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THREE EASY PIECES -- Mayer/Epstein/Anderson


The Fed's Faded Glory

by Martin Mayer

"Mr. Greenspan's repeated statements that inflation isn't a worry have the sound
of whistling past a graveyard..."
--Martin Mayer

[The article which appears below was written by Martin Mayer, a guest scholar at the Brookings Institution. It was originally published by The Wall Street Journal on June 26, 2001. Mr. Mayer is the Harvard-educated economist about whom James Grant once said, "If there is someone else who knows more about money, he has been keeping it to himself." Martin Mayer's latest book, The Fed, has just been published by the Free Press. -- Editor, The Gilded Opinion ]

If there is going to be "monetary policy," and almost everybody these days agrees that there ought to be monetary policy, the hard question is the target that policy should try to hit. There are three simple answers -- economic activity (technically, gross domestic product), inflation, and employment. The Federal Reserve system, which creates and enforces monetary policy in the U.S., is enjoined by law to promote growth, eliminate inflation, and increase employment, all at once. To achieve these goals, it has exactly one tool: It can raise or lower the interest rate that financial institutions pay when they borrow from each other overnight. It's hard to hit three targets with one bullet, and easy to kill the wrong one.

A Theatrical Enterprise

Years ago, the Fed had much more to work with. William McChesney Martin, as chairman of the Fed in the 1950s, could and did change the reserves banks had to keep at the Fed, increase or reduce activity at the "discount window" through which the Fed provided money for banks to lend, change the "margin requirements" that determined how much credit was available to stock market speculators, and set maximum interest rates banks could pay for deposits at a time when the only way banks could increase their total assets was by drawing new deposits or borrowing from each other. And in those days lending by the banks provided about two-thirds of the financing of American commerce and industry.

Banks' asset portfolios were stuffed with government bonds inherited from the budget deficits of the World War II years, and the value of these bonds fluctuated according to the interest rates the Fed could control. By relatively small movements of the rates, Martin could keep inflation under control while forcing the Eisenhower administration to accept what John F. Kennedy in the 1960 election would deride as a "stop/go" economy.

And it was all done behind closed doors: The public did not know for six months or more what decisions were made at the meetings of the Federal Open Market Committee, and even after six months the revelations were obscurely phrased to provide a minimum of information. What the Fed did affected what the banks did, which affected what the real economy did, which later affected prices in the stock market.

Former Fed governor Sherman Maisel reported that when President Richard Nixon joked in the Oval Office about how he hoped for easier money from Arthur Burns, whom he was swearing in as the new Fed chairman, all the people from the Fed were "extremely uncomfortable," because they had already given orders to their underlings to lower rates, and the underlings were doing it, but nobody knew. Banks and Wall Street houses hired "Fed watchers" to read the entrails.

Today, banks provide maybe one-fifth of the financing of American commerce and industry, and they are armored against a Fed trying to control them. "Reserve requirements" are meaningless, because most bank reserves are "vault cash" in ATM machines that would have to be stocked anyway. Banks get most of the money they lend by borrowing in the money markets, and the discount window is inoperative, because banks are scared that if they are seen borrowing from the Fed everyone will assume the market has locked them out. Meanwhile, banks can buy or sell "derivatives" that enable them to continue quite painlessly doing (or not doing) whatever it was the Fed wanted them to stop (or do).

The Fed, in other words, has much less real power than it had a generation ago. So it has become a highly theatrical enterprise, eager to seize attention and create attitudes. Where once the puppet-master was behind the scenes concealing the strings, the spin-master is now out front, announcing decisions and reasons for them while the market is open -- sometimes, indeed, just before the expiration of options and futures contracts, leveraging the exposures of stock speculators for the purposes of the central bank.

The problem with all this is not the confusion of government and theater, because governing is in many ways a theatrical art, but the absence of any viable economic theory to explain why the Fed's jiggling with overnight interest rates should have more than a marginal effect on economic activity. Since January, the Fed has knocked 2.5 percentage points from the overnight interest rate -- and looks likely to cut by another half point this week [editor's note: the rate was cut one quarter of a point] -- but the yield on AAA-rated corporate bonds has actually risen by about 0.25%, and it's the long rates that most affect investment planning.

From David Hume in 18th-century Scotland to John Maynard Keynes in the 1930s, it was assumed that if you put more "money" into an economy, people felt richer and spent more, which stimulated growth. But it was also assumed that if you raised interest rates you increased savings (people were paid more to save) and if you lowered interest rates you reduced the international value of your currency (by discouraging foreign investment). Also that the later stages of an upswing in the economy reduced productivity ("diminishing returns") as you began to plow the less productive farmland and hire the less efficient workers. None of this has been happening.

