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Set To Inflate

Tags Booms and BustsMoney and Banks

08/28/1998James Grant

The Wall Street Journal's David Wessel revealed the Fed's strategy for dealing with an economic downturn in its August 3, 1998, edition:

"The challenge for policy makers today isn't how to respond to a stock-market crash, if one occurs. They know what to do; the lessons of '29 and '87 have been well-studied. The Fed would flood the economy with money."

Well, the lessons haven't been studied well enough. It is the artificial creation of money and credit that leads to structural imbalances that precipitate crashes in the first place. Adding to the money stock only compounds the error and prevents a much-needed correction from occurring.

For more on the Austrian theory of the business cycle, we recommend Murray Rothbard's America's Great Depression and The Austrian Theory of the Trade Cycle and Other Essays, edited by Richard Ebeling with an introduction by Roger Garrison. Both are available in our on-line book catalog.

Here's an Austrian take on:

"The Coming Bust"
copyright,The Wall Street Journal, August 28, 1998

By James Grant

What we don't know about the future is almost everything. Yet a certain number of highly visible economic forecasters nowadays seem to doubt almost nothing. They are bullish on the U.S. economy--which, off and on for more than 200 years, has been the best and safest forecast. What's remarkable is that they are unqualifiedly bullish. They have brushed aside the Asian depression, the emerging-markets liquidation, the global currency crisis, the global credit crisis and (over the past several weeks) the confidence-sapping decline in the Dow Jones industrial average.

Of the 50 economists who participate in the Blue Chip forecasting survey, not one has predicted a recession to begin in the second half of 1998. Only nine percent expect a recession to begin in 1999. There is cold comfort in such massed optimism. Rarely is a hardened consensus right at an economic or financial turning point.

What gives the superbulls their confidence is the observation that postwar recessions have been preceded by a tightening of monetary policy. Ordinarily, what provokes the rise in the cost of borrowing is inflation. Today, however, there is no price inflation, and hence, the theory goes, no reason for the Federal Reserve to raise the federal funds rate. Ergo, the republic is safe.

But the republic is not safe. I do not pretend to know whether a downturn is looming (like a burglar, recessions arrive unannounced; economists read about them in the newspapers, along with everybody else). What I do believe is that the odds of economic and financial trouble are high and rising, and that the Fed-centered theories of so many Wall Street analysts are outmoded. Busts are not caused by the Fed alone. Fundamentally, what causes busts is booms.

Even for those who wrongly believe that the Fed is the sun around which the gross domestic product, the Standard & Poor's 500 and the other, lesser speculative and commercial planets revolve, there should be no complacency. By one criterion, Fed policy is already restrictive. The federal-funds rate, at which banks borrow and lend, is today the highest point on the entire spectrum of Treasury yields. (It is 5.5%; even the 30-year bond yield is lower.) From a banker's point of view, such an alignment of interest rates is decidedly sub-optimal. Traditional banking is based on the practice of borrowing at a short-term rate and lending at a longer-term rate. As short rates and long rates converge, the banking business becomes less profitable, and the process of credit creation--the lifeblood of the world economy--isinhibited.

Because the Fed has usually orchestrated the contraction phase of the credit cycle in postwar American experience, the bulls have come to believe that there can be no other bearish influences. But others there have always been (there were cycles in American credit before there was an American central bank).

The principal cause of the stringency in Asian credit markets is the palpable excesses of the preceding expansion. Reckless lending not only distorted the architecture of the regional economy, but also weakened the lenders' balance sheets. Now that bust has succeeded boom, the reverberations are being felt world-wide, including in the U.S., where bank stocks are falling and junk-bond yields are rising. The economic significance of the new stringency is that the marginal borrower is unable to find credit. Insofar as economic growth occurs at the margin, the contraction of credit is economic poison.

It is fashionably asserted that the Asian troubles, although undoubtedly hard on the Asians, are a blessing for the U.S. Without falling commodity prices and collapsing foreign-currency exchange rates, an overheating business expansion would have required an interest-rate coolant.

The argument is blindingly shortsighted. Even if the U.S. were an economic island (and whatever happened to globalization?), it wouldn't be spared a slump. The threat to a long-running bout of prosperity comes from within as much as from without. A great boom is mortal precisely because it is great: It creates its own excesses. A self-absorbed market becomes its own reason for being.

