Depression? Fed Is Making Same Errors All Over Again

The experts are busily reassuring us that there cannot be another Great Depression, but the government is already making the same mistakes that caused the last one.

All economic contractions have their roots in a liquidity crisis. In previous centuries such crises occurred when bank failures shrank deposits and the money supply. In the 20th Century liquidity crises are caused by the policy mistakes of central banks like the Federal Reserve.

At the time of crisis the government never understands the cause. The 1929 stock market crash was attributed to excessive liquidity in the banking system. This belief caused the Federal Reserve to drastically shrink bank reserves and the supply of money. The federal government compounded the error by raising taxes to balance the budget and passing protectionist legislation to save jobs. Experts interpreted the economic depression that followed as a sign that capitalism had worn out. If the United States was to have a future, they concluded, the country would have to take its cue from the new Soviet system of central economic planning.

The crash of 1987 has started off on the same foot. Worried all year about excessive liquidity, the Federal Reserve prevented any growth in bank reserves. As the economy was growing but the money supply was not, interest rates were forced up. Instead of realizing that higher interest rates were signaling that policy was too tight, the Fed saw the rise in rates as an indication that financial markets thought policy was too loose and feared inflation.

To reassure the markets that there would be no inflation, the Fed raised interest rates further, reasoning that an increase in the discount rate would lower long-term rates. Instead, long-term interest rates shot up. Before last week’s crash, U.S. interest rates had increased 40%.

Whenever shareholders see interest rates rising, they become fearful of economic slowdown and falling profits; they sell stocks, causing the market to fall. The West German central bank turned a normal market decline into a record collapse by raising interest rates again after the New York stock market had turned down.

That was a catastrophic mistake, because it placed U.S. shareholders in a sure-loss situation. Americans had been led to believe that either the Fed would have to raise interest rates further to prevent higher interest rates abroad from sinking the dollar, or foreigners would dump American stocks to avoid an exchange-rate loss on their holdings. Either way, stocks could only fall more, and panic ensued.

For the past five years our allies have piggybacked on the Reagan expansion, selling us the goods that they couldn’t sell at home. When these export-based economies saw the U.S. stock market predict recession, they realized that their own profits would fall, and they rushed to sell stocks. Stock markets collapsed all over the world, with record declines in Japan and England as well as in the United States.

Whether or not this global collapse leads to world recession depends entirely on what the Federal Reserve and other central banks do. Typically, central banks compound their errors because they are unwilling to admit mistakes.

Public criticism and careful monitoring of the Fed would help to prevent further mistakes, but in today’s politically charged pre-election environment everyone is too busy grinding axes to put the blame where it belongs. With so many people explaining the crash in terms that advance their own agendas, the Fed will get off the hook.

Predictably, Democrats are blaming Republicans, and Keynesian economists are seizing the opportunity to regain influence by blaming supply-side economists. Many supply-siders themselves have hitched their agenda to the crash, blaming it on the lack of a gold standard. Conservatives, standing on their dire warnings about deficit spending since the days of Franklin D. Roosevelt, blame the budget deficit. Even some Administration officials appear to be blaming President Reagan for blocking a budget compromise by his refusal to raise taxes. Foreigners blame the U.S. trade deficit, the main source of their livelihood.

Holding the Fed accountable does not seem to be in the picture. Consequently, there is nothing to prevent the Fed from deciding after a few weeks that it has pumped in enough liquidity to stabilize the market and must again restrain the money supply in order to prevent a renewal of “stock market speculation.”

When the Fed sends interest rates back up, the stock market will sink again. As the economy slides into recession, Republicans will raise taxes “to reassure the markets about the deficit.” As unemployment mounts, Democrats will shrink world trade further by passing protectionist legislation “to save jobs.” As the world economy grinds to a halt, economists and the media will be predicting inflation--just as they did before the 1981-82 recession and the 1984 economic slowdown, and again this year before the stock market crash.

If you don’t believe that there can be another Great Depression, just watch the policy-makers in Washington.