Re: What To Do About the Recession by William L. Anderson

From: Technotranscendence (
Date: Mon Nov 05 2001 - 13:14:46 MST

On Monday, November 05, 2001 12:20 AM Robert J. Bradbury wrote:
>> the inevitability of this current recession began when the Fed began to
>> force down interest rates during the mid-1990s. The Fed's actions had a
>> major role in triggering a boom, especially in the high-technology sector
>> of the economy. As the boom continued, it was fed by artificially low
>> interest rates and a false belief that we had entered a "new economy" in
>> which business cycles were a thing of the past.
> Is there any "real" evidence that the Fed is completely to blame here?

I don't think the Fed is completely to blame, though it is mostly to blame.
This does not come from hindsight either. Many free banking theorists
(e.g., Kevin Dowd), Austrian economists (e.g., most of the people at the
Ludwig von Mises Institute), and even some writers at _The Economists_ were
predicting an eventual bust in the late 1990s.

Other factors that have played a role -- albeit a minor one -- are the
pattern and mode of government intervention in the market. By this, I mean
things like previous bailouts and current ones. This not only interferes in
the market, but sets up a pattern of expectations. (Heck, if you knew ahead
of time that the government would bail out your business, wouldn't you be
much more likely to take more risks and not have as big a cash reserve,
etc. -- all other things being equal?)

Anderson and others (I've even sent a number of articles to this list over
the past year or so making pretty much the same claims as him) have provided
data on this. Some of this can be found at Of course,
the full picture is not in, but the main features have been established.

> Could there not also be some blame to be shared by the economists who
> were pointing out the tremendous gains in productivity that were
> being attributed to the application of information technologies
> (finally),

Well, different economists made different predictions -- based on different
beliefs and models. There were actually gains in productivity, BUT these
were despite Fed policy NOT because of it. Also, not all economists are in
a position to have an impact -- either because they don't have the
government's ear or because they are not that popular. Even the court
economists -- people like Lester Thurow (as some say, he's "less thorough
than the others.":) and Paul Krugman (an unreconstructed Keynesian who
graces the pages of the NYT) -- only add intellectual support. They don't
actual make policy.

> or to the accumulation of wealth that migrated into
> the hands of VCs who spent it all too often on yet-another
> dot-com business plan,

The problem with blaming them is that it's like blaming the victim. A VC or
an investment bank, for the most part, operates inside the scope of the
Fed's policies. (Granted, some are influential with the Fed and with the
government, but the solution to this is clear: remove or minimize their
influence. This can be done by reducing the powers of the Fed or, as I
prefer, abolishing it completely.) So, if the Fed sets interests rates too
low, the VC doesn't see that as something he or she can change. It's like
if the government sets the price of milk too low. Is the consumer of milk
to blame for buying more milk at the lower price? Or is the bad policy --
and those who put it into place and enforce it -- to blame? (See below.)

> or on the newly minted stock owning
> public who felt they had to play the market at never-before-seen
> P/E ratios or risk losing the lottery?

Again, if the Fed hadn't created an environment where people would take such
undue risks, this would be a marginal issue. A few might still gamble their
life savings and remortgage the home for the latest IPO, but most would not.
However, most of the blame falls squarely on the bad policy again. If the
bad policy did not exist, then the incentives would not be there -- and the
market signals would not be confused. (See below.)

> To argue that the Fed caused the recession by fueling a boom
> with low interest rates and then to argue that they cannot
> create another boom with similar methods seems to argue that
> the principles are only in effect when the economists want
> them to be.

At first glance, your arguments seems to make sense. However, the problem
is a little more complex than this. Some use the analogy of getting drunk
to feel good. Once you get a hangover, is the solution just to continue
drinking until the pain goes away? You can see where that would lead:
ultimately, death by alcohol poisoning.

But even this is only an analogy. What actually happens under inflation is
a lot more complicated. Let me use another analogy. The government could
set the price of some good, let's say oranges, below the market rate. This
would lead to shortages of oranges as it became less profitable or even
unprofitable to grow and sell oranges. Initially, however, before the
shortage really set in -- while there were still stocks of oranges to be
sold and which would go bad if unsold (so the owners of these stocks would
rather sell and get something than not sell and get nothing) -- the orange
market might boom. People might start eating more oranges. Restaurants
might sell orange juice and orange dishes at lower prices and so on. When
the shortage actually hit, businesses that relied on the orange trade would
go bust, slowly or suddenly, depending on their reserves, how closely they
were tied to oranges, and whether they were flexible enough to move into
another line of work. (This might include an effect on the creditors of
orange growers, farm hands at orange plantations, and the like -- to
illustrate how the effect would ripple outward.)

This analogy fits a little better than the alcohol one.

Now, let's take a look at how [government control of] interest rates impacts
an economy. Unlike oranges, money is traded in every market in a modern
economy. This is another way of saying that a) there's no specialized
market for money itself and b) money is a part of almost every exchange
(e.g., you trade your money for a cup of coffee, you client or employer
trades her or his money for your product/service/labor, the orange grower
trades oranges for money, etc.). This makes changes in money much more
important than changes in any other good. (Money is simply the most traded
good in any economy.) So, anything that impacts money will impact all else,
often very quickly, but not always at the same rate or to the same degree.

Now, interest rates are, if set by the market, a reflection of how people
(which make up the market: the market is just people's interactions) value
the future. If I'm willing, e.g., to pay you $110 in one year for $100 now,
then I prefer the present at a rate of 10% per anum over the future --
assuming I won't accept a higher rate of interest. (Why does this phenomena
arise? It's known as "time preference" and results from the fact that the
future is always uncertain. Thus, wealth had right now is always much more
valuable because certain over wealth to be had in the future because this is
always uncertain. You could lose your job, the market could crash, the
business not work out, you could have an unexpected new cost imposed, etc.
Of course, people vary in how much they value the present over the future.
Some people spend like mad, while others scrimp and save. Even the same
individual at different times can value the differences more or less. The
young, e.g., tend to be more present-centered than the middle aged.
Incentives can also impact this. During wartime people tend to be even more
uncertain about the future. And so on.)

