the federal reserve - garrison

7/28/2019 The Federal Reserve - Garrison

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The Federal Reserve:Then and NowRoger W. Garrison*

A good friend of mine has two sons who, in their youth, wereunusually mischievous. On one occasion, when my friendhad just replenished his liquor supply in preparation fora cocktail party that evening, his sons decided that a liquor cabinetwas a pretty good substitute for a chemistry set. They broke theseals and poured from one bottle directly into the next: scotch intorum; rum into gin; gin into scotch. And they added a little cremede menthe all around. When their father discovered the deed (notin time to save the evening guests from some innovative cocktails),he issued punishment in the form of reduced allowances andincreased yard duties. The two boys accepted the punishmentgracefully and promised never to do that again. 'You know," myfriend told me, "I believe them. They'll never do that again. Thenext time, it'll be something else."And so it is with the Federal Reserve. Mischievous by its verynature, it rarely does the very same thing twice. Fed-watchers,always looking for a precise pattern in monetary aggregates,hoping to get an exact fix on the Federal Reserve's modus oper-


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into doubts that the Federal Reserve has a significant effect-doubts even that money has much to do with the cyclical variationof employment and output. So-called real theories of the businesscycle account for each departure from trend-line growth in termsof some real shock to the economy-which typically means achange in technology or in resource availability.' In turn, thefocus on macroeconomically significant real shocks, which arerelatively few and far between in comparison to monetary shocks,has caused many modern macroeconomists to believe that busi-ness cycles themselves are far less troubling than was oncethought.2 To similar effect, the increasing reliance on an analyti-cal framework that' reduces all macroeconomic phenomena toconsiderations of aggregate demand and aggregate supply has ledtextbook writers to emphasize the temporariness of cyclical vari-ation rather than the pervasive discoordination and painful re-covery that characterize boom andSuch treatments of cyclical variations and of the relationshipbetween monetary and fiscal policy are fundamentally flawed.While important changes in the fiscal and inst itut ional environ-ment underlie the comparison between the Federal Reserveth en (1920s-1930s) and the Federal Reserve now (1980s-1990s), the Federal Reserve's power to create money mustfigure importantly in the accounts of both periods. Under-standing just how, though, requires an analysis that makes use


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From Textbook Macroeconomicsto Macroeconomic RealitiesMacroeconomic policy is conventionally divided into two catego-ries: monetary policy, which is formulated and implemented bythe Federal Reserve, and fiscal policy, which i s the net effect ofthe many spending and taxing decisions made by Congress.Macroeconomic textbooks typically introduce monetary and fiscalpolicies in sepa rate chapter s a nd t hen deal with t he interplaybetween the two by constructing multi-quadrant graphs inwhich the money supply, government spending, a nd th e levelof taxation, each represented in separate quadrants, have acombined economywide effect on the rate of interest and the levelof income.There is a certain logic to this policy decomposition. Inflating,spending, and taxing in the conventional macroeconomic frame-work have their own separate short- run effects on the interestrat e and income level: expansionary monetary policy causes in-comes to rise and in terest ra tes to fall; expansionary fiscal policy(increased government spending or decreased taxation) causesboth incomes and interest ra tes to rise. The effect of coordinatedmonetary and fiscal policy is simply the sum of the individualeffects. Economic expansion driven by both t he Federal Reserveand the federal budget, for instance, has a double-barreled effecton the level of income while leaving the rate of interest un-


