The credit crunch has upset the world-view of modern economists. As the Federal Reserve has discovered, the conventional tools aren’t working how the textbooks say they should, writes Robert P. Murphy.

With day after day of bleak news regarding the credit crunch — and in particular, articles that constantly remind us that the Fed’s recent actions haven’t been tried since the Great Depression — the average American is understandably perplexed. And although what I’m about to admit may not surprise many readers, it nonetheless may worry them further: most economists don’t have a clue what’s going on either.

It has become fashionable to compare our current economic crisis to the stagflation of the 1970s; I’ve done so myself. Yet beyond the weakening dollar and the stalling output that characterised that period and today, there is another similarity: during both the 1970s and today, the orthodox monetary prescriptions were (and are) not working as the textbooks said they should. The Federal Reserve’s toolkit of interventions were (and are) not able to deliver.

The credit crunch: a surprising crisis

Although my article so far sounds like a wiser-than-thou criticism of everybody else, I should admit that I too was caught off guard by the present situation. Just as the orthodox Keynesians were baffled in the 1970s by stagflation, so was I (as were many other free-market economists) surprised by the way things have played out during the present crisis.

Back in the 1970s, the Keynesians were surprised to find that no matter how much extra money they pumped into the system, unemployment remained stubbornly high. This upset their conventional worldview, which held that the Fed could choose an easy-money policy (yielding high inflation but low unemployment), or a tight-money policy (yielding low inflation but high unemployment). When confronted with stagflation, the Keynesian analysis and prescriptions became obsolete; the economy was suffering the worst of both worlds, with high inflation and high unemployment.

Lowering the federal funds rate?

There is something analogous happening in our present credit crunch. In short, the textbook understanding of how the Fed manipulates short-term interest rates hasn’t been true since August 2007. In principles of macroeconomics (or what seemed to be Naptime 101 when I taught this class), we economists lecture gullible students with the following story: When the Fed wants to lower the federal funds rate (i.e., the interest rate that banks charge each other for overnight loans of reserves on deposit with the Fed), it engages in an “open market operation.”

The Fed buys assets such as Treasury securities from the banks, and in return increases their reserve deposits held at the Fed. Because some banks now have more reserves than they did before, they are willing to lend them out at a lower interest rate. Now if the Fed wants to raise the federal funds rate, it sells Treasury securities to the banks in order to destroy some of their reserves.

Generally speaking, the above textbook description of Fed operations matches the actual facts, “which is nice” (as Bill Murray might say). As Figure 1 shows, when the Fed wants to raise interest rates, it sucks reserves out of the system, and when it cuts rates, it pumps reserves in:

Figure 1: Total Bank Reserves vs. Federal Funds Target Rate – Monthly, Jan. 1990 – Dec. 2006

Source: St. Louis Fed (Reserves and Target)

Figure 1 beautifully illustrates the Austrian Business Cycle Theory explanation of the housing bubble and consequent bust. In response to the dot-com crash and ensuing recession in 2000–01, Greenspan’s Fed slashed interest rates down to a shocking 1% by June 2003, and then held them there for a full year before ratcheting rates back up.

The libertarian’s gut instinct is to say that this pumped phony money into the housing bubble, and the quick uptick in total reserves seems to accord with this explanation. (Note that the massive spike in late 2001 was because of the September 11 attacks; the Fed was afraid a panic would cause the financial system to seize up and wanted to nip such fears in the bud.)

A new ‘stagflation’ – it doesn’t make sense

Now with the daily announcements of the Fed pumping in tens of billions into the financial sector — not to mention cutting the target rate 300 basis points since September — one would surely think that the Fed was trying to inflate its way out of the crisis.

As is its wont, the Fed presumably is printing new money like crazy, in an effort to paper over its past mistakes. The massive injections might get the economy through 2008 or 2009 without a major recession, but this (according to standard Austrian Business Cycle Theory) is why it’s a mistake! The huge misallocations of capital during the last round of monetary pumping need to be corrected, and a recession is the only way to move workers and other resources into more appropriate channels, where they can best contribute to consumer satisfaction.

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