What can go wrong with interest rates? They could be too high or too low.
Too high an interest rates results in deflation -- i.e., there will be less
loanable funds then the market [effectively] demands. The effect of
deflation is usually immediately noticeable -- business inventories rise,
some prices drop but sales also drop -- so it's typically not a big problem
at any time. This doesn't mean it's good, but because of its immediate
effects, the correction is usual swift. (It's the monetary equivalent of
having too high a price for oranges. If the government fixes the price of
oranges too high, a lot more oranges will be made than bought.)

Too low an interest rates results in inflation -- i.e., there will be more
loanable funds then the market [effectively] demands. The effects of
inflation, however, are not immediately noticeable and do not seem to be all
that bad. Investments will increase in certain areas and the economy will
appear to boom. Prices will rise, as the loanable funds make their way
through the economy. Eventually, however, the increased investing will not
be profitable and that's where the bust comes in.

Even under a totally free market in banking -- and we're very far from that
indeed (no place in the US hasn't been close to such a state since circa
1860) -- banks might guess the rate wrong, but the effect under such a
system is much more muted because of two things. Free market banks have an
incentive to get it right. Deflation causes an immediate loss in market
share and profits as other banks will compete for loan customers. (This is
akin to one orange grower charging really high prices for the same quality
of orange. All things being equal, the other orange growers will get more
business, make more sales.) Inflation causes a loss in specie (or whatever
the outside money is) from the inflating bank and, if this goes on long
enough, that bank may even go bankrupt as other banks cash in on it's newly
created loans and money.

Free market banks also have the information to get it right, since they can
watch their reserves inflows and outflows and their profitability.

The Fed does not have either of these: its has neither the incentive nor the
information to get it right. In fact, to some extent, it has the incentive
to err on the side of inflation. Why? For one, inflation is harder to
recognize. It also increases, in the short run, profits, investment, and
employment. The last makes it especially palatable for politicians.
Thirdly, it lowers the government's debt (lower interest rates means loans
for the government as less costly to the government). This makes it more
likely that inflationary policies will be more popular with politicians,
workers, and the government. (It also, in the long run, since most people
don't make the connection, increases the Fed's power. The more economic
problems there are, the more the Fed has to interfere and the more power it
has historically been given, from the Great Depression to today.)

Now, add to this, the exact path of inflation (or deflation) is, beforehand,
unknown. That most of the 1990s boom would be absorbed into high stock
prices was not a factor someone would have been able to predict accurately
in 1993. This is because, ex ante, the path inflation takes through the
economy is unknown in all cases. Market information is always imperfect and
markets are always in disequilibrium, more or less.

This does not mean inflation can do anything. When the Fed lowers interest
rates (below market rates), it is distorting the economy. The exact outcome
of this distortion can only be known in general outlines. Inflation will
travel unevenly too. The first to be impact will, naturally be those who
immediately take advantage of the lower interest rates -- such as the big
investors and big debtors. They will then, because they have more money on
hand (or look more profitable or can leverage even more credit) bid up the
prices of the goods and services they use or plan to use. The supplies of
those goods and services when then also become more profitable (though less
so than the initial beneficiaries). And so on.

Eventually, as you might note, this will change the relative prices of goods
and services. In the late 1990s boom, e.g., the price of technology stocks
and of technology workers shot up dramatically. (I know my salary shot up
during this period.) As you might guess, this draws resources (money,
people, etc.) away from other areas of use. This is why people like Murray
Rothbard (e.g., in _America's Great Depression_) say it's not overinvestment
per se that inflation creates, but malinvestment. All things being equal,
absent the below market rates, the technology sector might still have grown,
but not at the crazy unsustainable rate we saw. As we know with hindsight,
a lot of these things were bad investments.

They weren't bad because they were all fly-by-night operations. (Some were.
Easy money attracts people with loose morals.) A lot of them were well
planned and planned to stick around for years to come. However, the market
for their products wasn't there or didn't grow at the rate they predicted.
(I was part of such a concern until a few weeks ago.) Much of this -- not
all, because it's natural for businesses to fail too -- was the result of
inflation messing up market signals. By lowering interest rates, business,
investors, etc. planned for a different kind of world than could be built.

Relowering the rates is not the solution either. This will only lead to
more malinvestments -- if there's really anything left to invest in -- and
create ever more distortions. The best thing to do now is get interest
rates back to a market level -- but the best way to do this is to have a
free market in banking. Even with that, there will still be unrecoverable
costs associated with inflation. Inflation (and deflation) do real damage.
Horwitz goes over some of these costs in his "The Costs of Inflation
Revisited" (forthcoming in _The Review of Austrian Economics_), a draft of
which is online at (I covered
some of this in the early months of this year.)

> I don't disagree in general with the points being made, I just
> object to the idea of an argument of the form "A is true
> (the Fed can cause a boom) except when an economist doesn't
> want it to be true (it won't work this time)".

See above. I think this explains why you might think that, but that's only
at a prima facie look at Anderson's claims. He's talking about an
unsustainable boom -- not a boom in general.

See also the link below and the Horwitz book reviewed there. I also
recommend Kevin Dowd's _Laissez-Faire Banking_ and _Money and Markets:
Essays on Free Banking_ and George A. Selgin's _The Theory of Free Banking:
Money Supply under Competitive Note Issue_. There are also many at articles on inflation and the current recession.


Daniel Ust
  See "Macroeconomics for the Real World"at:

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