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levels as rising prices and wages build an inflationary premiuminto the structure of nominal interest rates. Similarly, expansion-ary fiscal policy, which increases real rates of interest, has onlya temporary effect on incomes under conditions of flexible pricesand wages. These assumptions and qualifications are acknow-ledged-though sometimes cryptically-in most modern macroe-conomic textbooks.But these treatments employ an exceedingly high level ofaggregation, whereby "income" summarily measures both thetotal output produced in exchange for that income and the spend-ing power capable of buying that output. This aggregation causesthe phrase "temporary effects of fiscal and monetary policy" toseem innocuous or benign, seriously understating the actualeffects of policy. The conventional wisdom is that policy in theform of such "stimulus packages" may temporarily push theactivities of producing, earning, and spending beyond levels thatcan be sustained. At worst, the dynamics of policy-inducedchanges in macroeconomic magnitudes give scope for politicalchicanery as incumbent administrations resort to fiscal andmonetary stimulants just prior to election^.^According to an increasingly common view, cyclical move-ments in income and output-whether attributable to policyactions or to real factors-are considered harmful only in that thetiming of consumption i s slightly less than optimal. This assess-


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7arriso n: The Federal Reserve: Then and Now

terms of unsustainable changes in the pattern of investment.Even if the spending power of income earners equals total outputin aggregate terms, a systematic, policy-induced mismatch be-tween decisions in the investment sector and the underlyingpreferences of consumers and wealth holders can lead to severeeconomic downturns and painful recoveries.By carefully identifying the relevant aspects of investmentpatterns in different cyclical episodes, we can identify both themeand variation in the story of boom and bust. We can find bothsimilarities and differences, for instance, in comparing the expe-rience of the 1920s and 1930s with that of the 1980s and 1990s.Further, we can show that the prolonged succession of policy-in-duced "temporary" effects, which has fundamentally changed therelationship between fiscal and monetary policy, has had perma-nent effects on the health of the economy.

Variation on a ThemeHow strong are the parallels between the boom of the 1920s andthe boom of the 1980s? How similar are the economic circum-stances of the early 1990s to those of the early 1930s?It may be tempt ing to tr y to account for our cu rre ntmacroeconomic plight by retelling the story of the interwarexperience, changing only the dates and a few minor details. But


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years before that term achieved currency in macroeconomicthought.7Parallels can be found not in the strict sense of a replay butin the broader sense of variation on a thenie. The story requiresa recasting of the characters and some major changes in the plot.The Federal Reserve no longer plays the lead; it plays instead anindispensable supporting role. Banking legislation and fiscalpolicy are more central to the storyline. In accounts of bothperiods,. however, we can say that unprecedented conditions al-lowed an artificial boom to go unchecked for a significant periodof time. Unprecedented in the 1920s was a strong central bankbent on stimulating growth in a peacetime economy. Unprece-dented in the 1980s was a banking industry operating in adramatically altered regulatory environment and a federal gov-ernment running deficits measured in the hundreds of billions.Interest rates in the recent episode play an important role notso much because of considerations of time discount but becauseof considerations of risk. During the 1920s, the low time discountsignaled by artificially depressed interest ra tes did not accuratelyreflect people's. actual willingness to save; during the 1980s, thelow risk premiums built into interest rates did not accuratelyreflect people's actual willingness to accept the risks of increas-ingly speculative investments-much less the additional risksattributable to the government's irresponsible fiscal policy. The


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terms, and-more importantly-investment projects were exces-sively long-term. As the boom proceeded, low interest rates luredcapital into relatively time-consuming production processes.That is, the timing of the output of these production processeswas skewed toward the future in comparison to the intertemporalpat tern of demand for output. While the intertemporal distortionof output is the essence of so-called rea l business cycle theory, i tis only a symptom, in the view presented here, of a pervasivedistortion in the economy's capital structure. The economywideinconsistencies-attributable to Federa l Reserve policy-be-tween investment decisions of the business community and thetime preferences of consumers made the bust inevitable. Therecovery, hampered by policies aimed a t re-igniting t he boom,consisted of extensive capital liquidation a nd a general intertem-poral rest ruc tur ing of capital.Modern textbook trea tments of the recent economic boom incomparison to the interwar boom hinge on a sharp distinctionbetween monetary and fiscal policy. The earlier boom was drivenby monetary policy; the la ter one by fiscal policy. I t is tr ue t hatthe 1920s were characterized by (relatively) tight fiscal policy andloose monetary policy as each is conventionally measured, andthat the 1980s saw a reversal in the relative strengths of the twopolicy alternatives. But the strict dichotomization between fiscaland monetary policy is badly overdrawn. In the 1980s, the signifi-cance of fiscal policy lay not in its augmentation of aggregate


