vol. 7, nos. 2-3, 1994, pp. 259-276
Reprinted as "The Federal Reserve: Then and Now"
Review of Austrian Economics
vol. 8, no.1, 1994, pp. 3-19
The Roaring Twenties and the Bullish Eighties:
The Role of Government in Boom and Bust
Roger W. Garrison
There are significant parallels between the Roaring 1920s and the
Bullish 1980s. Both decades were characterized by a policy-induced artificial
boom that ended with an inevitable bust. The Federal Reserve had a hand
in both episodes, keeping the interest rate artificially low in the first
one and keeping Treasury bills artificially risk-free in the second. Comparing
the two episodes in terms of Federal Reserve policy, federal government
borrowing, and the regulatory environment faced by the banking community
accounts for both similarities and differences between the economic realities
of the 1990s and those of the 1930s.
A good friend of mine has two sons who, in their youth, were unusually
mischievous. On one occasion, when my friend had just replenished his liquor
supply in preparation for a cocktail party that evening, his sons decided
that a liquor cabinet was a pretty good substitute for a chemistry set.
They broke the seals and poured from one bottle directly into the next:
scotch into rum; rum into gin; gin into scotch. And they added a little
crme de menthe all around. When their father discovered the deed (not in
time to save the evening guests from some innovative cocktails), he issued
punishment in the form of reduced allowances and increased yard duties.
The two boys accepted the punishment gracefully and promised never to do
that again. "You know," my friend told me, "I believe them. They'll never
do that again. The next time, it'll be something else."
And so it is with the Federal
Reserve. Mischievous by its very nature, 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 operandi,
are almost sure to be disappointed. The enduring capacity of the Federal
Reserve to exert a powerful influence on the course of economic events
derives importantly from its adaptability. New trends in fiscal policy
and modifications in the regulatory environment can change the nature and
significance of Federal Reserve actions in ways that are difficult to perceive
until after the fact.
In recent years, difficulties
in perceiving just how the Federal Reserve is affecting the course of the
economy have translated into doubts that the Federal Reserve has a significant
effect—doubts even that money has much to do with the cyclical variation
of employment and output. So-called real theories of the business cycle
account for each departure from trend-line growth in terms of some real
shock to the economy—which typically means a change in technology or in
resource availability.(1) In turn, the focus
on macroeconomically significant real shocks, which are relatively few
and far between in comparison to monetary shocks, has caused many modern
macroeconomists to believe that business cycles themselves are far less
troubling than was once thought.(2) To similar
effect, the increasing reliance on an analytical framework that reduces
all macroeconomic phenomena to considerations of aggregate demand and aggregate
supply has led textbook writers to emphasize the temporariness of cyclical
variation rather than the pervasive discoordination and painful recovery
that characterize boom and bust.(3)
Such treatments of cyclical
variations and of the relationship between monetary and fiscal policy are
fundamentally flawed. While important changes in the fiscal and institutional
environment underlie the comparison between the Federal Reserve then (1920s-1930s)
and the Federal Reserve now (1980s-1990s), the Federal Reserve's power
to create money must figure importantly in the accounts of both periods.
Understanding just how, though, requires an analysis that makes use of
a level of aggregation much lower than that of conventional macroeconomics.
From Textbook Macroeconomics to Macroeconomic Realities
Macroeconomic policy is conventionally divided into two categories:
monetary policy, which is formulated and implemented by the Federal Reserve,
and fiscal policy, which is the net effect of the many spending and taxing
decisions made by Congress. Macroeconomic textbooks typically introduce
monetary and fiscal policies in separate chapters and then deal with the
interplay between the two by constructing multi-quadrant graphs in which
the money supply, government spending, and the level of taxation, each
represented in separate quadrants, have a combined economywide effect on
the rate of interest and the level of income.