Monetary theory as a stepsister of general economic theory incorporated and has retained many of these now false rules of thumb, inserting arbitrary correctives as needed, and today the subject is a mess. Technological change has deep-sixed the old monetary theories without floating a new one. Laurence Meyer, who was in the forecasting business before he became a Fed governor, said not long ago that the Fed's own models assumed that its changes in interest rates were a "policy reaction" to developments in the real economy, not the main drivers of anything. In his own models, he said, "real interest rates are determined by forces of productivity and thrift" -- not by the Federal Open Market Committee.

Three years ago, Alan Greenspan told a meeting in Washington that the Fed had the best economists and mathematicians in the world, so its models were the best in the world, "and the fact that they have been wrong for fourteen straight quarters does not mean they will be wrong in the fifteenth quarter."

Graveyard Whistling

Because there is no viable theory, there is no way to predict whether the next stimulus by the Fed will promote economic activity, increase the prices of goods and services (the "cost of living") or raise the prices of assets (the "stock market bubble"). Mr. Greenspan's Fed has been lucky: Massive stimulation to pave over the problems of the 1990s went almost entirely into asset prices. But inflation has been pushing 3.5%, a level at which Martin's Fed went into crisis mode. Mr. Greenspan's repeated statements that inflation isn't a worry have the sound of whistling past a graveyard, especially because the tune harmonizes only with a decline in energy prices, which may be many months away.

When oil prices jumped in 1973, the U.S. suffered a decade of stagflation -- low growth in national product and painful increase in prices. It could happen again. Looking at monetary policy and what it does, Mr. Greenspan must now consider whether the benefit of pushing the stock market up a little is worth the growing risk that this time the Fed will be fueling inflation.


Neutered, Hah!

by Gene Epstein

 "In today's regime, the central bank sets the price of short-term money, and at that price, it provides all the supply the market demands. That was how it underwrote the expansion of money and credit that fueled the Internet and high-tech bubbles. At the same time, Mr. Greenspan was careful to blame it all on those who were prone to irrational exuberance -- while providing all the drugs that kept them high." --Gene Epstein

[Gene Epstein is the widely-read author of the "Economic Beat" column, a weekly feature of Barron's magazine.  In this July 2, 2001 installment, which was published as part of a larger piece in the July 2, 2001 issue, Epstein reflects upon Martin Mayer's June 26th Wall Street Journal article, which also appears here at THE GILDED OPINION. We thank Mr. Epstein and Barron's for permission to web-reprint this article. -- Editor, The Gilded Opinion]

....while granting that Fed policy can often be more symbol than substance, and even that the central bank wields less substantive power than it used to, we should reject an extreme view that has lately been making the rounds: the idea... that the Greenspan & Co. are merely the eunuchs guarding the economic harem, in charge of the palace lights and heating system, perhaps, but with no capacity at all to bring about procreative activities.

At least, something close to the eunuch theory seems to be the main thesis of financial writer Martin Mayer, both in his recent book, The Fed, and in last week's article in The Wall Street Journal called "The Fed's Faded Glory."

As Mayer would have it, the central bank pursues three goals -- fostering growth, fostering employment and curbing inflation -- with "exactly one tool," while in the pre-castration period of the 1950s, it "had much more to work with." Through the 'Fifties, according to his story, Fed chairman William McChesney Martin could place various institutional constraints on a banking system that accounted for about two-thirds of private-sector loans; in contrast, Mr. Greenspan is virtually neutered by the fact that the banks make only about one-fifth of all loans and have far more freedom to do what they want.

But ironically, even with all the power at McChesney Martin's disposal during his nearly 19-year reign, the economy suffered no fewer than four recessions. In fact, that was not just because the Fed then had more leeway to do harm; it was also because, then as now, the central bank proved powerless to prevent the forces of boom and bust that it helped unleash (about which more in a minute).

Fed interest rate

Consider one case of an ineffective tool: the Fed's right to raise and lower the margin requirements on stock purchases. Mayer cites it as an important weapon the central bank used to have in its arsenal, but seems to forget this rule is still on its books. McChesney Martin did change the margin requirement as many as 10 times (to as high as 90% on two occasions), but there's no evidence that his fiddling dampened market volatility. As noted, the Fed can change the margin requirement, although Greenspan has never done so. That's because -- as he's said several times -- studies show it doesn't work, because leverage can be had by other means.

