“You cannot move something very far by pushing on a string,” I’ve heard myself saying again and again in the classroom trying to explain the Federal Reserve’s attempts to support the lagging economy.
The Fed’s decision on Tuesday to increase the nation’s money supply and thus lower interest rates has economics teachers like me using every hackneyed metaphor in the book to explain current events to our students.
We shouldn’t complain. Events so far this year, both before and after September 11, have focused economics students on the relevance of what they’re studying in a remarkable manner.
Even the most listless students in the back row suddenly sit up when one starts to discuss how recessions often have the greatest impact on the newest entrants to the labor force, i.e. next May’s graduating seniors.
And while the U.S. economy’s continuing slide into mild recession is alarming to many people, it illustrates important lessons about the limitations of government policy.
Simply put, the business cycle – that historically long-established repeating pattern of booms and busts – is a natural process in human societies.
Prudent government actions may be able to dampen such swings somewhat, but not eliminate them entirely. And imprudent actions may make the ups and downs more violent, more likely to cause financial whiplash for households and businesses.
We had a long expansion for about 10 years, with “irrational exuberance” about the possibility of never-ending stock market gains and a “new economy” that would never again experience hard times because of the magic of modern information technology playing a particularly strong role in the last four years.
That was silliness against the backdrop of historical accounts of the business cycle dating to ancient Rome. Some drop in equity markets was inevitable, as was some type of recession.
Today we’re apparently are in our second quarter of shrinking output – the informal definition of a recession. The economy is still in pretty healthy shape by long-run historical standards and certainly a long way from the bread lines of the Great Depression.
The Fed started to increase the money supply to stimulate the economy right after the New Year. Its announced intent has been to push short-term interest rates down to one third of what they were at the end of 2000.
The federal funds rate—the speedometer that it looks at as it depresses the money supply gas pedal—is now targeted to go to 2 percent, compared to 6 percent before the stimulus began.
Despite this action, the media and some elected officials complain that the economy continues to slow and that the Fed’s actions are not “working.”
There may be nothing wrong with the Fed’s actions. What is more likely is that many people are suffering from irrational expectations.
No economist ever claimed that government actions to counter business cycle swings were some kind of magic bullet or instant cure. Indeed, over the past two decades most economists have become much more skeptical about the wisdom of the kind of economic micromanagement that their elders commonly prescribed in the Kennedy and Johnson years.
Alan Greenspan and his colleagues on the Federal Open Market Committee are not part of that “take no action” school. But they know that government stimulus actions—particularly in the area of monetary policy – have long lags. That is, many months pass before any effects should be expected.
How many months? Ten to 18 is a typical answer. In other words, that first rate cut made on January 3 should just be showing up now, even if nothing else had happened in the intervening period.
The Fed has been standing on the monetary gas pedal, but the economy is not a nitro-fueled dragster. It takes time for the increased fuel flow to hit the cylinders. Critics and skeptics need to be patient.
And there may be a more substantial hitch. A larger money supply lowers interest rates to businesses and consumers. But it does not force them to take out loans. If households are pessimistic about their continued prosperity or businesses do not see any need to invest in expanded capacity, they will not necessarily borrow more money.
Like the horse that cannot be made to drink, a cautious person can’t be forced to borrow, even if interest rates are near zero
Don’t take that as a prediction of gloom. Any recession that we are only now entering will eventually end. When it does, it will end largely because of market forces, not because of government action. And there is no indication that it will be an unusually deep or painful dip.
The Fed’s ongoing monetary expansion will contribute to eventual renewed growth. But it can’t be an instant cure. Americans, a famously impatient people, need to learn some patience.
© 2001 Edward Lotterman
Chanarambie Consulting, Inc.