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systematically out of line with the risk preferences of privatewealth holders. This systematic discrepancy between risks un-dertaken and risk preferences, which provides the thematiclink t o the interwar episode, justifies the claim tha t the 1980sboom was artificial and that the bust was inevitable.Deficit-Induced UncertaintiesIt is not difficult to demonstrate that chronic and dramaticfederal budget deficits create uncertainties in the private sec-tor.' A numerical example can serve to illustrate. Suppose thegovernment's anticipated rate of spending over the next severalyears is a trillion dollars per year and that i t anticipates collect-ing $800 billion per year in tax revenues. The difference, theanticipated annual deficit, of $200 billion represents yet-to-be-funded government spending.The business community understands that the governmentwill appropriate a trillion dollars worth of resources each year.Tax codes stipulate the particular targets of eighty percent ofthe government's appropriation activities. Production planscan be made in the light of these codified taxing procedures. Butthere can be no plans that effectively take into account the othertwenty percent, the anticipated deficit. In effect, the government isputting the private sector: "We are planning on appropriatinganother $200 billion worth of resources, but we are not saying


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the meantime, a $200-billion cloud of "intent to appropriate insome unspecified way" looms large over the private sector.There is no effective hedge against uncertainty of this kind.There are no probabilistic answers to the question ofjust how thegovernment will appropriate the additional resources. Shouldlong-term capital be shifted out of export industries because ofthe currently high foreign-trade deficit and correspondingly weakexport markets? Or should it be kept in place by anticipations of--orhopes for-a change in fiscal strategy? Should long-term financialcommitments be based on the current credit conditions or on thecontingency of some unknown likelihood that the Treasury willborrow more heavily in domestic as opposed to foreign credit mar-kets? Should land, durable assets, and even inventories be boughtor sold at prices that reflect current inflation rate? Or shouldsuch transactions reflect accelerating inflation based upon someguess about the extent and timing of debt monetization?Although the government's borrowing a t irresponsibly highlevels adds to the riskiness of private-sector activities, none of theserisks are born by the holders of Treasury securities. This discrep-ancy between risk created and risk assumed can be directly attrib-uted to the Federal Reserve in its capacity to monetize Treasurydebt. Overextended borrowers in the private sector must pay asubstantial default-risk premium in order to continue borrow-ing. Even overextended municipalities pay a default-risk pre-mium as their bonds are downgraded by bond-rating agencies.


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market constraint on further Treasury issues. The increasingsignificance of potential debt monetization suggests that themagnitude of the Federal Reserve's influence is not to be detectedin actual movements of monetary aggregates. The mere fact thatthe Federal Reserve stands ready to monetize debt gives theTreasury a much longer leash than it would otherwise have.TheArtificialBoomTextbook treatments of fiscal and monetary policy recognize thatthe fiscal authority and the Federal Reserve can work together.The Treasury issues debt and the Federal Reserve monetizes it.So long as government borrowing has not been pushed to irre-sponsible levels, debt issue and monetization have short-runeffects on output and incomes that reinforce one another andshort-run effects on the interest rate that cancel one another.These effects of policy are derived straightforwardly from stand-ard analysis which focuses on aggregate supply and aggregatedemand. But when borrowing becomes excessive, considerationsof risk become dominant. Going beyond the circumscribed focusof the textbook, we can recognize that the Treasury creates riskand the Federal Reserve externalizes it.To say that the Federal Reserve keeps the default-risk pre-mium off Treasury bills is not to say that the risk is actually


