The Federal Reserve-Then & Now (2)

The Federal Reserve: 

Then and Now 

Roger W. Garrison

Roger W. Garrison is associate professor of economics at Auburn University. 

He wishes to thank James Barth, Jeffrey Friedman, and Sven Thommesen for 

their helpful comments on an earlier version of this paper. 

The Review ofAustrian Economics Vo1.8, No. 1(1994): 3-19 

ISSN 0889-3047

PART 2

TheArtificial Boom

Textbook treatments of fiscal and monetary policy recognize that 

the fiscal authority and the Federal Reserve can work together. 

The Treasury issues debt and the Federal Reserve monetizes it. 

So long as government borrowing has not been pushed to irre- 

sponsible levels, debt issue and monetization have short-run 

effects on output and incomes that reinforce one another and 

short-run effects on the interest rate that cancel one another. 

These effects of policy are derived straightforwardly from stand- 

ard analysis which focuses on aggregate supply and aggregate 

demand. But when borrowing becomes excessive, considerations 

of risk become dominant. Going beyond the circumscribed focus 

of the textbook, we can recognize that the Treasury creates risk 

and the Federal Reserve externalizes it. 

To say that the Federal Reserve keeps the default-risk pre- 

mium off Treasury bills is not to say that the risk is actually 

eliminated. The burden of bearing it is simply shifted from the 

holders of Treasury securities to others. Borrowing and investing 

in the private sector becomes more risky than it otherwise would 

be. Holders of private debt and equity shares must concern 

themselves not only with all the usual risks and uncertainties of 

the marketplace but also with the risks and uncertainties attrib- 

utable to changes in the way the federal deficit is accommodated. 

Selling Treasury bills in foreign credit markets, in domestic credit 

markets, or to the Federal Reserve can have major effects on the 

strength of export markets, on domestic interest rates, and on the 

inflation rate. The inability of market participants to anticipate 

the Treasury's borrowing strategy translates into unanticipated 

changes in the value of private securities. 

If the additional risks attributed to federal budget deficits 

and imposed upon the private sector were allocated in some 

economically efficient way, there would have been no artificial 

boom arising from the irresponsible fiscal policy of the 1980s. The 

willingness to lend and to buy equity shares in the private sector 

would have been generally reduced, as wealth holders opted for 

the artificial security provided by government debt; but the re- 

duction in private-sector activity would have been minimized so 

long as the additional risks were assumed by those most willing 

to do so. This result, though, was precluded by institutional 

factors that hid the private-sector riskiness from those who were 

(unknowingly) financing risky undertakings. Again, the Federal 

Reserve plays a strong supporting role, as does the FDIC. To- 

gether, they enabled commercial banks and their depositors to 

finance risky ventures throughout the 1980s while being shielded 

either permanently or temporarily from the risks. This shield 

from risk bearing, like the low rate of interest in the 1920s, gave 

rise to an artificial boom and subsequent bust. 

The Depository Institutions Deregulation and Monetary 

Control Act of 1980 (DIDMCA) dramatically changed the bank- 

ing industry's ability and willingness to finance risky under- 

takings. Increased competition from nonbank financial institu- 

tions drove commercial banks to alter their lending policy so as 

to accept greater risks in order to achieve higher yields. The 

Federal Reserve in its long-established capacity of lender of last 

resort diminished the banks' concerns about possible problems 

of illiquidity while the FDIC absolved the banks' depositors of 

all worries about illiquidity and even about bankruptcy. Riskier 

loans, then, were only partially reflected in higher borrowing 

costs and lower share prices. In substantial measure, specific 

private-sector risks were transformed by DIDMCA, the Federal 

Reserve, and the FDIC into (1)the generalized risk of inflation 

in the event of excessive last-resort lending by the Federal Re- 

serve and (2) the risk of a large and unbudgeted liability in the 

event of excessive last-resort closings by the FDIC. Thus, economic 

activity in the private sector was spurred on by the lure of higher 

yields, yet it was largely unattenuated by considerations of 

risk, which were effectively externalized and diffused. 

The artificially low risk premiums stemming from the risk- 

externalizing effect of potential debt monetization in the 1980s 

paralleled the artificially low interest rates created by actual 

monetary expansion in the 1920s. What was without an earlier 

parallel, however, was the impact of deposit insurance in the 

post -warperiod. Throughout the 1980s, the FDIC continued 

to protect depositors while charging the banks a premium that 

was too low in general and, more significantly, that was unrelated 

to the riskiness of bank assets. This subsidy to risk-taking may 

have been significant enough, by itself, to create an artificial 

boom. There was no difficulty in finding risks to take. Banks could 

simply lend more heavily to overextended farmers, third-world 

countries, oil prospectors, and real estate developers; or they 

could find new risks such as those created by leveraged buyouts 

and the dramatic growth of the junk-bond market. It was the 

financial sector's demand for high-risk, high-yield securities, in 

fact, that gave junk bonds and other highly leveraged securities 

their buoyancy. 

Although it is possible to think of the FDIC as having its own 

independent effect throughout the 1980s, FDIC policy was actu- 

ally an integral part of the -fiscal, monetary, and regulatory 

environment that created and externalized risks. The Treasury 

created risk; the Federal Reserve and the FDIC externalized it. 