There is a certain logic
to this policy decomposition. Inflating, spending, and taxing in the conventional
macroeconomic framework have their own separate short-run effects on the
interest rate and income level: expansionary monetary policy causes incomes
to rise and interest rates to fall; expansionary fiscal policy (increased
government spending or decreased taxation) causes both incomes and interest
rates to rise. The effect of coordinated monetary and fiscal policy is
simply the sum of the individual effects. Economic expansion driven by
both the Federal Reserve and the federal budget, for instance, has a double-barreled
effect on the level of income while leaving the rate of interest unchanged.(4)
Yet the relevance of such
textbook treatments of policy hinges on several critical assumptions. By
expanding the money supply, policymakers intend to affect output and employment
rather than prices and wages. Any hopes for these intended real effects—as
opposed to purely nominal effects—must be based on the assumption that
prices and wages are somehow stuck above their market-clearing levels at
the outset of the expansion and that the new money lent at lower interest
rates is used only to mobilize otherwise idle resources. If, instead, pre-expansion
prices and wages are fully adjusted to their market-clearing levels, then
the effects of monetary expansion are only temporary. In the long run,
real incomes return to their pre-expansion levels as prices and wages adjust
upward; real interest rates return to their pre-expansion levels as rising
prices and wages build an inflationary premium into the structure of nominal
interest rates. Similarly, expansionary fiscal policy, which increases
real rates of interest, has only a temporary effect on incomes under conditions
of flexible prices and wages. These assumptions and qualifications are
acknowledged—though sometimes cryptically—in most modern macroeconomic
But these treatments employ
an exceedingly high level of aggregation, whereby "income" summarily measures
both the total output produced in exchange for that income and the spending
power capable of buying that output. This aggregation causes the phrase
"temporary effects of fiscal and monetary policy" to seem innocuous or
benign, seriously understating the actual effects of policy. The conventional
wisdom is that policy in the form of such "stimulant packages" may temporarily
push the activities of producing, earning, and spending beyond levels that
can be sustained. At worst, the dynamics of policy-induced changes in macroeconomic
magnitudes give scope for political chicanery as incumbent administrations
resort to fiscal and monetary stimulants just prior to elections.(5)
According to an increasingly
common view, cyclical movements in income and output—whether attributable
to policy actions or to real factors—are considered harmful only in that
the timing of consumption is slightly less than optimal. This assessment
allows for a quantitative estimate of the welfare loss due to temporal
suboptimality of approximately one tenth of one percent of total consumption—which
translates into about $8.50 per person per year.(6)
Disaggregating the economy's investment sector into policy-relevant patterns
of investment, however, reveals that the temporary effects are not so benign.
The scope for harm caused by monetary and fiscal stimulants can instead
be seen in terms of unsustainable changes in the pattern of investment.
Even if the spending power of income earners equals total output in aggregate
terms, a systematic, policy-induced mismatch between decisions in the investment
sector and the underlying preferences of consumers and wealth holders can
lead to severe economic downturns and painful recoveries.
By carefully identifying
the relevant aspects of investment patterns in different cyclical episodes,
we can identify both theme and variation in the story of boom and bust.
We can find both similarities and differences, for instance, in comparing
the experience of the 1920s and 1930s with that of the 1980s and 1990s.
Further, we can show that the prolonged succession of policy-induced "temporary"
effects, which has fundamentally changed the relationship between fiscal
and monetary policy, has had permanent effects on the health of the economy.
Variation on a Theme
How strong are the parallels between the boom of the 1920s and the
boom of the 1980s? How similar are the economic circumstances of the early
1990s to those of the early 1930s?
It may be tempting to try
to account for our current macroeconomic plight by retelling the story
of the interwar experience, changing only the dates and a few minor details.
But the story doesn't fit that well. Credit conditions as judged by real
rates of interest were relatively tight during the 1980s in comparison
to credit conditions during the 1920s. And although the overall monetary
expansion was actually greater in the more recent episode, the pattern
of monetary growth in the two periods differs importantly. In the 1920s,
the money growth rate peaked near the end of the decade as the Federal
Reserve attempted with increasing resolve to keep the boom going; in the
1980s, the peak growth rate of M1 came at mid-decade, after which monetary
growth fell to low single digits while the bull market continued. Adjusting
the story by replacing the conventional money or credit aggregates with
more narrow ones, such as the monetary base, or with broader ones, such
as the Divisia index, does little to improve the fit. And given the intense
Fed-watching in recent decades, it would in fact be surprising to learn
that the Federal Reserve had nonetheless ignited and sustained an artificial
boom for several years by simply repeating its misdeeds of the 1920s. There
is, after all, a kernel of truth in the notion of "rational expectations"—as
recognized by Ludwig von Mises years before that term achieved currency
in macroeconomic thought.(7)
Parallels can be found not
in the strict sense of a replay but in the broader sense of variation on
a theme. The story requires a recasting of the characters and some major
changes in the plot. The Federal Reserve no longer plays the lead; it plays
instead an indispensable supporting role. Banking legislation and fiscal
policy are more central to the storyline. In accounts of both periods,
however, we can say that unprecedented conditions allow an artificial boom
to go unchecked for a significant period of time. Unprecedented in the
1920s was a strong central bank bent on stimulating growth in a peacetime
economy. Unprecedented in the 1980s was a banking industry operating in
a dramatically altered regulatory environment and a federal government
running deficits measured in the hundreds of billions.