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13arrison: The Federal Reserve: Then and Now

the artificial security provided by government debt; but the re-duction in private-sector activity would have been minimized solong as the additional risks were assumed by those most willingto do so. This result, though, was precluded by institutionalfactors that hid the private-sector riskiness from those who were(unknowingly) financing risky undertakings. Again, the FederalReserve plays a strong supporting role, as does the FDIC. To-gether, they enabled commercial banks and their depositors tofinance risky ventures throughout the 1980s while being shieldedeither permanently or temporarily from the risks. This shieldfrom risk bearing, like the low rate of interest in the 1920s, gaverise to an artificial boom and subsequent bust.The Depository Institutions Deregulation and MonetaryControl Act of 1980 (DIDMCA) dramatically changed the bank-ing industry's ability and willingness to finance risky under-takings. Increased competition from nonbank financial insti tu-tions drove commercial banks to alter their lending policy so asto accept greater risks in order to achieve higher yields. TheFederal Reserve in its long-established capacity of lender of lastresort diminished the banks' concerns about possible problemsof illiquidity while the FDIC absolved the banks' depositors ofall worries about illiquidity and even about bankruptcy. Riskierloans, then, were only partially reflected in higher borrowingcosts and lower share prices. In substantial measure, specificprivate-sector risks were transformed by DIDMCA, the Federal


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to protect depositors while charging the banks a premium thatwas too low in general and, more significantly, that was unrelatedto the riskiness of bank assets. This subsidy to risk-taking mayhave been significant enough, by itself, to create an artificialboom. There was no difficulty in finding risks to take. Banks couldsimply lend more heavily to overextended farmers, third-worldcountries, oil prospectors, and real estate developers; or theycould find new risks such as those created by leveraged buyoutsand the dramatic growth of the junk-bond market. It was thefinancial sector's demand for high-risk, high-yield securities, infact, that gave junk bonds and other highly leveraged securitiestheir buoyancy.Although it is possible to think of the FDIC as having its ownindependent effect throughout the 1980s, FDIC policy was actu-ally an integral part of the -fiscal, monetary, and regulatoryenvironment that created and externalized risks. The Treasurycreated risk; the Federal Reserve and the FDIC externalized it.After all, speculative lending such as for commercial real estatedevelopment or for highly leveraged financial re-organizationsare risky in large part because of possible changes in such thingsas the inflation rate, interest rate, trade flows, and tax rates-thevery things that can undergo substantial and unpredictablechange when the federal budget is dramatically out of balance.The 1980s may best be understood, then, as a decade in which the


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policy of forbearance in cases of problem banks, and the implicitacceptance of the doctrine of "too big to fail," all help to accountfor the length of the artificial boom. But neither increased last-resort lending and forbearing nor more overt inflationary finance,such as was pursued in the 1920s, could keep the boom goingindefinitely. As with the artificial boom in the interwar period, aneventual bust was inevitable.Like the time-consuming production processes that wereout of line with time preferences, speculative loan portfoliosthat were out of line with risk preferences generated an artifi-cial boom in the 1980s that belonged to the same general classas that of the 1920s. However, the distinction between eco-nomic activities that are excessively future-oriented and eco-nomic activities that are excessively speculative-together withsome institutional considerations-allows us to see systematicdifferences between the 1930s and the 1990s.First, the downturn a t the end of the Bullish Eighties camein the form of a bank-led bust. A high rate of bank failures wasexperienced well before the general economic contraction. At theend of the Roaring Twenties, by contrast, the bank failures cameafter the economic contraction had begun. This difference in thetiming of events is consistent with differences in the nature ofthe two expansions. Industrial borrowers in the 1920s wereusing newly created funds for excessively capital-intensiveventures that, in general, were not otherwise excessively


