stability. On the contrary, it opened the gates for world-wide inflation and several currency crises. It made the U.S. dollar the reserve currency of the world, elevated the Federal Reserve System to the world central bank, and inundated the world with fiat dollars. The consequences of this course of events may haunt the United States in years to come.

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If it is true that the fiat money and credit expansion by the Federal Reserve and its ancillary financial institutions is the root cause of economic booms and busts, the advocates of economic stability have no choice but to demand a halt to fiat expansion. The U.S. Congress created the present system and conferred the power to create fiat credit on the Fed; it can limit or even negate this power at any time. But no one but a few lonely, politically-incorrect economists has the courage to propose such an obvious solution. Their voices are barely audible in the din of the public's call for more money and credit.

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Hans F. Sennholz, Emeritus Professor of Economics at Grove City College, is an adjunct scholar of the Mises Institute. Send him mail, and see his Mises.org Archive and his Personal Website.

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