The Kansas City Star Posted
July 8, 2003
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Federal
Reserve Chairman Alan Greenspan, as well as other Fed governors, have made it
very clear on several occasions that the Fed intends to do whatever it takes in
the way of monetary expansion to avoid a deflationary slump.
In the
last century we had two long deflationary periods. The first was the 1920s and
the second was the 1930s.
Most
people are surprised to hear that the "Roaring '20s" was a
deflationary period, but it was. Over that decade, wholesale prices fell by an
average of 1 percent a year while both real income and per capita real income
were growing nicely.
Deflation
was not a problem in the 1920s because it was an era of accelerating
productivity (increases in production per employee hour worked), which enabled
prices of manufactured goods to fall while income was increasing.
In the
1920s, new mass markets for automobiles and radios led to a surge in
manufacturing and a relative decline in the role of agriculture. It was not the
first time prices fell during an expansion fueled by innovation and
productivity gains.
Curiously,
Greenspan has also noted on several occasions the significant gains in worker
productivity over the past few years. But he seems not to connect higher
productivity to the absence of price increases in manufactured products.
Product price declines that are rooted in enhanced productivity are in fact a
positive economic development, not a negative one.
The
deflation that occurred in the 1930s stands in marked contrast to the
experience of the 1920s. The stock market crash of 1929, while often blamed,
was just the catalyst. A broad-based failure of public policy on three fronts
turned a serious recession into a 10-year slump.
The
Federal Reserve System, caught in a power struggle between its Washington-based
board of directors (now board of governors) and the New York Federal Reserve
Bank, did not provide the banking system the funds necessary to avoid a banking
panic.
Between
1929 and 1932, while one-third of the country's banks failed, the Fed actually
raised interest rates and let the money supply contract by one-third.
Most of
the failures were not due to bad loans. Banks were simply overwhelmed by
depositors demanding their money. Bankers were forced to call in their loans
and liquidate to meet that demand.
The Fed
could have stepped up and provided emergency funds necessary to meet depositor
demands, but it failed to recognize its obligation. Such a colossal failure by
the Federal Reserve to meet its responsibility as a lender of last resort is
unimaginable today.
If that
wasn't bad enough, Congress and President Herbert Hoover exacerbated the
problem with the Smoot-Hawley tariff bill (of course, our trading partners
retaliated by raising tariffs on U.S. exports, and world trade plunged) in 1930
and a tax increase in 1932 in a misguided attempt to balance the budget.
Then,
after a tepid recovery, the Fed in 1937 again contracted the money supply by
doubling the banking system's required reserves, which sent the economy and
prices spiraling down again.
Looking
back on the 1930s, it is hard to imagine a worse policy mix. The unemployment
rate stopped going up when it hit 25 percent.
Fortunately,
the current environment resembles the 1920s, not the 1930s. If the role of
productivity on prices is under appreciated, it could lead to an overly
expansive policy response by the Fed, with serious inflationary consequences in
a couple of years.
Fred G. Mitchell, CFA
Mitchell Capital Management Co.