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bank-led. During the Great Depression, firms whose revenues didnot cover operating costs simply closed their doors. Work onincomplete industrial projects whose present value had turnednegative was simply discontinued. Although this form of marketdiscipline was sometimes delayed by policies aimed a t rekindlingthe boom, eventually resource idleness characterized those sec-tors of the economy that were most out of line with underlyingeconomic realities, and liquidation could proceed apace.10 In thecurrent slowdown, many failing firms are first identified as non-performing loans in the portfolios of failed banks. As insolventbanks are closed by the FDIC, the bad loans ar e transferred tothe Resolution Trust Corporation (RTC), which functions as acaretaker until i t can sell the assets. In many cases, the physi-cal assets, such as franchised motels or restaurants, are notidled. Instead, the RTC contracts with an operating companyto run the business. The contract allows the operating companyto earn a profit while minimizing the cost to the RTC of main-taining the assets.The existence of many such failed-but-still-operating busi-nesses, including firms undergoing bankruptcy proceedings butstill operating with the newly evolved debtor-in-possession (DIP)financing, helps to explain why the current recession is a rela-tively shallow one by conventional measures. What otherwisewould be idle capital is partially masked by RTC policy as under-


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experience in the early 1990s, it would have been easier to drawresources out of idleness than to draw them away from the RTC.Asset managers of the RTC, trying to avoid spoiling marketstha t dumping real asse ts a t fire-sale price would entail , stock-piled them instead, creating a huge "overhang" which addedsignificantly to the uncertainties in the private sector. Also,solvent firms and would-be upstarts, who would have to raisetheir own capital to expand or enter the market, are not eager tocompete with bankrupt firms or with privately operated butRTC-owned businesses whose revenues do not have to cover thecosts of capital. Considerations of these sorts help to explain whythe government's recent recourse to monetary stimulation in theform of exceedingly low discount rates has met with such littlesuccess.Third, the unemployment currently being experienced has adistinctly different composition from that of the 1930s. It iswidely reported that white-collar workers are disproportionatelyaffected in the current recession as compared to earlier cyclicaldownturns. The time-preferencelrisk-preference frame of analy-sis makes this composition difference readily understandable.The boom in the 1920s involved resources allocated dispropor-tionately to capital-intensive projects, such as steel mills andmanufacturing plants. The labor complement to heavy industrytends to be predominantly blue-collar. The boom in the 1980s


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the 1980s, could sustain it no longer, the boom ended, but thedeficit spending and risk externalization escalated. In fact, de-creased tax revenues and increased payments of entitlements,both associated with recession, led to still more governmentborrowing. The dynamic of the bust, then, provided increasedscope for the very kind of irresponsible fiscal policy that made thebust inevitable.How Little "We" KnowThe failure a t the dawn of the last decade to extend deregulationto the provision of deposit insurance and the absence of anymarket check against the Treasury's fiscal excesses provide dra-matic illustration of the general fallacy of the mixed economy.Privatized profit seeking coupled with socialized risk bearingundergirded both the bull market of the 1980s and the harshereconomic realities of the 1990s. The risks assumed by lenders andborrowers, savers and investors, hedgers and leveragers are ren-dered inconsistent with the actual risk preferences of wealthholders in the marketplace by the FDIC subsidy to risk bearingand by the Fed-backed Treasury, whose power to issue risk-freedebt imposes risks on the private sector.Researchers a t the Federal Reserve are just two steps awayfrom recognizing the problem of deficit-induced uncertainties


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wrong, they may lose big. The second step is to recognize that the"We" may also refer to the holders of Treasury securities. Accord-ingly, the tit le phrase should be amended to read "How Little WeKnow or Care about Deficit Policy Effects." The potential for debtmonetization, as manifested by the Federal Reserve in i ts stand-by capacity, has absolved the Treasury's creditors of any inclina-tion to care. Externalizing risk has precluded any possibility t hatthe reluctance of creditors will provide a n effective check againstthe excesses of the Treasury.The tripling of federal government indebtedness since thebeginning of the 1980s' bull market stands as testimony to thecapacity of the Treasury to issue its artificially risk-free debt. Thebanking legislation of 1980 has shown us its capacity for blindingthe banking industry and the private sector to the black cloud ofdebt gathering above it. Together, the actions of the fiscal andmonetary authorities have demonstrated once again how publicinstitutions ostensibly devoted to stability and prosperity are, inthe end, responsible for crises and decay.

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the federal reserve - garrison

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