Will Bernanke's Cuts Save the US Economy?
In the hope of averting a credit crunch and recession Bernanke recently slashed the federal funds rate by 0.75 per cent, bringing it down to 2.25 per cent. Did he do the right thing? Well, Larry Kudlow, NRO's economics editor, certainly thinks so. He eulogised that Bernanke's rate cuts "are vastly more effective than the so-called economic-stimulus rebate plan coming out of Congress and the White House.
Ordinarily Keynesians would go along with Kudlow's assessment, even though he is a supply-sider. But these are not ordinary times, so says Stephen Roach of the Morgan Stanley Asia Chair. He argues that the cuts cannot even arrest falling home prices let alone boost them.
Moreover, Washington's efforts to encourage consumers to keep on spending are seriously misguided. A too-low savings rate, a too-large trade deficit and too much consumer debt are precisely what got the United States into this mess in the first place.
So who is right? As it turns out, neither of them. Kudlow's mistake is the usual one of believing that the Fed can successfully manipulate interest rates and that the money supply should be expanded in line with GDP. As a Keynesian Roach would basically agree with Kudlow on these points. However, as a Keynesian he is also blind to the fact that Keynesian thinking is entirely responsible for the monetary disorder and the economic distortions that are now making themselves felt throughout the economy. As for the idea that the central bank can control the money supply at will, D. H. Robertson noted
that the assumption . . . that the total magnitude of the money supply lies entirely within the discretion of the banking-system and not at all within that of the public, seems to have only limited validity for such periods. (Banking and the Price Level, Augustus M. Kelley, 1989, p. 81)
Part of the problem is that the economics profession overwhelmingly believes that recessions are a recurring economic infection for which low interest rates are the antibiotic. Contemporary economic commentary, being what it is, has now moved from that fallacy to an outright superstition whereby interest rates are now seen as some kind of economic talisman that will magically keep at bay the demons of recession. As soon as the material consequences of reckless monetary policies begin to reveal themselves -- or is it materialise? -- a chant is immediately heard calling for the high priest of the Fed to unleash low interest rates against the demons of falling output, falling asset values and rising unemployment.
And this is exactly what has happened. Those like Roach who are now objecting to the Fed's rates policy fail to see that their advice is bound to be unheeded because their Keynesian thinking prevents them from being able to expose the flaw in the Fed's line of thinking. Bernanke has been praised for learning from the monetary disaster that caused the Great Depression. Unfortunately he did no such thing. He approached that subject with a ready-made solution and interpreted the facts accordingly. This is why he apparently overlooked the fact that during the depression investment failed to respond to a regime of very low interest rates.
So let us see if we can delve a little deeper into Bernanke's economic point of view. In December 1927 the Fed's discount rate was 3.5 per cent, the call rate was 4.4 per cent and the prime rate was 4 per cent. Twelve months later they were 5 per cent, 8.6 per cent and 5.4 per cent, and by August 1929 the discount rate had risen to 6 per cent -- and still the speculative frenzy went on.
By December the discount rate was now 4.5 per cent, the call rate was 4.8 per cent and the prime rate was 8 per cent, and the economy was well and truly in depression. Now it gets really interesting. In December 1930 the respective rates were 2 per cent, 2.2 per cent and 2.9 per cent. The following December the discount rate had risen to 3.5 per cent and unemployment leapt to 15.9 per cent; and the next December the rates were 2.5 per cent, 1 per cent and 1.5 per cent respectively, and the depression was deepening with unemployment rocketing to 23.6 per cent.
In December 1933 the rates stood at 2 per cent, 0.9 per cent, 1.4 per cent and unemployment 24.9 per cent per cent. The Depression had deepened. Exactly 12 months later the discount rate was 1.5 per cent, staying at that level until December 1937 when it had fallen to 1 per cent where it stayed until December 1947. Despite the historically low discount rates unemployment remained horrifically high during the '30s though it started to slowly decline in 1935 falling to 20.1 per cent, reaching a 'low' of 14.3 per cent in 1937 before jumping to 19 per cent in 1938. It wasn't until 1941 that the unemployment rate fell below 14 per cent.
Some might argue that the commercial paper rate was probably too high. Not so. The rate was 5.85 per cent in 1929, falling to 3.59 per cent the following year and then 2.64 per cent in 1934, dropping to 1.02 per cent in 1935. After that it fell below 1 per cent and in 1940 it was 0.56 per cent -- and unemployment was 14.6 per cent. As D. H. Robertson observed:
While there is always some rate of money interest which will check an eager borrower, there may be no rate of money interest in excess of zero which will stimulate an unwilling one. (Ibid. p. 81).
Robertson was writing this in 1926. During the depression it was noted:
The market rate of interest conceivably may stand at zero, but if the average return to capital is represented by positive losses and all that will result from borrowing is more losses, loanable funds will not be employed to finance new productive activity. (C. A. Phillips, T. F. McManus, R. W. Nelson, Banking and the Business Cycle: A Study of the Great Depression in the United States, The Macmillan Company, 1937 p. 233).
So those who believe that a "sufficient" cut in rates always stimulate the American economy had better think again.
Back in February 2001 everyone had the jitters even though Greenspan had cut rates. Not surprisingly considering that GDP growth was zero. So what was the problem? Despite the aggregate employment figures looking steady they were concealing more than they revealed. Although national unemployment claims were up in January 2001 by about 20 per cent from the previous January, the figure was 40 per cent in the Midwest, where much of the nation's manufacturing is.
Austrians would confidently interpret this as indicating that producer costs had also risen along with idle capacity. Statistics showed that capacity utilisation had fallen to its lowest level since 1992, i.e., idle capacity was emerging. In addition, producer prices rose by nearly 5 per cent a year, the highest since 1990-91. This is exactly the kind of situation that Austrians warn against.
Monetary contraction aggravated the situation. Growth in M1 fell from 4 per cent in 1999 to -1.0 per cent in 2000. For 2001 it expanded by 9.6 per cent. From 2001 to early 2005 M1 leapt by more than 30 per cent. In the meantime, overpaid economic commentators are still publicly wondering why the dollar is falling and the current account deficit is growing. However, from January 2006 to the end of December 2007 the money supply (Austrian definition*) meaning bank credit, was flat.
All of this means that Greenspan created the conditions for another recession. Greenspan must have known that as a Keynesian Bernanke would unleash the monetary hounds, which he did. And all the while, the economic commentariat has been treating interest rates in much the same way ancient seers used to examine the entrails of a goat -- and with about as much success.
It's time they directed their attention to how changes in the money supply generated by manipulating interest rates triggers the so-called boom-bust cycle.
*The Austrian definition of the US money supply is currency outside Treasury, Federal Reserve Banks and the vaults of depository institutions.
Demand deposits at commercial banks and foreign-related institutions other than those due to depository institutions, the U.S. government and foreign banks and official institutions, less cash items in the process of collection and Federal Reserve float.
NOW (negotiable order of withdrawal) and ATS (automatic transfer service) balances at commercial banks, U.S. branches and agencies of foreign banks, and Edge Act corporations. NOW balances at thrifts, credit union share draft balances, and demand deposits at thrifts.
AMS definition therefore equals cash plus demand deposits with commercial banks and thrift institutions plus saving deposits plus government deposits with banks and the central bank.