The Free Market 21, no. 2 (February 2003)
Late last year, in a move that gives even politics a bad name, the Federal Reserve announced yet another cut in its key interest rates. Around the same time, Fed Governor Ben Bernanke gave a speech praising the power of alchemy to lower the price of gold, and, similarly, the power of the Fed to print as many dollars as it wants. Hence, the Federal Funds Rate is down to 1.25 percent, while the discount rate stands at 0.75 percent.
Economists from all sides applauded this “long overdue” move by Greenspan’s fed, its first cut in 2002 after 11 in 2001. Writers from the “Supply Side” faction of economic thinking have been warning about the alleged dangers of “deflation,” while others see the Fed as being the last hope to “stimulate” the economy.
Austrian economists, however, are not clapping. While the economic mainstream may see Austrians as being obstructionist oddballs, I think that we have a few things to say about this latest Fed move, which in our book is not a positive, but rather a negative move that is likely to have opposite effects from its intent. To put it another way, the Fed is not hastening economic recovery; it is impeding it.
Writers for this publication have expounded upon the Austrian business cycle theory, developed by Ludwig von Mises and F.A. Hayek, in which attempts by central monetary authorities to artificially increase monetary growth through credit creation leads to an unsustainable boom and, finally, to the bust. This last business cycle was classic in how it fit the ABCT.
Unfortunately, just as the drunk is beginning to become a bit sober, the Fed pours some more pure grain alcohol into the punchbowl. To put it another way, the ABCT declares that the only way to recovery is to permit the full liquidation of malinvested capital and resources that occurred during the boom. The Fed’s actions once again are impeding that progress.
One place where Austrians differ strongly from the economic mainstream is in the view that the recession or bust is a necessary part of the business cycle. As Murray N. Rothbard put it in his classic America’s Great Depression, once the bust has occurred, the worst thing government can do is to try to stop it. Liquidation of capital and other malinvestments is going to happen whether the government wants it to happen or not. It is best to permit nature to run its course, which hastens the economic recovery.
Mainstream economists, on the other hand, insist that an economic contraction should never be permitted to happen, and if it does, government must do all it can to stop the process at once. In their minds, the liquidation phase of the business cycle somehow is unnatural and must be restrained at all costs.
To see this belief in action, one must look at Japan. In the late 1980s, there were a number of bubbles from the stock market to real estate in that country, as its aggressive export policies led to large infusions of cash both from abroad and from its own central bank. (This was a time when Japanese speculators were purchasing huge amounts of real estate in the United States at unheard-of prices, leading the pundits to declare that Japan would soon “own” this country. No one is uttering such nonsense today.)
Since about 1990, Japan’s economic picture has darkened with the country seemingly mired in a permanent recession. While some “economists” like Paul Krugman have argued that the issue in Japan is simply a matter of aggregate demand (Japanese save too much, he believes), the real problem seems to be that Japan’s authorities, at the urging of its troubled but politically powerful businesses, are not permitting the necessary liquidation to occur.
For example, Japan’s banks still have not written off the bad real estate loans from more than a decade ago. Furthermore, many of its manufacturing firms are still trying to conduct business as though the boom were still a reality. No one, but no one wants to liquidate, since doing so obviously would mean businesses would shut down and Japan’s vaunted corporate welfare system would be stretched to its limits. Thus, the people of Japan continue to live in a world of economic fiction, waiting for Godot or whomever to wave the magic wand of recovery, while Japan’s central bank cuts its lending rate to zero.
Over the past decade, Japan’s government took on a large number of construction projects aimed at giving the economy a “fiscal stimulus,” taking on unprecedented levels of debt in the process. Krugman wrote that while one might make fun of the worthless bridges, roads, and “tunnels to nowhere” that were built, the massive projects in his mind kept Japan from sliding into depression. In other words, Krugman’s recipe to cure the problem of massive malinvestments is for the government to get in on the act itself and have its own set of wrongheaded investments.
In the meantime, the recession lingers. This is not due to any mystery of the business cycle, but rather an example of natural law at work. Present consumer markets simply will not support Japan’s overburdened capital structure, and all the gyrations and manipulations by the authorities will not change that simple fact. Had the government permitted the liquidation of malinvested capital a decade ago, Japan would be in recovery today. Instead, it has a bleak future.
While many signs here have not been good, for the most part I have been optimistic over the last year about our chances for economic recovery. I say that because the necessary liquidations here have been going apace. Granted, Congress and the White House have committed major blunders like the infamous post-September 11 airline bailout and the disastrous steel tariffs, but much of the needed “cleansing” of malinvested capital has continued apace and with little fanfare.
The stock market bubbles of the late 1990s are ancient history, and the government’s Microsoft settlement, while an abomination, at least gives some finality to a case that has stymied growth and investment in the high technology sector for several years. In other words, the basis for recovery is being laid—despite the wrongheaded efforts of the Fed.
However, by cutting interest rates and pushing up the money supply, the Fed has done whatever is possible to make the necessary liquidation as long and painful as possible. The rate cuts have sent very different messages from what market forces have been literally screaming for the past two years: deal with malinvested capital, please!
Instead, the artificially low interest rates created by the Federal Reserve System have sent false signals to investors that long-term capital projects are feasible—at the same time the financial markets have been saying the opposite. This is extremely confusing, to say the least.
If investors are doing what the Fed wishes—making large-scale capital investments—then they are prolonging the recession by trying to continue to string out bad investments. On the other hand, it also is possible that investors recognize what the politicians refuse to see, that many long-term projects that seemed promising a few years ago now are not viable.
One thing is for sure. Green-span’s repeated attempts to manipulate interest rates do nothing for the economy. At best, they are useless, except that they mean when the recovery occurs, investors will be enticed by artificially low interest rates and are sure to make large-scale errors in capital spending, creating conditions for a future recession. At worst, they encourage continued investments into projects that should be in the process of liquidation, not expansion.
The best thing Greenspan can do, other than to close down the fraudulent entity known as the Federal Reserve System, is to sit back and do absolutely nothing. A sedentary Alan Greenspan harms no one. When he is active, however, watch out. The man is dangerous.
William L. Anderson, an adjunct scholar of the Mises Institute, teaches economics at Frostburg State University (banderson@mail.frostburg.edu).