Interest rates in the recent
episode play an important role not so much because of considerations of
time discount but because of considerations of risk. During the 1920s,
the low time discount signaled by artificially depressed interest rates
did not accurately reflect people's actual willingness to save; during
the 1980s, the low risk premiums built into interest rates did not accurately
reflect people's actual willingness to accept the risks of increasingly
speculative investments—much less the additional risks attributable to
the government's irresponsible fiscal policy. The boom of the 1980s was
no less artificial, however, than the one in the 1920s. To see why, we
shall have to shift our focus from the easy money provided by the Federal
Reserve in the 1920s to the risk-free securities provided by the Treasury
in the 1980s. But first let us highlight aspects of the 1920s that have
identifiable counterparts in the 1980s.
The Federal Reserve played
a leading role in the dramatic boom of the 1920s (and the bust of the 1930s).
Artificially cheap credit provided by the Federal Reserve underlay the
economic expansion that lasted through mid-1929. This credit expansion,
in an economic environment largely devoid of Fed-watchers, drove a wedge
between saving and investment. Guided by low rates of interest, investment
outstripped saving in aggregate terms, and—more importantly—investment
projects were excessively long-term. As the boom proceeded, low interest
rates lured capital into relatively time-consuming production processes.
That is, the timing of the output of these production processes was skewed
toward the future in comparison to the intertemporal pattern of demand
for output. While the intertemporal distortion of output is the essence
of so-called real business cycle theory, it is only a symptom, in the view
presented here, of a pervasive distortion in the economy's capital structure.
The economywide inconsistencies—attributable to Federal Reserve policy—between
investment decisions of the business community and the time preferences
of consumers made the bust inevitable. The recovery, hampered by policies
aimed at re-igniting the boom, consisted of extensive capital liquidation
and a general intertemporal restructuring of capital.
Modern textbook treatments
of the recent economic boom in comparison to the interwar boom hinge on
a sharp distinction between monetary and fiscal policy. The earlier boom
was driven by monetary policy; the later one by fiscal policy. It is true
that the 1920s were characterized by (relatively) tight fiscal policy and
loose monetary policy as each is conventionally measured, and that the
1980s saw a reversal in the relative strengths of the two policy alternatives.
But the strict dichotomization between fiscal and monetary policy is badly
overdrawn. In the 1980s, the significance of fiscal policy lay not in its
augmentation of aggregate demand but in the private-sector risks and uncertainties
that were attributable to chronic and dramatic federal budget deficits.
This shift in focus directs attention to the Federal Reserve's critical
supporting role throughout the decade and to the banking legislation at
While irresponsible fiscal
policy created additional risks and uncertainties to be born by the private
sector, the Federal Reserve in its capacity to monetize Treasury debt kept
the risk premium off of Treasury securities. Further, while extensive changes
in the regulatory environment faced by the banking industry led banks to
take on increasingly riskier portfolios, the Federal Reserve in its capacity
of lender of last resort—together with policies of the FDIC—kept the risk
premium off of bank securities and minimized the worries of the banks'
depositors. Although the story of the 1980s is institutionally complex,
the general nature of the problems in the private sector is relatively
simple. The regulatory and policy environment led the business community
to take on risks that were systematically out of line with the risk preferences
of private wealth holders. This systematic discrepancy between risks undertaken
and risk preferences, which provides the thematic link to the interwar
episode, justifies the claim that the 1980s boom was artificial and that
the bust was inevitable.
It is not difficult to demonstrate that chronic and dramatic federal
budget deficits create uncertainties in the private sector.(8)
A numerical example can serve to illustrate. Suppose the government's anticipated
rate of spending over the next several years is a trillion dollars per
year, and that it anticipates collecting $800 billion per year in tax revenues.
The difference, the anticipated annual deficit, of $200 billion represents
yet-to-be-funded government spending.
