The Economy Is Cyclical?
The Central Bank Whipsaws the Economy
SEPTEMBER 01, 2001 by ROGER W. GARRISON
Filed Under : Federal Reserve
According to a memorable title, “Business Cycles Aren’t What They Used to Be—and Never Were” (Gerald Sirkin, Lloyd’s Bank Review, v. 104, 1972). In today’s political and economic environment, we need to be clear about which characteristics endure and which ones can and do change over time. We might begin with a reminder about characteristics that have never been justifiably associated with the business cycle. The term itself suggests a rhythmic variation of business activity. But despite the once-popular notion of a built-in 55-year cycle dreamed up by Russian economist Nicolai Kondratieff, no such econo-rhythms have any claim on our attention.
The “cycle” as applied to twentieth-century fluctuations—and to 21st-century worries—is better described as a boom-bust sequence. It is a whipsaw effect with no necessary recurrence implied. The economy is somehow set off on an unsustainable growth path—a path on which market forces are pitted against one another. Eventually and inevitably, the tradeoff between maintaining an excessively high growth rate and accommodating people’s current demands for consumables is made in favor of the latter. When resources are finally diverted away from the future-oriented investment projects, jobs are lost and a period of liquidation ensues.
The most conspicuous enduring characteristic of the boom-bust sequence is revealed by investigating the originating “somehow.” The origin of this macroeconomic misstep must have an essential element of centrality about it. A fully decentralized economic system cannot “somehow” set itself off on an unsustainable growth path. Such a systematic distortion suggests central decision-making, and the central element of note in our economic system is of course the central bank.
Credit expansion by the Federal Reserve orchestrates a boom. Abundant credit at artificially low rates of interest encourages more investment activity than can be carried through to completion. Entrepreneurs borrow the new money and buy resources. If the central bank had the power to print more resources too, the boom would be sustainable. But neither the Federal Reserve nor any other governmental institution has such powers. Hence, the boom is artificial and leads to a bust.
Beyond its origins in ill-conceived or politically motivated monetary policy, the boom-bust sequence has other enduring characteristics, such as excessive investment in long-term projects and dramatic movements in the prices of interest-sensitive and highly speculative assets. One curiously enduring complement of a maturing boom is the widely held belief that business cycles are a thing of the past. In the 1920s Irving Fisher believed we had reached a new plateau of prosperity. References to the “new economy” in today’s financial press should be seen as dark reminders of Fisher’s plateau. Editorials sounding related themes (“Conquering the Business Cycle”; “Have the Laws of the Cycle Been Repealed?”; “An Era of Cycle-Free Growth”) should be read as old hat rather than new era.
Even the reasons offered for believing that we’ve entered a new economy, while different in their details, are tellingly similar. The expansion of the 1990s actually involved real economic growth—attributable to the Internet, the digital revolution, and just-in-time inventory management. True enough, but the expansion of the 1920s also involved real economic growth—attributable to technological advancements in automobiles, home appliances, and food processing.
In both periods the real growth, which in the absence of credit expansion would have been accompanied by price reductions, helped keep price inflation in check. That is, increases in the money supply and the ongoing real economic growth had largely offsetting effects on the overall level of prices. F. A. Hayek described this circumstance as artificial price-level stabilization—a term that could only be puzzling to Irving Fisher and modern-day monetarists, who take price-level stability as the hallmark of macroeconomic health. But Hayek demonstrated that the absence (or slightness) of price inflation is of little comfort in a period when cheap credit is stimulating investment beyond people’s willingness to save. Price-level constancy does not equal macroeconomic stability.
The Art of Fed Watching
Business cycles aren’t what they used to be if only because some people—and policymakers—make judgments and take actions on the basis of their experience with previous booms and busts. The history of the art of “Fed watching” illustrates the point. During the early years of the Federal Reserve, there were no Fed watchers.
In fact, there was precious little that one could have watched. Data on the monetary aggregates and credit conditions were not readily available—a circumstance that helps explain how the boom (the monetary deception) could be so long-lasting.
During the 1960s and 1970s the availability of data on the key money-supply aggregates allowed Fed watchers to monitor its efforts to manipulate credit conditions. And in the early 1980s, when money-growth targeting replaced interest-rate targeting, those same aggregates allowed Fed watchers to compare track records to intentions and to make predictions about the Fed’s habitual overshooting. This was a period of relatively short business cycles.
In today’s environment, the monetary aggregates have lost the meaning they once had. The much-watched M1 and M2 derived their significance from two vital links: (1) the ability of the Federal Reserve to control those aggregates by adjusting the monetary base and (2) the near-constancy of the velocity of money, which maintained a near-constant ratio between the money supply and the price level. After extensive banking reforms severely weakened both links, the Federal Reserve returned to interest-rate targeting.
Present-day Fed watchers can only watch and wonder. The monetary aggregates are readily available but not very helpful. M1 is essentially the same as it was a year ago. Over that same period, M2 has risen by 8 percent and the new MZM has risen by 13 percent. (The “ZM,” which stands for zero maturity, indicates all financial instruments payable at par on demand.) Unfortunately, none of these money aggregates are both readily controllable and strongly correlated with the price level or any other macroeconomic variable.
Currently, there is timely information about the Federal Reserve’s changing interest-rate target. Both the administered discount rate and the targeted federal funds rate are publicly announced within a couple of hours of each decision to change them. What is not known, however, is the interest rate that would prevail in the absence of credit-market management by the Federal Reserve. The all-important “natural rate of interest”—like the “natural rate of unemployment”—becomes unobservable in a Fed-dominated environment.
Our suspicions of political motivation—along with the 13 percent MZM growth—suggest that the managed rates (of interest and unemployment) are somewhere below the respective natural rates. If so, the resulting pattern of investments is unsustainable; the economy is living on borrowed time. It’s a familiar story. The Internet and MZM notwithstanding, business cycles are what they used to be: The central bank has whipsawed the economy once again.