This article originally appeared at Mises.org.
If you listen to TV commentators, you’ve been told the worst is behind us. Growth is picking up, and Europe is coming out of its slumber. No one seems to be concerned that this tepid below-2-percent growth is being entirely fed by the central bank’s massive money printing. It’s a “growth at any price” policy. How quickly we forget.
Back in the boom days, anyone who questioned double-digit growth in housing prices was viewed as an unenlightened Cassandra, lacking knowledge on how the new economy had fundamentally changed the law of scarcity. Austrian economists consistently warned that a boom built on foundation of easy money could only lead to a disaster. Today, most of the growth is coming from the interest rate-sensitive sectors of the economy, such as cars and housing. This should be ringing warning bells everywhere.
The conventional wisdom is that the Fed will begin to taper when growth picks up. This is a complete misreading of what is actually happening. The Fed made a monumental mistake, and does not really know how to get out of the trap it had set upon itself.
The Fed embarked on a “we know best” policy of QE3 (a third round of quantitative easing) last fall, and induced a market bubble in the spring. The Standard & Poor’s 500 index gained 12 percent from January to June 2013, while growth remained subdued. The Fed realized its mistake and now wants to get out. The problem is that in economics, as with most things in life, it’s much easier to get into trouble than out of it. The Fed wants to take away the punch bowl; but it knows that interest rates will rise, the stock market will crash and the economy will tank. The longer it waits, the greater will be the inevitable adjustment.
If we do not learn from history, we are bound to repeat it. We have been here before. The depression of 1920 and Roosevelt recession of 1937 show us what happens when excessive monetary printing is followed by tepid tapering.
The 1937 Recession is a perfect example of Austrian business cycle theory. It was severe but short. Output fell by 11 percent and industrial production by 32 percent. Unemployment surged back up from 14 percent to 19 percent.
There is considerable disagreement on the cause of the recession, with some economists blaming the tightening of fiscal and monetary policy. Reserve requirements were increased, and the budget deficit was reduced. Yet spending in the 1937 fiscal year was $7.6 billion, compared to $6.5 billion in 1934 and $6.4 billion in 1935: two spectacular boom years. Taxes went up about 1 percent of gross domestic product from 1936 to 1937, but were less as a percentage of GDP than the rebound years of 1938 or 1939. Writing in 1956, E. Cary Brown found that fiscal policy changes accounted for less than a quarter of the downturn. The Fed did raise reserve requirements, but banks were already holding abundant excess reserves. The new requirements had very little impact.
The real cause of the 1937 recession occurred much sooner. The die was cast early in 1934 when the United States set the price of gold at an overvalued $35 an ounce. The ensuing gold inflows caused the money supply to explode, increasing 12 percent per year (M2) from 1934 to 1936. A boom ensued with real output growing 10 percent in 1934, 8.9 percent in 1935 and 13 percent in 1936. As Austrians would say, the additional money masqueraded as real savings. Since no real resources had been liberated, a scramble for resources followed. Eventually, many of the investment projects that had been undertaken turned out to be unprofitable and needed to be abandoned. The 1937 recession was necessary and desirable to free up resources from the malinvestments of the previous years. A recession is a realignment of resources closer to what society really wants to be produced. The central bank could have continued printing, extending the illusion of prosperity; but this would have just delayed and amplified the final adjustment.
By late 1936, the Fed started to get worried. And in March 1937, the chairman of the Fed, Martin Eccles, said: “[R]ecovery is now under way, but if it were permitted to become a runaway boom it would be followed by another disastrous crash.”
In December 1936, the central bank began sterilizing the gold inflows so they no longer boosted monetary growth. This was a timid tapering by contemporary standards. Monetary growth slowed from 12 percent to essentially nothing. This was the equivalent of gently tapping on the brakes. Anyone who considers this excessive is implying that a capitalist economy needs monetary juice to operate. Yet there is ample evidence from the 19th century of a stable money supply resulting in solid growth, and money is a measure of value and serves its function best when it is stable.
The bust was written in the cards. It could not be avoided, just postponed. It is not the bust, but the boom, that should be feared. The bust was of short duration and could have been much worse if the Fed had not pulled the punch bowl then and there.
We currently fear Fed tapering, as we should. Yet we should be even more fearful that it doesn’t taper. Today, we really have a dreaded choice of losing an arm now or two arms and a leg tomorrow. Because the price distortions have been massive, the adjustment will be horrendous. Government policy makers and government economists simply do not understand the critical role of prices in helping discovery and coordination.
Recognizing that the economy is still weak, the Fed at its Wednesday meeting yet again declined to begin tapering. When the Fed is finally forced to cut back, interest rates will rise, Wall Street will call for relief and the economy will slump. This may be delayed with additional printing for a couple of months; but the adjustment will occur, and it will be severe — probably much worse than in 2008. However, this time there are no arrows left in the government’s quiver to spend or print its way out of trouble.