The business community understands
that the government will appropriate a trillion dollars worth of resources
each year. Tax codes stipulate the particular targets of eighty percent
of the government's appropriation activities. Production plans can be made
in the light of these codified taxing procedures. But there can be no plans
that effectively take into account the other twenty percent, the anticipated
deficit. In effect, the government is saying to the private sector: "We
are planning on appropriating another $200 billion worth of resources,
but we are not saying just how, just when, and just whose."
The government may continue
issuing new Treasury bills while holding the line on the money supply.
This would mean continued strains on credit markets, real rates of interest
higher than they otherwise would be, and continued trade deficits as the
Treasury sells those bills both at home and abroad. Alternatively, the
government may rely more heavily on money creation. The Federal Reserve
may begin buying Treasury bills at an accelerated rate. This process of
debt monetization would take the pressure off credit markets and strengthen
export markets. It would reduce the real rate of interest (temporarily)
but would build an inflation premium into the entire structure of interest
rates. As still another alternative, the government may institute new taxes
of some kind or raise tax rates in some yet-to-be-specified way. In the
meantime, a $200-billion cloud of "intent to appropriate in some 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 of just how the government will appropriate the additional
resources. Should long-term capital be shifted out of export industries
because of the currently high foreign-trade deficit and correspondingly
weak export markets? Or should it be kept in place by anticipations of—or
hopes fora change in fiscal strategy? Should long-term financial commitments
be based on the current credit conditions or on the contingency of some
unknown likelihood that the Treasury will borrow more heavily in domestic
as opposed to foreign credit markets? Should land, durable assets, and
even inventories be bought or sold at prices that reflect the current inflation
rate? Or should such transactions reflect accelerating inflation based
on upon some guess about the extent and timing of debt monetization?
Although the government's
borrowing at irresponsibly high levels adds to the riskiness of private-sector
activities, none of these risks are born by the holders of Treasury securities.
This discrepancy between risk created and risk assumed can be directly
attributed to the Federal Reserve in its capacity to monetize Treasury
debt. Overextended borrowers in the private sector must pay a substantial
default-risk premium in order to continue borrowing. Even overextended
municipalities pay a default-risk premium as their bonds are downgraded
by bond-rating agencies. The power to tax alone is not enough to protect
municipal bondholders against default. But the interest rate paid by the
federal treasury contains no default-risk premium at all. The Federal Reserve
stands ready to monetize the Treasury's debt in circumstances that otherwise
would require an outright default. It is true, of course, that actual
monetization imposes costs in the form of price distortions and a general
price inflation, but these costs are imposed on the economy in general—not
just the holders of Treasury securities. Since a "monetization risk," unlike
a default risk, is born by holders and non-holders alike, there is no monetization-risk
premium—separate from the economywide inflation premium—built into the
nominal yield on Treasury securities. The very potential for debt monetization
is what breaks the link between fiscal irresponsibility and some corresponding
The Federal Reserve, then,
plays a critical supporting role in the pursuance of fiscal policy. Relieving
the holders of Treasury securities of any risk burden increases the attractiveness
of those securities and thus eliminates what would otherwise be a binding
market constraint on further Treasury issues. The increasing significance
of potential debt monetization suggests that the magnitude of the
Federal Reserve's influence is not to be detected in actual movements
of monetary aggregates. The mere fact that the Federal Reserve stands ready
to monetize debt gives the Treasury a much longer leash than it would otherwise
The Artificial Boom
Textbook treatments of fiscal and monetary policy recognize that the
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 irresponsible levels, debt issue and monetization
have short-run effects on output and incomes that reinforce one another
and short-run effects on the interest rate that cancel one another. These
effects of policy are derived straightforwardly from standard analysis
which focuses on aggregate supply and aggregate demand. But when borrowing
becomes excessive, considerations of risk become dominant. Going beyond
the circumscribed focus of the textbook, we can recognize that the Treasury
creates risk and the Federal Reserve externalizes it.
To say that the Federal
Reserve keeps the default-risk premium off of Treasury bills is not to
say that the risk is actually eliminated. The burden of bearing it is simply
shifted from the holders of Treasury securities to others. Borrowing and
investing in the private sector becomes more risky than it otherwise would
be. Holders of private debt and equity shares must concern themselves not
only with all the usual risks and uncertainties of the marketplace but
also with the risks and uncertainties attributable to changes in the way
the federal deficit is accommodated. Selling Treasury bills in foreign
credit markets, in domestic credit markets, or to the Federal Reserve can
have major effects on the strength of export markets, on domestic interest
rates, and on the inflation rate. The inability of market participants
to anticipate the Treasury's borrowing strategy translates into unanticipated
changes in the value of private securities.