It will be said that the high-tech expansion of the 1990s bears little or no resemblance to the savings-and-loan-fueled real estate boom of the 1980s. But there are striking similarities. Both booms were nourished by cheap credit and by equity valuations that were derived in part from cheap credit. And both yielded more productive capacity than would otherwise have been forthcoming. Contrary to typical postwar experience, the end result of each process was not an inflation of consumer prices. Rather, it was an inflation in stock, bond and real estate prices.

The consequence of this inflation was a cornucopia of new office buildings in the 1980s and of a range of low-priced merchandise and services--low-tech and high-tech, domestic and imported--in the 1990s. The prices of the items in oversupply naturally tended to fall. Here was the kind of inflation that the American people could get behind and support. It was purely pleasurable until it began to stop.

Even before the Fed came into existence in 1914, economists of the Austrian school were developing a theory about such an investment cycle. Letting a central bank create an artificially low interest rate, they realized, could set a boom in motion. When, however, the boom went overboard (and why would it not, in view of the subsidized interest rates?), the excess of capital investment would make the economy lopsided, a flaw that would come to light when the flow of credit stopped.

It is this process that is now playing out in the U.S. It was a 3% federal-funds rate in 1993 that not only helped the banking system recover from the 1990-91 recession, but also sparked the public's breakneck rush into mutual funds. The stock market has hardly looked back since. Nor has the rate of growth in U.S. capital spending.

In general, the viability of capital projects conceived and executed in the manic phase of a boom depends critically on the continuation of boom conditions. A near-ideal environment is required to validate the heroic assumptions on which the projects were financed. Thanks to the late-cycle proliferation of optimistic forecasts, there is widespread faith that these assumptions are right. In such heady circumstances, record-high stock prices seem anything but exorbitant. The trouble starts when the boom subsides. Then it becomes clear that many supposedly essential investments were actually, as the Austrian economists said, "malinvestments." Stock prices fall, anticipating a decline in the rate of return on capital.

Contributing mightily to the Asian slump was the well-nigh universal expectation that it could never happen. "Before the crisis," relates the 1998 annual report of the Bank for International Settlements, "the last year in which real GDP growth was significantly less than 5% in Indonesia was 1985; in Malaysia, 1986; in Korea, 1980; and in Thailand, 1972. This consistently good performance contributed to strong increases in asset prices and led firms and households, as well as banks, to underestimate the risks of overinvesting."

It would be a miracle if, after seven-plus years of economic expansion and 16-plus years of rising stock prices, the U.S. were not similarly overextended. Certainly, the "risks of overinvesting" are in the front of almost no American's mind. At last report, notes John Lonski, chief economist at Moody's Investors Service, just 26.6% of household liquid financial assets consisted of money in the bank, the lowest portion of such wealth in bank deposits in at least 60 years. Fully 57.6% of the household sector's liquid financial assets was invested in the stock market, Mr. Lonski adds, the highest such percentage in at least 60 years.

When stocks were going up every day, Wall Street's economists were quick to credit globalization. Now that much of the world's economy has plunged into the economic and financial abyss, Wall Street contends that America didn't need the rest of the world anyway. And, besides, the Federal Reserve won't tighten monetary policy.

As a matter of fact, the Fed has already tightened by doing nothing in the face of a broad-based decline in market interest rates. Crowded in by troubles, Mr. Greenspan may presently ease, and this may temporarily reignite the speculative boom. But let the record show that Japanese money market interest rates were 7.5% in 1991, as the Japanese economy began to slip under the waves. Now they are 0.5%, and the Japanese economy is still slipping. Is the U.S. following Asia into a slump? We may hope that it isn't, and we may predict that it won't. But it's the height of folly to say that it can't.

----- Mr. Grant is editor of Grant's Interest Rate Observer


James Grant

James Grant is an associated scholar of the Mises Institute. He founded Grant’s Interest Rate Observer in 1983 following a stint at Barron’s, where he originated the “Current Yield” column. His latest books include John Adams: Party of One; Mr. Market Miscalculates; and Mr. Speaker! The Life and Times of Thomas B. Reed, the Man Who Broke the Filibuster.

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