With the Federal Reserve's discount rate at 3%, the lowest in 30 years, investors in Europe and Japan are seeing their worst fears confirmed as the dollar tests all-time lows. Political realities in Washington mean that interests rates and the dollar will more than likely fall even lower.
The federal Reserve policy has the appearance of a capitulation to election year expediency. Ironically, it will do little to alleviate what the Bush administration calls the "credit crunch."
Prosperity, in the form of jobs and higher real wages, may not come this year or next, no matter how much short-term rates falls. They are, arguably, already negative in real, inflation-adjusted terms.
But Americans can expect whoever next sits in the White House to continue the ritual refrain that recovery is "right around the corner."
The whole idea of a credit crunch is political. It reflects a preoccupation with the asset side of the national balance sheet that it generally found among the socialist economies of Europe and the developing world.
In this asset-driven view, money is seen as public property, not a private store of value, and thus is the sole responsibility of government.
Concern about adequate credit, and the value of asset such as real estate, now drives economic policy debates in Washington.
The liability approach to money -- the hard-currency, or monetarist, view -- generally guided American economic though until 1933. Under President Franklin D. Roosevelt, the radical debt expansion necessary to finance the New Deal programs begun in earnest.
An adequate quantity of liabilities -- that is, bank reserves -- means that participants in a free market who possess sufficient assets to collateralize a loan will obtain needed credit.
Hard Money Smells Sweeter
Adherents to the quantity theory of money do not accept the notion of a credit crunch, so long as bank reserves show steady growth.
All things being equal, free, rational people should prefer the world of hard money to a politicized allocation of credit. In the absence of a pervasive system of wage and price controls, quotas, and trade protectionism, a credit-driven regime inevitably leads to inflation and currency debasement, an environment inconsistent with a free-market, democratic society.
Germany's hyper-inflation of the 1920s, for example, compelled post-World War II governments in Bonn to eschew the mere appearance of expansionary bias, even in the face of double-digit unemployment.
Mexico, where inflation has also left painful scars, has pegged its currency to the dollar to allay inflationary fears -- but without conforming internal monetary expansion to the growth rate prevailing north of the Rio Grande.
In Russia, the Yeltsin government continues to print rubles to meet public demand, all the while demanding hard-currency loans from the West to balance a chronic trade imbalance and maintain the ruble's artificial value versus the dollar.
In the United States, however, painful memories of inflation from the 1960s through 1982 are all but forgotten. The temptation to resort again to monetary expansion is overpowering the "independent" central banking system that was designed by populist, hard-money exponents like Virginia Democrat Carter Glass. They knew that the evil of inflation lies more in its political and social effects than its economic implications.
Heretofore responsible members of the financial and business communities call for easy credit. Washington, through a servile central bank, dutifully provides the sought-after dose of loose money, rather than setting a new course based on low or even zero inflation.
Since the late 1950s, the United States has dug out from each cyclical recession with a combination of fiscal stimulus and monetary ease. The mixture tended to increase the national debt, while raising unemployment during each successive economic downturn.
With the gradual elevation of the minimum unemployment rate has come a higher level of "core" inflation. This is still low by Latin American or southern European standards, yet high enough to significantly erode the wages of people who are unable to seek shelter in purchases of nonspeculative, short-term financial instruments.
Shorter Investor Horizons
With more and more dollars chasing over fewer nonspeculative assets, investor horizons have progressively shortened and tolerance of risk has increased.
The criteria for purchasing a stock or bond today are not the long-term likelihood of repayment and return, but whether another investor might purchase the asset at a higher nominal price in the near future. This is commonly known as the "greater fool" theory of investment.
So the only hope for economic recovery in 1992 is seen as Fed expansion of high-powered money. In the first quarter of 1992 alone, total bank reserves rose a near-record 27%, measured on a quarter-to-quarter average basis -- an example of how Washington uses inflation to create the illusion of economic growth.
Capital inflows from Europe and Japan are down dramatically from the torrential levels of the mid-1980s -- and no longer available to finance federal deficits. Private borrowers are thus forced to complete with Uncle Sam for greenbacks.
Biting the Fiscal Bullet
The new Basel guidelines allow commercial banks to put up zero capital for holding Treasury debt and small percentages of government-agency paper; but they must have as much as 100% of the risk-based capital requirement on private credits. It is small wonder that lenders prefer to buy bonds rather than make loans.
With risk-averse politicians unwilling to bite the fiscal bullet by cutting spending and therefore government borrowing, an inexhaustible supply of government debt is available to banks and investors. And thus the productive, nonfinancial sector of the economy goes begging for capital.
Republicans and Democrats alike bemoan the lack of credit for business and call for the Fed to ease interest rates yet again. But no one among them dares suggest that the "credit crunch" -- and related increases in core inflation and unemployment -- are the result of half a trillion dollars a year in direct and indirect federal borrowing.
Foremost among the apologies for "reflation" is the idea that the monetary aggregate M2, which includes small time deposits, is not growing fast enough to support economic recovery.
Yet if cash flowing to depositors of failed thrifts and banks is added into the monetary numbers, M2's growth rate is roughly consistent with that of other aggregates.
When rational depositors of a failed institution receive payouts from the federal government, do they put the funds into another bank account, yielding as little as 3%? Or will they go into a nonbank money market or equity mutual fund yielding two or even three times that rate?
The Plain Truth
The answer is obvious to virtually everyone except the current members of the Federal Reserve and their political patrons in the Eastern banking and real estate establishments. Were the Fed truly intent upon making M2 grow, it would allow interest rates to rise rather than fall.
True believers in the quantity theory of money at the Fed (there are a few) distrust M2 and other broad aggregates, anyway. Beneath a menacing $4 trillion in gross federal debt, it is time to consider whethers supply-side economics was ever fairly tested during the 1980s.
Yes, individual tax rates were cut. But federal spending and borrowing continued to grow, forcing the Fed to use tight-money policy to stabilize domestic prices. This, in turn, deprived the economy of adequate supplies of affordable credit to fuel real economic growth.
The credit-driven (or supply-driven) view of money says that expanding the money supply will result in lower rates, particularly long-term rates. But this view, like the notion that any level of debt is tolerable when it is growing faster than national productivity, is fundamentally flawed.
It treats money as a political commodity rather than a private store of value, the common property and patrimony of a free society.
Long-term rates will fall when the Fed stops printing money and convinces bond market investors, at home and abroad, that America has abandoned the selfish expediency of reflation and currency debasement.
Time to Sober Up
As and when the United States embraces fiscal sobriety, stops accumulating deficits, and begins the difficult and necessary task of retiring the Treasury's massive debt, real interest rates will come down and the recently battered greenback will soar. Every dollar of federal indebtedness retired is a dollar free to finance real economic activity.
The alternative is to take another ride on the boom-and-bust inflation roller coaster, eventually ending in yet another recession and asset collapse worse than today's, an inevitable repudiation of the burgeoning national debt, and likely political and social upheaval.
"Governments and political parties are committed to the idea that is a good policy to lower the rate of interest below the height it would attain on a free market," Ludwig von Mises wrote in 1956. "And they believe that the expansion of bank credit is the right means to produce this desired effect.
"They do not realize that the boom which they artificially create by such credit expansion must finally result in the catastrophe of the depression," the economist went on.
"The fanatical supporters of inflationism, unbalanced budgets, and reckless government spending have, it is true, succeeded in banning sound [money] theory from universities and textbooks. [But] today people are fully aware of the fact that credit expansion is the ultimate cause of the slump." Mr. Whalen is a director of the Whalen Co., a consulting firm in Washington.