If the additional risks
attributed to federal budget deficits and imposed upon the private sector
were allocated in some economically efficient way, there would have been
no artificial boom arising from the irresponsible fiscal policy of the
1980s. The willingness to lend and to buy equity shares in the private
sector would have been generally reduced, as wealth holders opted for the
artificial security provided by government debt; but the reduction in private-sector
activity would have been minimized so long as the additional risks were
assumed by those most willing to do so. This result, though, was precluded
by institutional factors that hid the private-sector riskiness from those
who were (unknowingly) financing risky undertakings. Again, the Federal
Reserve plays a strong supporting role, as does the Federal Deposit Insurance
Corporation. Together, they enabled commercial banks and their depositors
to finance risky ventures throughout the 1980s while being shielded either
permanently or temporarily from the risks. This shield from risk bearing,
like the low rate of interest in the 1920s, gave rise to an artificial
boom and subsequent bust.
The Depository Institutions
Deregulation and Monetary Control Act of 1980 (DIDMCA) dramatically changed
the banking industry's ability and willingness to finance risky undertakings.
Increased competition from nonbank financial institutions drove commercial
banks to alter their lending policy so as to accept greater risks in order
to achieve higher yields. The Federal Reserve in its long-established capacity
of lender of last resort diminished the banks' concerns about possible
problems of illiquidity while the FDIC absolved the banks' depositors of
all worries about illiquidity and even about bankruptcy. Riskier loans,
then, were only partially reflected in higher borrowing costs and lower
share prices. In substantial measure, specific private-sector risks were
transformed by DIDMCA, the Federal Reserve, and the FDIC into (1) the generalized
risk of inflation in the event of excessive last-resort lending by the
Federal Reserve and (2) the risk of a large and unbudgeted liability in
the event of excessive last-resort closings by the FDIC. Thus, economic
activity in the private sector was spurred on by the lure of higher yields,
yet it was largely unattenuated by considerations of risk, which were effectively
externalized and diffused.
The artificially low risk
premiums stemming from the risk-externalizing effect of potential debt
monetization in the 1980s paralleled the artificially low interest rates
created by actual monetary expansion in the 1920s. What was without an
earlier parallel, however, was the impact of deposit insurance in the post-DIDMCA
period.(9) Throughout the 1980s, the FDIC
continued to protect depositors while charging the banks a premium that
was too low in general and, more significantly, that was unrelated to the
riskiness of bank assets. This subsidy to risk-taking may have been significant
enough, by itself, to create an artificial boom. There was no difficulty
in finding risks to take. Banks could simply lend more heavily to overextended
farmers, third-world countries, oil prospectors, and real estate developers;
or they could find new risks such as those created by leveraged buyouts
and the dramatic growth of the junk-bond market. It was the financial sector's
demand for high-risk, high-yield securities, in fact, that gave junk bonds
and other highly leveraged securities their buoyancy.
Although it is possible
to think of the FDIC as having its own independent effect throughout the
1980s, FDIC policy was actually an integral part of the fiscal, monetary,
and regulatory environment that created and externalized risks. The Treasury
created risk; the Federal Reserve and the FDIC externalized it. After all,
speculative lending such as for commercial real estate development or for
highly leveraged financial re-organizations are risky in large part because
of possible changes in such things as the inflation rate, interest rate,
trade flows, and tax rates—the very things that can undergo substantial
and unpredictable change when the federal budget is dramatically out of
balance. The 1980s may best be understood, then, as a decade in which the
policy-induced externalization of risk gave rise to a substantial but ultimately
unsustainable economic boom.
Potential debt monetization can keep Treasury bills risk free for the
indefinite future; the reimbursement of depositors of failed banks can
continue so long as the FDIC can be recapitalized out of general tax revenues.
But the banking industry cannot be shielded from the consequences of excessive
risk-taking forever. For almost a decade the banking industry and the speculative
activities it supported were able to keep the economic expansion going.
