 INSTITUTIONAL
ADVISORS AUG 2008
Will Fed Stimulation End
the Credit Contraction?
Bob Hoye
Institutional Advisors
Posted Aug 6, 2008
 The late bubble has been
the greatest on record and is the accumulated consequence of
95 years of Fed stimulation.
Every experiment in currency
depreciation ends with great market and political volatility.
Keynes thought that he
had invented a way to end credit contractions. But, because he
was ignorant of market history he didn't know that almost every
century has an example of some intellectual having a personal
revelation about avoiding or prematurely ending a post-bubble
contraction. An early example occurred with the post-1618 bust,
when in 1622 Missleden prescribed adding credit to a credit contraction.
The forever-esteemed editor
of The Economist, Walter Bagehot, wrote in 1873:
"A panic in a word,
is a species of neuralgia, and according to the rules of science
you must not starve it. The holders of the cash reserve must
be ready... to advance it most freely for the liabilities of
others."
No problems, if the right thing
is done at the right time. As noted below, the subsequent period
was described as "The Great Depression" and it ran
from 1873 to 1895.
Actually, such sound advice
had been implied by the Bank of England in a report following
the big problem in 1825:
"We lent by every possible
means and in modes we have never adopted before; we took in stock
on security, we purchased Exchequer bills, we made advances on
Exchequer bills, we not only discounted outright, but we made
advances on Exchequer bills of exchange to an immense amount,
in short, by every possible means... seeing the dreadful state
in which the public were, we rendered every assistance."
The subsequent general contraction
endured from the climax of the bubble in 1825 until the mid 1840s.
At the height of the 1929
mania the Fed with its "elastic" currency was celebrated,
as the old system was condemned. The following is by John Moody:
"The old breeder of
financial panics, the National Banking Law, which had been a
menace to American progress for two decades, has now been replaced
by a modern, scientific reserve system which embodied an elastic
currency and an orderly control of the money market."
In so many words, "nothing
could go wrong".
Similar confidence in
the old system prevailed as the 1873 bubble came under the usual
credit changes that signal a top. A leading New York paper, the
Herald, editorialized:
"True, some great event
may prick the commercial bubble of the hour, and create convulsions;
but while the Secretary of the Treasury plays the role of banker
for the entire United States it is difficult to conceive of any
condition of circumstances which he cannot control. Power has
been centralized in him to an extent not enjoyed by the Governor
of the Bank of England. He can issue the paper representatives
of gold, and count it as much as the yellow metal itself. [He
has] a greater influence than is possessed by all the banking
institutions of New York."
In so many words, "nothing
could go wrong".
Ironically, the editorial contained
some totems that are still deemed to have great power. Even today,
for some the terms "centralized", "banker for
the U.S." and "influence" provide considerable
assurance. On the initial panic into late September, the Herald
editors extolled abiding confidence in the Treasury System with:
"A crisis in our financial
dealings has been met and passed without loss of confidence...
Here are growth, understanding, [and] increased knowledge."
As it had done on previous
crises, the Treasury added liquidity and appeared to have avoided
disaster. Under similar pressures, today's Fed and Treasury have
injected liquidity and on the technical rebound into May such
orthodoxy was celebrated:
"The policy response
to financial asset deflation was not only extremely fast, but
extremely well coordinated. US policymakers deserve the Nobel
Prize."
Back to all the confidences
and issuance of liquidity in the early panics of the post-1873
contraction. The usual business cycle prevailed, but the recessions
were stronger than the expansions. By 1884 leading economists
began calling the prolonged contraction as the "The Great
Depression." Although it ended in 1895, it was still being
analysed as such until as late as 1939.
In order to preserve the notion
about an infallible Federal Reserve System, it has been expedient
to lay the blame on the Fed keeping too tight a policy during
the post-1929 contraction. A couple of notes suggest otherwise:
A Fed memorandum following
the 1929 crash explained:
"The drain upon bank
reserves was met in the classic way with a policy of free lending".
By free they meant liberal
and this was exemplified by George Harrison, who was head of
the New York Fed. As with today, the NY branch was huge compared
to the whole Reserve System and Harrison, in discounting freely,
exceeded his authority by a factor of six. This was conventional
theory and practice and as with a number of examples did not
prematurely end a post-bubble contraction.
It seems that part of
the tout at the top of the mania includes a celebration of whatever
central banking or treasury system happens to be
in place. Naturally, with the recrimination and revulsion that
goes with any post-bubble contraction the prevailing system will
be criticized.
The first stage will likely
be an ad hominem attack on the personalities running the Fed.
Bernanke will be worked over for not providing the exact interest
rate change that would have prevented the contraction. The rate
change of the perfect amount made with perfect timing only exists
in the imagination of interventionist economists.
Eventually, the contraction
could become severe enough to prompt rigorous scrutiny. This
would involve examining the history of central banking - not
for policy errors, but for systemic inadequacy.
August,
2008
-Bob Hoye
Institutional Advisors
email: bobhoye@institutionaladvisors.com
website: www.institutionaladvisors.com
Hoye Archives
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