Tuesday, September 21, 2010

John Kenneth Galbraith and the (Now Not So) Innocent Fraud of the Fed

John Kenneth Galbraith was an interesting and insightful man, more of an institutionalist economist than anything else. 

Generally, I agree with his discussion of the Fed, found below, which is excerpted from his essay The Economics of Innocent Fraud: Truth For our Time.  Based on the Fed's actions today, I do think JKG's observations are worthy of a codicil, which is that, while the Fed has little consequence on the real economy, it can be quite effective in enriching the banks at the expense of savers.  The Fed's zero interest rate policy and quantitative easing "lite" (soon to be QE2) are harming real Americans and need to stop.

COME NOW to our most prestigious form of fraud, our  most elegant escape from reality. As sufficiently noted,  the modern economic system is unpredictable in its  movement from good times to bad and then eventually  from bad to good. Boom, bubble and inflation go on to declining   production, rising unemployment, reduced earnings,   stable but lower prices. Then, in time, to a revival -to  higher employment, greater earnings, talk if not the reality  of inflation. To limit unemployment and recession in the  United States and the risk of inflation, the remedial entity  is the Federal Reserve System, the central bank.  For many  years (with more to come) this has been under the direction   from Washington of a greatly respected chairman,  Mr. Alan Greenspan. The institution and its leader are the  ordained answer to both boom and inflation and recession or depression with its lower production, financial and economic   contraction, distress and reduced employment.  Quiet measures enforced by the Federal Reserve are thought  to be the best approved, best accepted of economic actions.  They are also manifestly ineffective. They do not accomplish   what they are presumed to accomplish. Recession and  unemployment or boom and inflation continue. Here is  our most cherished and, on examination, most evident form  of fraud.
The false and favorable reputation of the Federal Reserve  has a strong foundation: There is the power and prestige of  banks and bankers and the magic accorded to money.  These stand behind and support the Federal Reserve and  its member- that is, belonging-banks. If in recession the  interest rate is lowered by the central bank, the member  banks are counted on to pass the lower rate along to their  customers, thus encouraging them to borrow. Producers  will then produce goods and services, buy the plant and  machinery they can now afford and from which they can  now make money, and consumption paid for by cheaper  loans will expand. The economy will respond, the recession  will end. If then there is a boom and threat of inflation, a  higher cost of borrowing initiated also by the Federal Reserve   and imposed on its lending to member banks will  raise interest rates. This will restrain business investment  and consumer borrowing, counter the excess of optimism,  level off prices and thus insure against inflation.
The difficulty is that this highly plausible, wholly agreeable process exists only in well-established economic belief  and not in real life. The belief depends on the seemingly  persuasive theory and on neither reality nor practical experience.   Business firms borrow when they can make money  and not because interest rates are low.  As this is written, in  2003, during a recession, the lending rate of the Federal Reserve   has been reduced roughly a dozen times in the recent  past. These reductions have been strongly approved as the  wise and effective response to the recession, so acknowledged   in both popular and learned comment. How good  this simple, painless design, free from politics and in the  hands of responsible and respected professional and public  figures free from political taint. No disagreeable debate, no  pointless controversy. Also, and uncelebrated, no economic  effect.
Especially as regards recession, hope always awaits the  next Federal Reserve meeting. There is then promise, prediction   and ultimately no result.  On no economic matter  does history more reliably repeat itself. One should, however,   be gentle. The action is reputable and well regulated;  there is general agreement by the participants and approval from the financial world; it is just that nothing perceptible  occurs. Recovery comes, but not in any visible way, from Federal Reserve action. Housing improves as mortgage  rates decline. Elsewhere there is painful indifference. Interest  rates are a detail when sales are bad. Firms do not borrow   and expand output that cannot be sold.
SINCE 1913, when the Federal Reserve came fully into existence, it has had a record against inflation and notably  against recession of deep and unrelieved inconsequence. In  World War I, prices doubled in the course of the two years  the United States was at war. No remedy came from the  new and magical central bank. In the 1920s, in Florida and  then disastrously on Wall Street, came unbridled and, in  its aftermath, deeply damaging speculation. There was no  effective restraint from the Federal Reserve. Then for a decade   the Great Depression, and once more no curative action   from Washington and the Fed. Informed debate, no  result. Deflation and depression persisted.
During World War II, because of the previous wartime  experience, inflation was greatly feared. In the event, however,   it was closely controlled and no seriously unpleasant  memory remains. Historians pass the problem by. This  agreeable outcome was more than slightly because, acting  on what had earlier occurred, there was no reliance on the  Federal Reserve. Economic policy in this truly difficult time  could not be based on hope or mythology. As one principally   responsible for limiting inflation in those years (I was  the deputy administrator in charge of price policy in the  Office of Price Administration and thus immediately concerned   with the action against inflation), I shared the belief  that the Federal Reserve was irrelevant. So it was.
In the decades since World War II, there have been lesser  threats of inflation and recession. The Federal Reserve, after  learned and intense discussion, has acted. There have been well-voiced approval, optimistic prediction and no effect.
Such are Chairman Greenspan's public skills, such is the  ingrained faith in any action involving money, that the Fed,  as affectionately it is called, will receive credit if and when  there is full recovery. The fact will remain: When times are  good, higher interest rates do not slow business investment.  They do not much matter; the larger prospect for profit is  what counts. And in recession or depression, the controlling   factor is the poor earnings prospect. At the lower interest   rates, housing mortgages are refinanced; the total  amount of money so released to debtors is relatively small  and some may be saved. Widespread economic effect is absent   or insignificant.
In restraining inflation, or what seems such purpose, the  Federal Reserve must be especially cautious; it cannot he  thought to be in conflict with economic well-being. If and  when recession returns, the defining forces, as later noted,  will be the consumer spending and industry investment so  called forth. On these, what follows from central-bank action   is minimal. Business firms respond to diminishing  sales. Here the Federal Reserve has no decisive role. Only in  innocence does it control general consumer and business  spending.
Nonetheless, it is thought good to have an uncontroversial,   politically neutral institution headed as in all recent  times by an informed, confident and respected figure of no  slight theatrical talent. How agreeable decisions taken in  reputable surroundings beneath the portraits of the financially celebrated of the past. It is thus that economic policy  should be decided. That nothing important results is overlooked.   The belief that anything as complex, as diverse and  by its nature personally as important as money can be  guided by well-discussed but painless decisions emanating  from a pleasant, unobtrusive building in the nation's capital   belongs not to the real world but to that of hope and  imagination. Here our most implausible and most cherished   escape from reality. No one should deny those participating   their innocently acquired prestige, their sense of  personal competence, their largely innocent enjoyment of  what in economic effect is a well-established fraud. Perhaps we should let their ineffective role be accepted and  forgiven.