Although risk aversion normally characterizes sound banking, high-flying
banks in the 1980s were able to indulge in risky lending despite the preferences
of their depositors and to escape both market-imposed or government-imposed
discipline until the cumulative effects of externalizing risk turned the
undue risk-taking into a financial crisis. The Federal Reserve's routine
functioning as lender of last resort, the FDIC's de facto policy
of forbearance in cases of problem banks, and the implicit acceptance of
the doctrine of "too big to fail," all help to account for 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 going indefinitely. As with the artificial boom in
the interwar period, an eventual bust was inevitable.
Like the time-consuming
production processes that were out of line with time preferences, speculative
loan portfolios that were out of line with risk preferences generated an
artificial boom in the 1980s that belonged the same general class as that
of the 1920s. However, the distinction between economic activities that
are excessively future-oriented and economic activities that are excessively
speculative—together with some institutional considerations—allows us to
see systematic differences between the 1930s and the 1990s.
First, the downturn at the
end of the Bullish Eighties came in the form of a bank-led bust. A high
rate of bank failures was experienced well before the general economic
contraction. At the end of the Roaring Twenties, by contrast, the bank
failures came after the economic contraction had begun. This difference
in the timing of events is consistent with differences in the nature of
the two expansions. Industrial borrowers in the 1920s were using newly
created funds for excessively capital-intensive ventures that, in general,
were not otherwise excessively speculative. It is true, of course, that
there was heavy speculation in securities markets in the 1920s—much more
so then than in the 1980s—but the cause-and-effect relationship in the
recent episode was the reverse of that in the earlier one. That is, in
the 1920s, monetary expansion, which allowed banks to support heavy industry,
also fueled speculation in securities markets. However, because the risks
of that speculation were born, in the first instance, by the buyers of
the securities, there was no policy-induced externalization of risk to
weaken banks even as the expansion continued. In the 1980s, policy-induced
speculation, on the part of the banks themselves and their industrial borrowers,
eroded bank capital, weakening the banks throughout the boom—so much so
that the erosion of their capital base eventually turned boom into bust.
Second, while the idleness
of plant, equipment, labor, and other resources that characterized the
1930s has its counterpart in the semi-idleness in the 1990s, the disposition
of unprofitable assets is different now, largely because the recent bust
was bank-led. During the Great Depression, firms whose revenues did not
cover operating costs simply closed their doors. Work on incomplete industrial
projects whose present value had turned negative was simply discontinued.
Although this form of market discipline was sometimes delayed by policies
aimed at rekindling the boom, eventually resource idleness characterized
those sectors of the economy that were most out of line with underlying
economic realities, and liquidation could proceed.(10)
In the current slowdown, many failing firms are first identified as non-performing
loans in the portfolios of failed banks. As insolvent banks are closed
by the FDIC, the bad loans are transferred to the Resolution Trust Corporation
(RTC), which functions as a caretaker until it can sell the assets. In
many cases, the physical assets, such as franchised motels or restaurants,
are not idled. Instead, the RTC contracts with an operating company to
run the business. The contract allows the operating company to earn a profit
while minimizing the cost to the RTC of maintaining the assets.
The existence of many such
failed-but-still-operating businesses, including firms undergoing bankruptcy
proceedings but still operating with the newly evolved debtor-in-possession
(DIP) financing, helps to explain why the current recession is a relatively
shallow one by conventional measures. What otherwise would be idle capital
is partially masked by RTC policy as underemployed capital—analogous to
the underemployed labor associated with 1930s-style make-work projects.
"Zombie banks," banks that are allowed to continue operations after their
net worth has turned negative, have their counterpart in RTC-owned or DIP
financed "zombie firms."(11)
While the underemployed
capital in zombie firms limited the depth of the recession, it added to
the length. Recovery consists of re-employing resources idled by the bust.
As confirmed by experience in the early 1990s, it would have been easier
to draw resources out of idleness than to draw them away from the RTC.
Asset managers of the RTC, trying to avoid spoiling markets that dumping
real assets at fire-sale price would entail, stockpiled them instead, creating
a huge "overhang" which added significantly to the uncertainties in the
private sector. Also, solvent firms and would-be upstarts, who would have
to raise their own capital to expand or enter the market, are not eager
to compete with bankrupt firms or with privately operated but RTC-owned
business whose revenues do not have to cover the costs of capital. Considerations
of these sorts help to explain why the government's recent recourse to
monetary stimulation in the form of exceedingly low discount rates has
met with such little success.