But the Fed does have the power to determine short-term interest rates, both within and beyond the banking system. The chart on this page chooses one example among many: the 30-day interest rate on commercial paper, which is direct borrowing by corporations from institutions.

Notice that as the FOMC cut the fed-funds rate through the fall of '98, the commercial paper rate fell; and as it tightened through '99 and 2000, this commercial rate rose, only to plummet again through the easing of 2001. Note also that this rate began to fall in the last few months of 2000, even before the first rate cut of January 3. The reason apparently is that in this era of Greenspan glasnost, cuts and hikes are often anticipated before they actually happen.

When you think about it, the Fed's still-undisputed power to anchor all short-term interest rates is obvious enough. If the fed-funds rate, which is the rate at which member banks can borrow from each other overnight, is set at 32%, then this means the banks will find it profitable to lend short-term money at around that rate. And if that's the case, then no creditworthy borrower outside the banking system would be willing to pay much higher than that rate. Why should he, when he can always take his business to one of the banks, despite their shrunken role, can still boast the kind of backing other financial institutions lack: the unique power of the Federal Reserve to print all the money that's required to maintain the fed-funds rate at the level it desires.

Which brings us back to the other kind of power the Fed possesses: the power to do harm.

Mayer writes that we lack a theory to fully explain the central bank's influence on the economy, and here he has a point. But it would help if he and others would begin to appreciate just how often the Fed creates its own messes.

In today's regime, the central bank sets the price of short-term money, and at that price, it provides all the supply the market demands. That was how it underwrote the expansion of money and credit that fueled the Internet and high-tech bubbles. At the same time, Mr. Greenspan was careful to blame it all on those who were prone to irrational exuberance -- while providing all the drugs that kept them high. Then, feeling that the boom was getting out of hand, he cut off their supply by hiking interest rates.

The eunuch guarding the harem? Say rather, the fox in charge of the chicken coop.

Instead of reading Martin Mayer on this topic, try The Mystery of Banking, published in 1983 by the late, great Austrian economist Murray Rothbard(1).

While his description of the Fed's operations is a bit outdated, Rothbard explains in typically lucid prose what money is, how it is created, how banking evolves and why gold and silver almost inevitably become the money of choice. He then shows the difference between a free market in money and the controlled market imposed by government.

Much of the essence of Rothbard's case is admirably summarized in a 1966 essay called "Gold and Economic Freedom" (appearing in a 1967 collection entitled Capitalism: The Unknown Ideal). As the author writes, the Federal Reserve was created in 1913 for the express purpose of underwriting the expansion of money and credit, which in turn causes boom and bust. The article was written by Alan Greenspan(2).

(1) Rothbard's entire Mystery of Banking can be downloaded off the internet in pdf at www.mises.org/mysteryofbanking/mysteryofbanking.pdf

(2) See Greenspan's essay published here at THE GILDED OPINION


The Fallible Fed: A review of Martin Mayer's The Fed

by William Anderson

"For all of the mysteries and complicated formulas surrounding modern finance, it is really quite simple: Securities must be 'backed' by assets. Once upon a time, the bedrock asset in the financial system was gold. Today, it is debt, and, most ominously, it is government debt." -- William Anderson

[In the last of our threesome dealing with Martin Mayer's new book, The Fed, William Anderson takes a decidedly "Austrian" view of things. Dr. Anderson has a Ph.D. from Auburn University in economics and, starting this fall, will be an assistant professor of business management at Frostburg State University in Maryland. His review comes to us from the website of The Ludwig von Mises Institute where it was posted on July 10, 2001. We thank Dr. Anderson and Jeff Tucker for their permission to republish this work.-- Editor, The Gilded Opinion]

Austrian economists, I believe, understand the Federal Reserve System like no other people because they despise it so much. In fact, Austrians condemn central banking in general because they recognize that these institutions are set up primarily to fund profligate spending by politicians and to rescue banks from their own bankruptcy.

Outside the Austrian School, however, central banks often seem to wear a halo. Historians praise them, most mainstream economists support them, and politicians quickly discover that they cannot exist without them. This does not mean that these folks actually understand central banking. In fact, most economists, having been schooled in either Keynesianism or monetarism or both, have a general idea of what the Fed does, but they are so woefully ignorant in financial matters that their "knowledge" proves to be less than worthless.

People trained in finance, unfortunately, are generally agnostic when it comes to knowing much about economics per se. Thus, the modern world of economics and finance gives us the worst possible combination: economists who don't understand financial instruments and financial "experts" who dont comprehend economics. Out of this witch's brew come modern fiscal and monetary policies that emanate from Washington and nearly every other capital of the world.

