12
Jan
09

The Fed Creates a Crisis and Hampers the Recovery

by William Anderson (Original here)

When Ron Paul made eliminating the Federal Reserve System a centerpiece of his presidential primary campaign last year, media pundits and others scratched their heads in amazement.  After all, they reasoned, is not the Fed a collection of “conservative, buttoned-down” public officials who are given the mission of providing prosperity?

Indeed, whenever Ben Bernanke and his predecessor, Alan Greenspan, have traveled to Capitol Hill to testify before congressional committees, they are treated as royalty, economic geniuses whose every word is treasured, even if Congress and the press cannot comprehend all of them.  If there is any criticism for these men, it is that they have not inflated enough.

However, in watching one exchange last year between Rep. Paul and Bernanke, I was struck not only by the lack of comprehension of economic logic that Bernanke possessed, but also his utterly wrong view of the actions of the Herbert Hoover administration.  In response to Rep. Paul’s criticism of the numerous Fed-oriented bailouts, Bernanke quoted Andrew Mellon, Hoover’s secretary of the treasury, who had advocated that the government permit weak businesses to go under in order to “purge the rottenness from our system.”

Unfortunately, Bernanke got it wrong.  After quoting Mellon, he assumed that Hoover had followed Mellon’s advice, which clearly is not what happened.  Instead, as Murray Rothbard conclusively pointed out in his classic America’s Great Depression, Hoover ignored Mellon and continued his attempts to bail out failing businesses and implement huge public works projects in order to “increase employment.”

The irony is that Hoover’s policies did “liquidate” the farmers, the bankers, and many others, despite the efforts of the government to keep it from happening.  Unfortunately, the liquidation was much worse than it would have been had Hoover done what his predecessors had done: not intervene into the economy during a downturn.  (President Warren G. Harding, although ridiculed by historians for his relative laissez-faire viewpoints, nonetheless understood the limitations of federal power in economic affairs and refused to intervene when the economy faced a serious downturn in 1921.)

When the U.S. economy bottomed out in early 1933, the process was disastrous.  By delaying the inevitable, Hoover’s policies made things even worse than they would have been otherwise.  If that were the end to this sorry tale, then at least there could have been a robust recovery; that did not happen because the government under Franklin D. Roosevelt blocked the economy from rebounding as it had done in 1922 and beyond.

The New Deal under FDR ensured that any recovery would be anemic, as the government (in the name of preventing unemployment) attempted to organize the entire U.S. economy into a series of cartels.  Furthermore, the government made it difficult for financial markets to invest in new private enterprises, as the New Deal attempted to limit entrepreneurial entry into the economy.  The result was a very limited recovery with unemployment averaging well over 10 percent until the end of 1941.

Had Bernanke understood the history of the Great Depression – he allegedly is a “scholar” of that era – perhaps he might have understood that the actions of his Federal Reserve System not only created the boom which led to perhaps trillions of dollars of malinvestments, but also is preventing the brief-but-necessary liquidation of malinvested assets.  Not only did his reply to Rep. Paul demonstrate his ignorance of economic history, but his subsequent actions further point to his lack of basic economic knowledge.

First, and most important, by backing the wrong-headed actions by Congress and the U.S. Department of the Treasury, and by purchasing hundreds of billions of dollars of private securities, the Fed is propping up businesses and financial institutions that either should be permitted to fail or at least reorganize to become more economically viable.  Second, the Fed and its government allies, by propping up weak entities with money that essentially has flown off the printing press, prevents resources from flowing to those areas of the economy that are financially stronger, thus weakening the entire economy.

The central problem in the U.S. economy is that the Fed, by pursuing a wrongheaded policy of artificially lowering interest rates and conducting a regime of easy credit, has encouraged malinvestments on a massive scale.  After the malinvestments were exposed, the Fed then piled onto the damage by attempting to prevent their liquidation.  (Bernanke and Treasury Secretary Henry Paulson, plus President George W. Bush, told members of Congress that there would be “riots in the streets” if Congress did not pass the original bail-out proposals.)

If that were not enough, Bernanke and the Fed have signed onto the upcoming “stimulus” programs being touted by President-Elect Barack Obama which are nothing less than wasteful pork-barrel projects that constitute a wish-list for vote-hungry politicians.  Combined with the promised surge in financial and business regulations that the government is going to impose, this means businesses are going to be starved for resources, just as they were during the 1930s.

Bernanke and other Fed officials have done something else that may prove to be just as disastrous as the ill-advised actions they have so far taken: they have joined in the “blame the market” chorus and permitted the Fed to be seen as the guy on the white horse riding in to save Americans from those greedy and savage markets.  This is analogous to the local firefighters being fêted as heroes when they throw gasoline onto the house fires that they have set themselves.  Not only did they cause the original fire, but they also make things much worse after they supposedly “ride to the rescue.”

Not only was the Fed the main culprit in creating the unsustainable boom, but it also has been the chief enabler of the disastrous policies that the government has implemented following the collapse of the boom.  Because the Fed stands behind all of the “stimulus” transactions with its promise of “liquidity,” policymakers can operate with the fiction that the Great Backstop in Washington will prevent future financial disasters.

If ever a government agency should be sent to the trash heap, it is the Federal Reserve System.  For nearly a century, it has inflated the dollar, stood behind questionable and downright unsustainable financial activities, and launched one boom-and-bust cycle after another.  Yet, even when such actions are exposed, nonetheless the central bank has plenty of enablers in Congress and in the media who somehow believe that the Fed can reform itself and should be given even more power and authority than before.

In fact, in the wake of every Fed-created disaster since its unfortunate inception in 1913, Congress has bestowed the central bank with even more regulatory and financial tools than it had before the previous economic crisis occurred.  It is obvious that when it comes to fighting economic “fires,” Congress and a sizable portion of the American pundit and political classes seem to believe that the best “firefighting” tools are buckets filled with gasoline.  Thus, our “leaders” have ensured that the previous crisis will not be our last.  Like Bill Murray’s character in “Groundhog Day,” we will be forced to re-live the same sequence of events over and over again.

William L. Anderson, Ph.D., teaches economics at Frostburg State University in Maryland, and is an adjunct scholar of the Ludwig von Mises Institute. He also is a consultant with American Economic Services.

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1 Response to “The Fed Creates a Crisis and Hampers the Recovery”


  1. 4 December 2009 at 09:16

    As argued in http://euandus3.wordpress.com/2009/12/04/the-federal-reserve-we-screwed-up-but-should-be-given-more-authority/ , Bernanke admits that the Fed screwed up in the housing bubble and should be given even more authority to protect us from systemic risk. You try connecting the dots.


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