Third, the unemployment
currently being experienced has a distinctly different composition from
that of the 1930s. It is widely reported that white-collar workers are
disproportionately affected in the current recession as compared to earlier
cyclical downturns. The time-preference/risk-preference frame of analysis
makes this composition difference readily understandable. The boom in the
1920s involved resources allocated disproportionately to capital-intensive
projects, such as steel mills and manufacturing plants. The labor complement
to heavy industry tends to be predominantly blue-collar. The boom in the
1980s involved resources allocated to speculative development, such as
commercial real estate and financial services. The labor complement to
this kind of capital tends to be predominantly white-collar. In both episodes,
the composition of unemployment matches the pattern of capital misallocation.
Finally, macroeconomic policy
after the bust reveals a critical difference between the current situation
and that of the 1930s. When further monetary expansion, which sustained
the boom of the 1920s for nearly a decade, could sustain it no longer,
both the monetary expansion and the boom came to an end. The public's increased
demand for currency relative to checking-account money, coupled with the
increased reluctance on the part of commercial banks to lend, swamped the
Federal Reserve's efforts to re-inflate.(12)
Despite the futher padding of the monetary base, the dynamics of the bust
itself was an effective check against continued monetary expansion. By
contrast, when further deficit spending and risk externalization, which
sustained the boom of the 1980s, could sustain it no longer, the boom ended,
but the deficit spending and risk externalization escalated. In fact, decreased
tax revenues and increased payments of entitlements, both associated with
recession, led to still more government borrowing. The dynamics of the
bust, then, provided increased scope for the very kind of irresponsible
fiscal policy that made the bust inevitable.
How Little "We" Know
The failure at the dawn of the last decade to extend deregulation to
the provision of deposit insurance and the absence of any market check
against the Treasury's fiscal excesses provide dramatic illustration of
the general fallacy of the mixed economy. Privatized profit seeking coupled
with socialized risk bearing undergirded both the bull market of the 1980s
and the harsher economic realities of the 1990s. The risks assumed by lenders
and borrowers, savers and investors, hedgers and leveragers are rendered
inconsistent with the actual risk preferences of wealth holders in the
marketplace by the FDIC subsidy to risk bearing and by the Fed-backed Treasury,
whose power to issue risk-free debt imposes risks on the private sector.
Researchers at the Federal
Reserve are just two steps away from recognizing the problem of deficit-induced
uncertainties as evidenced by a recent article entitled "How Little We
Know About Deficit Policy Effects."(13)
Macroeconomic data as illuminated by several sophisticated modeling and
econometric techniques have led two economists at the Minneapolis Federal
Reserve Bank to conclude with confidence that "Deficit policies may matter,
and then again they may not. Existing studies really don't tell us much
about their effects."(14) The first step
from this disturbingly limp conclusion to a healthy understanding of the
deficit problem is to recognize that the "We" in the title of the article,
intended to mean "We Economists," can be extended to mean "We Lenders-Borrowers-Savers-Investors-
Hedgers-Leveragers" or simply "We Market Participants." Market participants
do not know how deficit accommodation will affect future market conditions,
so they have to make guesses. And if they guess wrong, they may lose big.
The second step is to recognize that the "We" may also refer to the holders
of Treasury securities. Accordingly, the title phrase should be amended
to read "how little we know or care about deficit policy effects."
The potential for debt monetization, as manifested by the Federal Reserve
in its stand-by capacity, has absolved the Treasury's creditors of any
inclination to care. Externalizing risk has precluded any possibility that
the reluctance of creditors will provide an effective check against the
excesses of the Treasury.
The tripling of federal
government indebtedness since the beginning of the 1980s' bull market stands
as testimony to the capacity of the Treasury to issue its artificially
risk-free debt. The banking legislation of 1980 has shown us its capacity
for blinding the banking industry and the private sector to the black cloud
of debt gathering above it. Together, the actions of the fiscal and monetary
authorities have demonstrated once again how public institutions ostensively
devoted to stability and prosperity are, in the end, responsible for crises
*The author wishes to thank James Barth and Sven Thommesen
for their helpful comments. An earlier version of this paper was presented
in May 1991 at a conference on the Federal Reserve sponsored by the Ludwig
von Mises Institute of Auburn University and held at Jekyll Island, GA
(the site of the signing of the Federal Reserve Act in 1913).
1. Real business cycle theorists take
the empirically demonstrated links between money and economic activity
to be a result of "reverse causation": changes in the money supply are
seen as the effect rather than the cause of changes in economic activity.
