Unforeseen Contingencies

Last year (Fall 2006), at a conference at Hillsdale College, economist Larry White argued in favor of replacing the Fed with a free banking system. Harvard’s Robert Barro responded that this might have made sense in the early days of the Fed, but by now we’ve finally learned how to do central banking right.

"Right." Yes, indeed!

Today’s extraordinary "intermeeting" rate decrease by the Fed gives lie to the constructive rationalism of the supporters of central banking. Greenspan, the paragon of central bankers, enabled the subprime fiasco. His heir, Bernanke, is making even a worse shambles. Here’s the story:

For quite some time, Americans have been living on credit. American consumer spending has been phenomenal, but much of it has been driven by cheap credit: the housing boom, the explosive growth of mortgage instruments, and the expansion of credit cards and growing consumer debt are examples. American private borrowing has roughly been matched by private saving (occasionally not quite) so it’s been a wash. But with Bush 43, federal government has additionally been borrowing, and since there aren’t excess savings in America, the balance - roughly the deficit - has been financed from abroad.

During the orgy of borrowing, Greenspan’s Fed intervened, fostering and facilitating it by expanding the money supply and keeping rates low. Low rates were crucial to the real estate boom, cheap credit was especially important for the crazy house flipping in Florida and similar boom markets.

Now it turns out that many of the private investments were bad ones - and people who took on debts can’t pay them off. (Why do you suppose the credit card banks were so adamant about tightening bankruptcy laws a few years back, in the midst of good times for them?) This isn’t a problem of insufficient liquidity, it’s a problem of bad investments, and dumping more money into the mess won’t fix it. A bad investment remains bad, regardless of how much money one tosses at it. But Ben Bernanke has now called for an emergency injection of liquidity with this sharp and extraordinary interest rate cut. The idea is that lower rates and more funds will stimulate activity and fend off a recession. But credit-driven activity is the problem - haven’t we had enough of activity for activity’s sake? What the economy needs is an end to artificial credit manipulation, an end to government deficits (for which borrowing costs are largely hidden) and liquidation of the mistaken investments and a fresh start, a fresh start undistorted by government interventions that push investment and consumer spending in unsustainable directions.

But instead we get: more money from the Fed, which might postpone crashes (or might not), but will certainly generate inflation; more tax "cuts" from the Republicans (read tax "deferments and transfers:" a tax cut without a corresponding spending cut in the current situation means someone will have to pay more), and eventually more spending ("fiscal stimulus"), probably from our future Democratic President and Congress.

All these chickens, home to roost. This won’t be a recession as we Americans have become accustomed to thinking of them, this will be a long, drawn-out blood-letting, involving low or negative growth, plus inflation. It’s hard to see how it could be different. Bothe private and public sectors are addicted to cheap credit and high interest rates strangle us, foreigners are increasingly skeptical about loaning us further funds (but happy to buy our fire sale assets), and the only alternative finance source - money creation - is already leading us into inflation.

No wonder Bernanke is in a panic.