Fear The Boom, Not The Bust
PHOTOS.COM
If you listen to TV commentators, you’ve been told the worst is
behind us. Growth is picking up, and Europe is coming out of its
slumber. No one seems to be concerned that this tepid below-2-percent
growth is being entirely fed by the central bank’s massive money
printing. It’s a “growth at any price” policy.
How quickly we forget.
Back in the boom days, anyone who questioned double-digit growth in
housing prices was viewed as an unenlightened Cassandra, lacking
knowledge on how the new economy had fundamentally changed the law of
scarcity. Austrian economists consistently warned that a boom built on
foundation of easy money could only lead to a disaster. Today, most of
the growth is coming from the interest rate-sensitive sectors of the
economy, such as cars and housing. This should be ringing warning bells
everywhere.
The conventional wisdom is that the Fed will begin to taper when
growth picks up. This is a complete misreading of what is actually
happening. The Fed made a monumental mistake, and does not really know
how to get out of the trap it had set upon itself.
The Fed embarked on a “we know best” policy of QE3 (a third round of
quantitative easing) last fall, and induced a market bubble in the
spring. The Standard & Poor’s 500 index gained 12 percent from
January to June 2013, while growth remained subdued. The Fed realized
its mistake and now wants to get out. The problem is that in economics,
as with most things in life, it’s much easier to get into trouble than
out of it. The Fed wants to take away the punch bowl; but it knows that
interest rates will rise, the stock market will crash and the economy
will tank. The longer it waits, the greater will be the inevitable
adjustment.
If we do not learn from history, we are bound to repeat it. We have
been here before. The depression of 1920 and Roosevelt recession of 1937
show us what happens when excessive monetary printing is followed by
tepid tapering.
The 1937 Recession
is a perfect example of Austrian business cycle theory. It was severe
but short. Output fell by 11 percent and industrial production by 32
percent. Unemployment surged back up from 14 percent to 19 percent.
There is considerable disagreement on the cause of the recession,
with some economists blaming the tightening of fiscal and monetary
policy. Reserve requirements were increased, and the budget deficit was
reduced. Yet spending in the 1937 fiscal year was $7.6 billion, compared
to $6.5 billion in 1934 and $6.4 billion in 1935: two spectacular boom
years. Taxes went up about 1 percent of gross domestic product from 1936
to 1937, but were less as a percentage of GDP than the rebound years of
1938 or 1939. Writing in 1956, E. Cary Brown
found that fiscal policy changes accounted for less than a quarter of the downturn. The Fed
did
raise reserve requirements, but banks were already holding abundant
excess reserves. The new requirements had very little impact.
The real cause of the 1937 recession occurred much sooner. The die
was cast early in 1934 when the United States set the price of gold at
an overvalued
$35 an ounce.
The ensuing gold inflows caused the money supply to explode, increasing
12 percent per year (M2) from 1934 to 1936. A boom ensued with real
output growing 10 percent in 1934, 8.9 percent in 1935 and 13 percent in
1936. As Austrians would say, the additional money masqueraded as real
savings. Since no real resources had been liberated, a scramble for
resources followed. Eventually, many of the investment projects that had
been undertaken turned out to be unprofitable and needed to be
abandoned. The 1937 recession was necessary and desirable to free up
resources from the malinvestments of the previous years. A recession is a
realignment of resources closer to what society really wants to be
produced. The central bank could have continued printing, extending the
illusion of prosperity; but this would have just delayed and amplified
the final adjustment.
By late 1936, the Fed started to get worried. And in March 1937, the
chairman of the Fed, Martin Eccles, said: “[R]ecovery is now under way,
but if it were permitted to become a runaway boom it would be followed
by another disastrous crash.”
In December 1936, the central bank began
sterilizing
the gold inflows so they no longer boosted monetary growth. This was a
timid tapering by contemporary standards. Monetary growth slowed from 12
percent to essentially nothing. This was the equivalent of gently
tapping on the brakes.
Anyone who considers this excessive is implying
that a capitalist economy needs monetary juice to operate. Yet there is
ample evidence from the 19th century of a stable money supply resulting
in solid growth, and money is a measure of value and serves its function
best when it is stable.
The bust was written in the cards. It could not be avoided, just
postponed. It is not the bust, but the boom, that should be feared. The
bust was of short duration and could have been much worse if the Fed had
not pulled the punch bowl then and there.
We currently fear Fed tapering, as we should. Yet we should be even
more fearful that it doesn’t taper. Today, we really have a dreaded
choice of losing an arm now or two arms and a leg tomorrow. Because the
price distortions have been massive, the adjustment will be horrendous.
Government policy makers and government economists simply do not
understand the critical role of prices in helping discovery and
coordination.
Recognizing that the economy is still weak, the Fed at its Wednesday
meeting yet again declined to begin tapering. When the Fed is finally
forced to cut back, interest rates will rise, Wall Street will call for
relief and the economy will slump. This may be delayed with additional
printing for a couple of months; but the adjustment will occur, and it
will be severe — probably much worse than in 2008.
However, this time
there are no arrows left in the government’s quiver to spend or print
its way out of trouble.