For a critical account of this and other aspects of real business cycle
theory, see Mark Rush, "Real Business Cycles," Federal Reserve Bank
of Kansas City Economic Review, 72, no. 2 (February, 1987), 20-32.
2. "Real cycle theorists question...
the conventional wisdom, which asserts that business cycles harm the economy."
Ibid. 26. Rather than causing the economy harm, minor changes in the
economy's output are understood to be a consequence of an efficient market
coping with minor (macroeconomically speaking) changes in underlying realities.
(In this context, the Great Depression is seen as something of an "outlier"
not well accounted for by this or any other theory of the business cycle.)
3. Long-run aggregate supply, which
reflects resource availabilities and technology, is invariant with respect
to the price level and hence is represented by a vertical supply curve.
Thus, the real effects of a money-induced change in aggregate demand, as
would be measured horizontally, are strictly temporary, lasting only until
the price level has become adjusted to the larger money supply.
4. A typical textbook treatment of
macroeconomic policy is contained in William J. Baumol and Alan S. Blinder,
Principles and Policy, 5th ed. (New York: Harcourt, Brace, Jovanovich,
Publishers, 1991), Chs. 11 and 13 and passim.
5. For early and non-trivial formulation
and application of modern political business cycle theory, see William
D. Nordhaus, "The Political Business Cycle," Review of Economic Studies,
42, no. 130 (April 1975) 169-90 and Edward R. Tufte, Political Control
of the Economy. Princeton: Princeton University Press, 1978.
6. Robert E. Lucas, Jr., Models
of Business Cycles (London: Basil Blackwell, 1987) 27. Despite his
low estimate of the social cost of cyclical variation of output, Lucas
rejects real business cycle theory on the grounds that the candidates for
real shocks are too small to account for actual fluctuations. Ibid.,
71. Textbook authors typically offer no quantitative estimate of the harm
attributable to business cycles, but the fact that Baumol and Blinder's
900-page textbook devotes less than six pages—and nowhere more than two
consecutive pages—to the subject of business cycles carries its own message.
7. Ludwig von Mises, The Theory
of Money and Credit (New Haven: Yale University Press, 1953; originally
published in German in 1912). Mises fully recognized the strategic significance
of expectations in his 1953 addendum entitled "Monetary Reconstruction."
He expressed the limits to—and the short-run nature of—inflationary finance
in terms of Lincoln's Law: You can't fool all the people all the time (see
8. Deficit-induced uncertainties underlie
the arguments in Roger W. Garrison, "Public-Sector Deficits and Private-Sector
Performance," in Lawrence H. White, ed., The Crisis in American Banking
York: New York University Press, 1992), 29-54.
9. For a treatment of the effects of
FDIC policy, see Roger W. Garrison, Eugenie D. Short and Gerald P. O'Driscoll,
Jr., "Financial Stability and FDIC Insurance," in Catherine England and
Thomas Huertas, eds., The Financial Services Revolution:Policy Directions
for the Future (Boston: Kluwer Academic Publishers, 1987), 187-207.
10. On the role of government in adding
to the severity of the Great Depression and delaying recovery, see Gene
Smiley, "Can Keynesianism Explain the 1930s?: Reply to Cowen," Critical
Review 5, no. 1 (Winter 1991), 81-114 and Richard K Vedder and Lowell
E. Gallaway, Out of Work. New York: Holmes and Meier, 1993, 74-149.
11. The term "zombie S&Ls" was
coined by Edward J. Kane in the context of the savings-and-loan crisis,
which was a precursor to the crisis in the banking industry and subsequent
recession. See Edward J. Kane, "Dangers of Capital Forbearance: The Case
of the FSLIC and the "Zombie" S&Ls," Contemporary Policy Issues,
5, no. 1 (January 1987), 77-83. For a healthy perspective on RTC policy
and DIP financing, see Stephen Delos Wilson, The Bankruptcy of America,
Germantown, TN: Ridge Mills Press, 1992, 81-96 and passim.
12. See Smiley, "Can Keynesianism
Explain the 1930s?" p. 88.
13. Preston J. Miller and William
Roberds, "How Little We Know About Deficit Policy Effects," The Federal
Reserve Bank of Minneapolis Quarterly Review, 16, no. 1 (Winter 1992),
14. Ibid., 8.