Monday, April 21, 2008

Another Fed Critique

Steve Hanke gets shrill and joins the list of observers taking the Fed to task for past monetary profligacy.

U.S. Treasury Secretary Henry Paulson... rolled out a grand plan to crown the Federal Reserve as the nation's new financial stabilizer. The Fed a stabilizer? That's who created the financial mess we're in.

[...]

During the Greenspan-Bernanke era the Fed has embraced the view that stability in the economy and stability in prices are mutually consistent. As long as inflation remains at or below its target level, the Fed's modus operandi is to panic at the sight of real or perceived economic trouble and provide emergency relief. It does this by pushing interest rates below where the market would have set them. With interest rates artificially low, consumers reduce savings in favor of consumption, and entrepreneurs increase their rates of investment spending... And then you have an imbalance between savings and investment. You have an economy on an unsustainable growth path.

The current U.S. financial crisis follows the classic Fed pattern. In 2002 then governor Bernanke set off a warning siren that deflation was threatening the U.S. economy. He convinced his Fed colleagues of the danger. As former chairman Greenspan put it, "We face new challenges in maintaining price stability, specifically to prevent inflation from falling too low." (Given the U.S. economy's productivity boom, the Austrians viewed the prospects of some deflation as just what the doctor ordered.)

In the face of possible deflation, the Fed panicked. By July 2003 the Fed funds rate was at a record low of 1%, where it stayed for a year. This set off the mother of all modern liquidity cycles...

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