Monetary Policy: Is the Fed Pushing on a Piece of String?

By: Gerard Jackson | Sun, Nov 2, 2008
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Determined to make sure there will be no repeat of the 1930s depression, the fed cut the funds rate to 1 percent, the lowest level since 2003-04. Moreover, from the 8 October to the 22 October the fed raised the monetary base from $984,375 billion to $114,749 billion, a 16 per cent increase in two weeks. Clearly Mr Bernanke is a man of action. But is it the right action?

Bernanke is mesmerized by the tragedy of the 1930s. He does not want to go down in history as the central banker who caused a second Great Depression because he was too timid to act on monetary policy. Unfortunately Mr Bernanke does not nearly know as much about the 1920s and 1930s as he thinks he does. This is why he is unwittingly making things worse.

The most important thing to keep in mind is that the Great Depression was the product of a monetary disorder that had its roots in the early 1920s. Now one cannot really talk about this unless two fundamental facts are always kept in the foreground: Fact one is that money is not neutral. By this it is meant that increasing the money supply will influence individual prices and so distort the price structure. Some 200 years ago Lord King explained that the monetary effect on prices is not equal and is therefore

not produced immediately upon the issuing of the notes, and some time must elapse before the new currency can circulate through the community and affect the prices of all commodities. It is this interval between the creation of the new paper and the rise of prices which may be a source of advantage to the persons who obtain loans from the Bank. The merchant, to whom the notes are immediately issued, employs them in the purchase of goods at the prices which they then bear, or is enabled by the payment of a former debt to obtain credit for them at those prices. (Lord Peter King, A Selection from the Speeches and Writings of the Late Lord King, Longman, Brown, Green, and Longmans, 1844 p. 85).

By distorting prices, including interest, the most important of all prices, monetary expansion distorts the capital structure and creates malinvestments that will eventually reveal themselves in the form of idle capital once the boom reaches its final phase. It follows that injecting more money into the economy to counter the consequences of the previous injections merely makes matters worse. This brings us to the second fundamental fact: any attempt to maintain a stable price level must eventually result in a recession for reasons already outlined. In response to the erroneous view that a stable price level is essential if the public's demand for money is to be satisfied, the brilliant Lord King responded with the observation that

It is manifest ... that the proportion of circulating medium required in any given state of wealth and industry is not a fixed, but a fluctuating and uncertain quantity; which depends in each case upon a great variety of circumstances, and which is diminished or increased by the greater or less degree of security, of enterprise and of commercial improvement. The causes which influence the demand are evidently too complicated to admit of the quantity being ascertained by previous computation or by any process of theory. (Ibid. p. 67).

One of the problems we face today is that the vast majority of economists cannot distinguish between a monetary induced fall in prices and productivity induced fall. The first phenomenon is deflation, i.e., a monetary contraction. The second phenomenon is the result of falling costs brought about by more investment in the material means of production. By preventing the market from allowing the fruits of increased productivity to be reflected in falling prices and hence a rise in real incomes, economic policy has served to skew the pattern of incomes in a way that is detrimental to the economic welfare of a great many wage earners.

This is what happened during the 1920s. The latter half of the nineteenth century demonstrated that falling prices, economic growth and expanding job markets are perfectly compatible. Milton Friedman -- a great defender of the stable price level fallacy -- was forced to admit this when he observed that after the Civil War

[T]he price level fell to half its initial level in the course of less than fifteen years and, at the same time, economic growth proceeded at a rapid rate. The one phenomenon was the seedbed of controversy about monetary arrangements that was destined to plague the following decades; the other was a vigorous stage in the continued economic expansion that was destined to raise the United states to the first rank among the nations of the world. And their coincidence casts serious doubts on the validity of the now widely held view that secular price deflation and rapid economic growth are incompatible. (Milton Friedman and Anna J. Schwartz, A Monetary History of the United States 1867-1960, Princeton, N.J.: Princeton University Press, 1971).

Pushing on a piece of string might sound apt but it really is a grossly misleading analogy. The reason why low interest rates in the 1930s failed to stimulate investment and so raise the demand for labour is that Hoover and Roosevelt's economic policies crushed profits. No businessman will borrow money if he cannot make enough to pay off the loan. Punishing business is no way to encourage investment and raise the real demand for labour. But this is precisely what Hoover and Roosevelt did. And both of them remained stubbornly oblivious to the social, political and economic consequences of their destructive actions.

Hoover's policy of holding wage rates above their market clearing levels caused unemployment to soar. In 1929 the two-way division between employees and corporations was 81.6 per cent and 18.4 per cent respectively. In 1933 employees share had rocketed to 99.4 per cent, payrolls fell from $32.3 billion to $16.7 billion and unemployment rose to a horrifying 25 per cent. Roosevelt and his advisors did not learn a damn thing from Hoover's misguided policies and so kept the economy thoroughly depressed until Hirohito and Hitler restored full employment.

I'm afraid Mr Bernanke will go to his grave completely unaware of what really happened in the 1920s and 1930s. When Greenspan began to expand the money supply to drag the economy out of the recession that the Bush administration had inherited I remarked at the time that he was laying down the foundations for another recession (The US economy and Alan Greenspan: what is going wrong?). Well, his recession arrived on schedule.



Author: Gerard Jackson

Gerard Jackson

Gerard Jackson is Brookes economics editor.

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