The New York Times/May 11, 2008 Economic View When Should the Fed Crash the Party? By PETER L. BERNSTEIN
IN the darkest days of the Depression, Treasury Secretary Andrew W. Mellon, one of the richest men in the United States, opposed any government action to stem the tide of plunging business activity and soaring unemployment. Instead, he urged a policy of supreme indifference. "Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate," he said. "It will purge the rottenness out of the system," he added, and values "will be adjusted, and enterprising people will pick up the wrecks from less competent people." John Maynard Keynes, for one, thought that prescriptions like Mellon's were preposterous. The economist called those who held such views "austere and puritanical souls" who believed that it would "be a victory for the mammon of unrighteousness" if general prosperity were not "subsequently balanced by universal bankruptcy." Keynes perceived too much good in prosperity to treat it as the enemy, and he revolutionized economic theory to prove his point. Keynes won the argument, and government intervention to overcome rising unemployment and falling profits has been standard operating procedure forever after. Nevertheless, the debate over intervention is not ancient history. It replays in today's headlines. As the world economy wrestles with the credit crisis and a shattered housing sector, there are those who grumble that too much prosperity caused the excesses that became the root cause of all our troubles. Now, they fear, aggressive countercyclical policies will lead to inflation and threaten a run on the dollar. In some ways, this view derives from Mellon's dark advice. Just recently, William Fleckenstein, a successful investment manager in Seattle, said: "Part of me keeps hoping we'll just let financial gravity take over and have this brutal crack-up. We'd have a decent foundation instead of the balsa wood structure we had coming out of the last bubble." This school holds Alan Greenspan responsible for current problems. Critics of Mr. Greenspan, the former Fed chairman, contend that he pressed the panic button as the year-over-year inflation rate plunged from 3.6 percent year over year in May 2001 to only 1 percent just 13 months later. Such a precipitous decline had not occurred since the 1930s. In response, the Fed sliced its key interest rate to 1 percent from 4 percent over the next 24 months and held it there until June 2004 — accompanied by a rapidly expanding money supply. Now, Mr. Greenspan's critics contend, his determined creation of excess liquidity has left his successor, Ben S. Bernanke, with a mess. In this view, Mr. Bernanke is making matters only worse by carrying out extreme interventions. They see him taking the risk of higher inflation to break the credit crunch and to prevent the economy from falling into what he fears could be a steep decline with deflationary consequences. As James Grant, a well-known expert in fixed-income markets, warns, "Maybe the policymakers' response to the crisis accounts for the parallel bull markets in gold and bonds." Did Mr. Greenspan's Fed make the right decisions? Did it set a bad example for Mr. Bernanke to follow? It is important to remember that deflation is devilishly hard to deal with. When people expect prices to decline, they tend to hold back from spending, which only makes prices fall further. The policy choices open to the Fed are limited. It can try to stem the tide by cutting interest rates, but once the interest rate falls to zero, there is no place else for it to go. Then the authorities have no choice but to open up the monetary spigot, a route that can haunt them later by creating inflationary pressures or asset bubbles. A profound issue is at stake here. Keynes's perspective creates its own problems. Prosperity does not manage itself. William McChesney Martin Jr., the Fed chairman in the 1950s and '60s, famously declared that the Fed's role was "to take away the punch bowl just when the party gets going." If we could refrain from squeezing out the last drop of punch on the upside — a temptation that Mr. Greenspan could not resist during the high-tech boom of the 1990s — fewer maladjustments would develop, and the downside would be less ominous and easier to control. In the real world, however, managing prosperity is just as complex as managing recessions. How does anyone know precisely when the party gets too good? Mr. Martin's timing with the punch bowl was less neat than he would have liked. Real G.D.P. declined by an average of 2.5 percent during the three recessions that followed his removal of the punch bowl. During Mr. Greenspan's tenure, which lasted just about as long as Mr. Martin's, G.D.P. declined by an average of only 0.7 percent over two recessions. In any case, those who echo Mellon's view about letting downturns run their course are inconsistent in their arguments. This school favors government intervention on the upside, but wants no part of government action when trouble develops. Like Mr. Martin, it believes that government should deal with prosperity by cutting it short, before the party really gets good. But when the economy slips into recession, let 'er rip! IN the end, this dispute boils down to consequences, not hard-and-fast rules. The vice chairman of the Federal Reserve, Donald L. Kohn, laid down a wise general principle in a speech in February, when he asserted that, "In circumstances like these, the decisions of policymakers must take account of not only the most likely course of the economy, but also the possibility of very unfavorable developments." The onset of the credit crisis last summer could have led to a replay of many features of the Depression. Was it worth the risk of taking no action, and the resulting social and political consequences, in order to clean house and start fresh? I have no doubt that today's authorities are taking risks and are going to make mistakes in managing the complex fallout from the speculative fevers of recent years. Nevertheless, I would still reject Mellon's advice and those who echo it, because the consequences would be unthinkable. Peter L. Bernstein, a financial consultant and economic historian, is the editor of the Economics & Portfolio Strategy newsletter. Copyright 2008 The New York Times Company -- Jim Devine / "Segui il tuo corso, e lascia dir le genti." (Go your own way and let people talk.) -- Karl, paraphrasing Dante. _______________________________________________ pen-l mailing list pen-l@lists.csuchico.edu https://lists.csuchico.edu/mailman/listinfo/pen-l