Martin Mayer, who has distinguished himself in earlier worksand who was one of the few financial journalists who actually understood the roots of the 1975 New York City financial crisishas attempted to shed some light on the Fedand generally succeedsin The Fed: The Inside Story of How the World's Most Powerful Financial Institution Drives the Markets (The Free Press, 2001).

I agree with Gene Epstein of Barrons, who believes that a reader will learn more from Murray Rothbard's The Mystery of Banking. Rothbard was well-known for his everlasting hatred of the Fed (which, I may add, was well-deserved). Mayer, on the other hand, while not worshipful of our august central bank, cannot quite bring himself to condemn this monstrosity, either.

Unlike so many others, who have written about the Fed in hushed, reverent tones, Mayer does admit that, for all of the hype that politicians and the press give the Federal Reserve System, "a lot of them don't know what they're doing." If he were absolutely honest, he could include Alan Greenspan himself in that group of the blind who are leading the blind.

For someone not trained in finance (like me), The Fed is quite helpful if one wishes to understand just what is going on in the markets and in banking today. For all of the mysteries and complicated formulas surrounding modern finance, it is really quite simple: Securities must be "backed" by assets. Once upon a time, the bedrock asset in the financial system was gold. Today, it is debt, and, most ominously, it is government debt. As I explained twenty years ago to an incredulous group of middle-school students who still believed that we were on a gold standard, the "backing" of money in this country is based upon the "ability" of the government to go into hock.

Furthermore, the Fed was created to back up the system of fractional reserve banking, which Rothbard and other Austrians have correctly defined as being legal fraud. State authorities prosecute and punish polygamy, but they tremble before the "majesty" of the bank, which simply commits a form of polygamy with the money of its depositors.

If one is a Fed-watcher (which I admit to be from what I wish were a safe distance), then The Fed is important reading. Mayer seems to mostly understand modern money and banking even though his analysis is hardly Austrian. He also allows the reader to see just how the Fed, like an octopus, has been able to slowly but surely extend its arms over the entire financial system, much of the permission to expand given it by Congress in the aftermath of crises generally spawned by the Fed itself. In addition to Mayer's explanation of the Fed and its actions, his chapter on central banks is important reading for those who don't understand why governments more than three centuries ago began to originate them.

When the Fed was formed in 1914 (after being created by Congress the year before), its primary purpose was to serve as a "banker's bank," an institution that would provide "liquidity" to banks in order to ward off periodic runs that would generally plunge the economy into recession. The push to create the Fed, while strong since the end of the Civil War, became even stronger after the panic of 1907, which occurred after the Knickerbocker Trust Company in New York failed in the wake of a stock-market bubble that burst.

From its humble beginnings as primarily a decentralized backup system encompassing twelve districts across the United States (which are still in place today), the Fed quickly gained importance during World War I as a huge holder of short-term government debt. Its place secured by its WWI performance, the Fed went on to quickly inflate the currency, leading to the short but drastic recession of 1920 and 1921. Led by Benjamin Strong, the head of the New York Federal Reserve Bank, the Fed really turned on the crank during the 1920s in order to prop up the British pound, which had been unwisely set at its pre-WWI exchange rate.

The Austrians, especially Rothbard, have documented all of this, of course (e.g., see Rothbard's article "The Origins of the Federal Reserve"). However, it is nice to read an outsider who gives us an account that differs from the disinformation which comes from Milton Friedman and the monetarists, that the decade of the 1920s was a "golden age" of the Fed and that, had Benjamin Strong not died of tuberculosis in 1928, the Fed would have simply provided "much-needed" liquidity into the system after "Black Thursday" on Wall Street in October 1929.

Furthermore, Mayer helps puncture the contention by Friedmanites that aggressive purchase of government bonds would have ameliorated the crisis of the early 1930s by noting that the problem was not necessarily a lack of liquidity or bank reserves, but rather that the whole system was falling apart and a few loans by already bankrupt banks would not have fixed things.

Mayer, unfortunately, does not tell us that Herbert Hoover's own "fiscal" policies including the encouragement of wage and price rigidities; the disastrous Smoot-Hawley Tariff, a "gift" from Congress in 1930; and the unwise doubling of the tax burden in 1932 played a major role in pulling healthy firms into the abyss of the Great Depression.

The author goes on to describe the different Fed chairmen, from Mariner Eccles, Franklin Roosevelt's appointee, to the latest monetary dictator, Alan Greenspan. As one might expect from a book that attempts to give a detailed history of the Fed, there is much more information than I can ever lay out in a brief review such as this. While Mayer might be supportive in general of the Federal Reserve System, he certainly does not regard the players in the system as demigods, and he still knows at least some fraud when he see it.

