The Fed may be preparing to adopt exactly the wrong policy in
falling stock prices, recessionary fears, and collapsed world
Instead of allowing a much-needed market correction to run its course,
may attempt to head it off by driving interest rates lower. Some
pundits even suggest the Fed should intervene to save the stock market,
if a portfolio that grows in double digits has become a middle-class
If the Fed follows this advice, or anything like it, it will prolong
suffering and cause more debacles. Look at the example of the Bank of
which, during the last three years of recession, has pushed some
rates to below 1 percent. Far from encouraging broad-based borrowing —
are not idiots, after all — the policy has only worked to salvage
financial institutions and to insulate whole sectors from coming to
with the downturn.
Such short-sighted attempts to shore up failure assume that
serve no real economic function. They are exogenous shocks to the
system that hit as randomly as lightning. Currency speculators then take
advantage of recessions to make a killing off the misery of others. The
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
be reversed by a central bank, is false. Instead of recovery, for
Japan is falling further behind precisely because it was unwilling to
the structural problems in its financial system caused by government
and otherwise let the market be. A similar process, on a different
playing itself out in Russia.
For the nineties, the U.S. has been in the boom phase of the cycle
set in motion in the last year of the Bush presidency. Beginning soon
the 1992 election, Bill Clinton made his peace with the bond market and
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
has enjoyed the free ride of having the dollar become the de facto world
The problem with economic booms is this: it is never obvious to
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
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
errors. They correct the effects of “irrational exuberance,” in
famous phrase. They purge the economy of unwarranted projects undertaken
during the boom phase of the cycle, and represent macroeconomic honesty
after a long period of fibs. In this sense, we should think of
a difficult but necessary and even good phase of the cycle. The attempt
dodge an inevitable recession is the attempt to force water to run
As economist Murray Rothbard showed in America’s Great Depression,
Great Depression might have been the Short Recession if politicians
intervened to prevent the working out of economic law. They should have
the stock market crash as a rebuke for prior credit expansion, letting
and businesses fail and begin anew on a sound basis. Instead, they
up wages and prices, and instituted central planning.
Back then, central bankers were rightly reluctant to intervene on the
side of the cycle. Not today. The Fed has lent its support to the
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 resort.
The Fed may say it believes in market forces, but it is not always
to let prices take their natural course in a crisis, especially when the
banking industry comes under strain. It’s not only old-line Keynesians
MIT’s Paul Krugman who cheer Fed intervention. The Wall Street Journal
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
to guarantee stability, either of prices or the macroeconomy.
But the Fed’s job cannot be to achieve the unachievable. A market
cannot be “stable” in any statistical sense: it is a dynamic process
simultaneously by both risk-taking and security seeking, both profits
losses, both successes and failures. When failures and losses occur in
clusters, it is for a reason and it serves a purpose.
The Fed should neither precipitate nor hamper trends on either side
the business cycle. It has been a quiet conspirator in an unwarranted
anything it does to try to prevent the bust can only make matters worse.