Questionable Rescue Operations

This article appeared in the January 2008 issue of Globe Asia.

Military history is written by the victors.Economic history is written, to a degree, by centralbankers. In both cases you have to take official accountswith a large dose of salt.

You thought you knew that the Duke of Wellington whippedNapoleon at the Battle of Waterloo.

But according to the expert on Waterloo, Peter Hofschröer,Wellington’s army of 68,000 men was locked in a bloody stalematewith Napoleon’s force of 73,140 until late in the afternoon of June 18,1815. That’s when Field Marshall Blücher’s 47,000 Prussian troopsentered the field of battle and turned the tide.

The Iron Duke’s official account has Prince Blücher failing toarrive until early evening and with only 8,000 troops. Somehow39,000 Prussians simply vanished. As they say, the rest is history—literally history as written by Wellington.

Doctored accounts often gain wide circulation in the sphereof economics, too. Unfortunately, false beliefs are very difficult tooverturn by facts, and fallacies play a significant role in economicpolicy discourse.


To get a handle on the current state of received ideasconcerning the Federal Reserve, there is no better place to start thanformer Fed Chairman Alan Greenspan’s The Age of Turbulence: Adventuresin a New World. According to Greenspan, the Fed got thingsjust about right during his tenure (August 1987-January 2006).

Let’s take a closer look. Were there any mistakes or perversepolicy patterns during the Greenspan era? The easiest way to answerthis question is to measure the trend rate of growth in nominalfinal sales to US purchasers (GDP – exports + imports – the changein inventories) and then examine deviations from that trend.

During Greenspan’s tenure nominal final sales grew at a 5.4%annual rate (see chart). This reflects a combination of real salesgrowth of 3% and inflation of 2.4%.

The first deviation from the trend began shortly after AlanGreenspan became chairman. In response to the October 1987stock market crash, the Fed turned on its money pump and over thenext year final sales shot up by 7.5%, well above the trend line.

Having gone too far, the Fed then lurched back in the other direction.The ensuing Fed tightening produced a mild recession in 1991.

From 1992 through 1997 growth in the nominal valueof final sales was quite stable. But successive collapses in certainAsian currencies, the Russian ruble, the Long Term Capital Managementhedge fund and finally the Brazilian real triggered anotherexcessive Fed liquidity injection and a boom in nominal final sales.

This was followed by another round of Fed tightening, whichcoincided with the bursting of the equity bubble in 2000 and aslump in 2001.

The last big jump in nominal final sales was set off by the Fed’sliquidity injection to fend off the false deflation scare in 2002. Backthen the annual increase in the price index for core personal consumptionexpenditures was drifting below 1%, signaling an approachingdeflation.

This moved then Fed governor Ben S. Bernanke (now chairman)to deliver a dense and noteworthy speech, “Deflation: MakingSure it Doesn’t Happen Here,” on November 21, 2002.

The most memorable line: a semi-serious reference to the possibilitythat the Fed, in a real pinch, could increase the money supplyby dropping bills from helicopters.

The Fed did not, in any event, employ aircraft in its open marketoperations. But it did manage to work the Fed funds rate down to1% and final sales surged. And as night follows day, the Fed startedputting on the brakes in 2004.

During the Greenspan era, the facts are clear: the Fed overreactedto real or perceived crises and created three post-crisis demandbubbles (see chart). These bubbles were followed by monetarytightness which was necessary to eliminate the bubbles.

Recently we have witnessed the Bernanke-led Fed reacting evenmore dramatically to a financial crisis than did the Greenspan Fed.In response to market turmoil in Europe on Martin Luther King’sbirthday (a national holiday in the US), the Fed enacted an emergencyinterest rate cut of 75 basis points in both the federal fundstarget rate and the discount rate the next day, January 22.

Austrian cycle

Click on chart for larger view

This was quickly followed by another 50 basis point cut inboth rates at the Fed’s regular open market committee meeting ofJanuary 30. This left the federal funds rate and the discount rate at3.0% and 3.5%, respectively.

But the Fed’s money pump might not work this time around. Thecurrent US downturn has all the hallmarks of an Austrian businesscycle. In this type of cycle, a credit boom spawns an asset price boomwhich eventually sows the seeds of its own destruction-- a slump.

The US and European business cycle of the late 1920s and early1930s was a classic Austrian cycle. The Japanese boom and bust ofthe late 1980s was also a manifestation of the Austrian cycle.

With an Austrian cycle, banks play a key role -- both on theway up and down. As the downturn unfolds asset prices begin todeflate. In consequence, banks’ capital becomes impaired and banksscramble to rebuild it.

The economy is vulnerable to what economists of the Austrianschool of economics terms a “secondary deflation,” where banks callin loans and are stingy about extending credit.

Households produce their own version, liquidating riskier assets(like stock mutual funds) and moving into cash and governmentbonds. In the economy at large, investment and consumptionsuffer.

If this scenario plays out, the Fed’s rescue package will be throwninto doubt as the banks become averse to creating credit, build reservesand use their liquidity to purchase government bonds. Inshort, the credit creation mechanism clogs up and becomes inoperative.

If there is a chance that monetary policy might fail to rescuethe slumping US economy, what about fiscal policy? President Bushsigned a $170 billion fiscal stimulus package on February 13.

Most of this involves tax rebates— checks from the government.The idea behind this is that people will rush out to spend their windfallsand consumption will get a boost.

There is a problem with this type of Keynesian fiscal policy.People adjust their consumption with respect to variations in theirlong-term expected (or permanent) income, and pay little heed totransitory variations.

In consequence, one-time tax rebates (such as those adopted in1975) do not result in more consumption because they do not alterpeople’s permanent income.

As the US economy sinks, the monetary and fiscal life buoyshave been deployed. Beware. There are good reasons to question theefficacy of these rescue operations.

Steve H. Hanke

Steve H. Hanke is a Professor of Applied Economics at The Johns Hopkins University in Baltimore and a Senior Fellow at the Cato Institute.