Gene Epstein, writing in Barron’s ($), continues his assault on the Fed.
Auburn University economics professor Roger W. Garrison points out that the enduring capacity of monetary and fiscal policy to do harm derives directly from their adaptability. One period is never the same as the next. But the 1920s and the 1990s have a lot in common. Of course, they had very different outcomes — the stock market has not fallen 90% and jobless rate not risen to 25%, as happened in the ‘30s. But through both periods, fiscal policy stayed on the sidelines, while the Federal Reserve dominated the show.
From ‘96 through 2000, excess credit coming from the Fed was used to purchase nearly $1 trillion worth of primary and secondary offerings of stock — effectively zero percent credit, to the issuing companies. More about that in a minute.
As most of us know, the stock market also played a role in the boom and bust cycle of the 1920s. Not so well-known is that the tale was textbook, except not in the textbooks you normally read.
Fed-watchers were years away from being born, so the central bank could flood the economy with artificially cheap credit without getting it in the papers. Result: a huge imbalance between the amount invested and the amount saved. Resources that would otherwise have been producing consumer goods with the existing capital stock were instead devoted to its augmentation.
Even worse, the low interest rates launched investment projects that took more time to complete. And why not? A four-year project that breaks even at a 5% interest rate might suddenly look hugely profitable on borrowed money of 3%. Similarly, although far less rationally, the $1 trillion raised from stock offerings in the late 1990s often helped finance ventures that were years away from earning money, assuming earnings were even possible.
Getting back to the ‘Twenties, there was no reason to believe that once workers in these long-lead-time projects were paid their salaries, they would start saving more than before. So there was only way for the economy-wide “malinvestments” to stay afloat: They had to keep drawing new money from the Federal Reserve.
But the monetary expansion that resulted could only lead to more such malinvestments in need of life-support. The process came to an end once the Fed decided to tighten credit in the stock market. Because “once the credit system had become infected with cheap money,” an economist named A. William May wrote several years later, “it was impossible to cut down particular outlets of this credit without cutting down all credit, because it is impossible to keep different kinds of money in water-tight compartments.”
The Great Depression of the 1930s was under way.