In describing the antics of Jimmy Carter's administration, as well as the Ronald Reagan follies, Mayer gives us a mixed picture. He correctly criticizes Friedman's view, that somehow the Fed can coordinate monetary policy that money can grow at a planned maximum of 3 percent a year. Then, however, he goes on to tell the reader that inflation is not a monetary phenomenon. More specifically, he says Friedman claims that inflation is a monetary phenomenon, and then he leaves it at that, implying that such a belief is stupid and naïve.

If inflation is not tied to money, then what else is there? Furthermore, Mayer claims that Friedman and his followers had a naïve view of Say's Law, which he wrongly says is the belief that whatever is produced is automatically sold, end of story. He goes on to say that those who believe in Say's Law hold that free markets automatically and immediately correct themselves, as though Carl Menger, Ludwig von Mises, Rothbard, and other Austrians never existed.

As others and I have written on Say's Law, it is an acknowledgement that one can only consume what one can produce, which is the bane of any kind of government policy to "increase aggregate demand" by increasing the supply of money. Friedman's scheme to replace the Federal Reserve with a computer has nothing to do with Say's Law, and someone as adept at understanding finance as Mayer should have instinctively understood that.

Mayer also allows his animosity toward gold to show, which I believe further discredits some of his analysis. He describes Greenspan's 1966 article on gold in Ayn Rands The Objectivist as "a truly nutty screed," in which Greenspan correctly identifies the source of the states antagonism toward gold that gold prevents the willy-nilly funding of the confiscatory welfare state.

Mayer's hatred of gold also has him taking shots at U.S. Representative Ron Paul, of all people, calling Paul "a medical doctor infected with the gold bug." Since Paul is one member of Congress and maybe the only one who shows that rare trait of integrity, it is sad to see Mayer treating him so shabbily.

The author demonstrates monetary ignorance elsewhere. On page 221, he writes:

There remains a mystery to haunt the dreams of central bankers, because nobody knows why monetary stimulus becomes consumer price inflation in one country and asset inflation in another. For the followers of Milton Friedman, the strikingly successful result of monetary policy in the United States in the early 1990s has a bittersweet taste, for the Master had always insisted that monetary stimulus inevitably showed up (perhaps after a lag) as an increase in consumer prices. And inflation in America remained dormant.

Such a statement is beyond mere ignorance, since Austrians have been answering that very issue for years. Mises, Hayek, Rothbard, and modern Austrians including Joseph Salerno have clearly pointed out the answers that seem to have so eluded Mayer. But, then, Austrians understand money, and Mayer does not.

I must admit that one thing I have taken from this book is that the financial system is much more fragile than even I had thought it to be. Modern economists from Keynesians to monetarists believe that, as long as the Fed follows expansionary monetary policies in a downturn, depression is not possible.

To be more specific, while Japan sits mired in recession despite interest rates of near zero, while the other Asian "tigers" are recovering from the banking and financial disasters of four years ago, and while the Euro slowly sinks despite efforts by European central bankers, Americans seem to be pretty smug in their belief that "it can't happen here." The dollar, after all, is the de facto world currency, and all we have to do in a crisis is to print more dollars.

Austrians are skeptical of this reasoning, and well they should be. Only thirty years ago, and twenty-five years after the U.S. stood alone after World War II, the dollar was a joke; it received the same treatment at some overseas currency exchanges that North Korean money receives today. It was not its natural destiny that the dollar recovered after the disastrous policies of the 1970s; rather, it was the cessation of inflation and the liberation of the U.S. economy during the 1980s from some of the worst Depression-era regulations that placed the dollar atop the heap.

While Americans are loathe to admit it, loose money means loose lending policies, which mean the inevitable spate of bad loans. Furthermore, loose money means inflation and destabilization, which means that a large number of those risky loans won't be paid back in a timely manner if at all. Members of Congress, who are not the brightest apples in the bunch anyway, find their eyes glazing over when faced with the complication of financial schemes. Thus, the Fed, bankers, and others who are game for what in reality is something akin to financial fraud go on their merry way, unencumbered by Congress, the law, or anything else that would serve as a brake for their foolishness or so they believe.

However, free markets still have the final word. One can concoct whatever financial scheme one may choose, but in the end it still comes down to assets and liabilities. Unsound policies soon create conditions where liabilities outnumber the assets, and someone must pay the piper.

July 14, 2001

Copyright © 2001. All Rights Reserved.

Reprinted by USAGOLD with permission of the authors cited above. No further reproduction without permission.

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