After all, speculative lending such as for commercial real estate 

development or for highly leveraged financial re-organizations 

are risky in large part because of possible changes in such things 

as the inflation rate, interest rate, trade flows, and tax rates-the 

very things that can undergo substantial and unpredictable 

change when the federal budget is dramatically out of balance. 

The 1980s may best be understood, then, as a decade in which the 

, policy-induced externalization of risk gave rise to a substantial 

but ultimately unsustainable economic boom. 

The Bust 

Potential debt monetization can keep Treasury bills risk free for 

the indefinite future; the reimbursement of depositors of failed 

banks can continue so long as the FDIC can be recapitalized out 

of general tax revenues. But the banking industry cannot be 

shielded from the consequences of excessive risk-taking forever. 

For almost a decade the banking industry and the speculative 

activities it supported were able to keep the economic expansion 

going. Although risk aversion normally characterizes sound 

banking, high-flying banks in the 1980s were able to indulge in 

risky lending despite the preferences of their depositors and to 

escape both market-imposed or government-imposed discipline 

until the cumulative effects of externalizing risk turned the 

undue risk-taking into a financial crisis. The Federal Reserve's 

routine functioning as lender of last resort, the FDIC's de facto 

policy of forbearance in cases of problem banks, and the implicit 

acceptance of the doctrine of "too big to fail," all help to account 

for the length of the artificial boom. But neither increased last- 

resort lending and forbearing nor more overt inflationary finance, 

such as was pursued in the 1920s, could keep the boom going 

indefinitely. As with the artificial boom in the interwar period, an 

eventual bust was inevitable. 

Like the time-consuming production processes that were 

out of line with time preferences, speculative loan portfolios 

that were out of line with risk preferences generated an artifi- 

cial boom in the 1980s that belonged to the same general class 

as that of the 1920s. However, the distinction between eco- 

nomic activities that are excessively future-oriented and eco- 

nomic activities that are excessively speculative-together with 

some institutional considerations-allows us to see systematic 

differences between the 1930s and the 1990s. 

First, the downturn at the end of the Bullish Eighties came 

in the form of a bank-led bust. A high rate of bank failures was 

experienced well before the general economic contraction. At the 

end of the Roaring Twenties, by contrast, the bank failures came 

after the economic contraction had begun. This difference in the 

timing of events is consistent with differences in the nature of 

the two expansions. Industrial borrowers in the 1920s were 

using newly created funds for excessively capital-intensive 

ventures that, in general, were not otherwise excessively 

speculative. It is true, of course, that there was heavy specula- 

tion in securities markets in the 1920s-much more so then than 

in the 1980s-but the cause-and-effect relationship in the recent 

episode was the reverse of that in the earlier one. That is, in the 

19209, monetary expansion, which allowed banks to support 

heavy industry, also fueled speculation in securities markets. 

However, because the risks of that speculation were born, in the 

first instance, by the buyers of the securities, there was no 

policy-induced externalization of risk to weaken banks even as 

the expansion continued. In the 1980s, policy-induced specula- 

tion, on the part of the banks themselves and their industrial 

borrowers, eroded bank capital, weakening the banks throughout 

the boom-so much so that the erosion of their capital base 

eventually turned boom into bust. 

Second, while the idleness of plant, equipment, labor, and 

other resources that characterized the 1930s has its counterpart 

in the semi-idleness in the 1990s, the disposition of unprofitable 

assets is different now, largely because the recent bust was 

bank-led. During the Great Depression, firms whose revenues did 

not cover operating costs simply closed their doors. Work on 

incomplete industrial projects whose present value had turned 

negative was simply discontinued. Although this form of market 

discipline was sometimes delayed by policies aimed at rekindling 

the boom, eventually resource idleness characterized those sec- 

tors of the economy that were most out of line with underlying 

economic realities, and liquidation could proceed apace. In the 

current slowdown, many failing firms are first identified as non- 

performing loans in the portfolios of failed banks. As insolvent 

banks are closed by the FDIC, the bad loans are transferred to 

the Resolution Trust Corporation (RTC), which functions as a 

caretaker until it can sell the assets. In many cases, the physi- 

cal assets, such as franchised motels or restaurants, are not 

idled. Instead, the RTC contracts with an operating company 

to run the business. The contract allows the operating company 

to earn a profit while minimizing the cost to the RTC of main- 

taining the assets. 

The existence of many such failed-but-still-operating busi- 

nesses, including firms undergoing bankruptcy proceedings but 

still operating with the newly evolved debtor-in-possession (DIP) 

financing, helps to explain why the current recession is a rela- 

tively shallow one by conventional measures. What otherwise 

would be idle capital is partially masked by RTC policy as under- 

employed capital-analogous to the underemployed labor associ- 

ated with 1930s-style make-work projects. "Zombie banks," banks 

that are allowed to continue operations after their net worth has 

turned negative, have their counterpart in RTC-owned or DIP-fi- 

nanced "zombie firms."" While the underemployed capital in zombie firms limited the 

depth of the recession, it added to the length. Recovery consists 

of re-employing resources idled by the bust. As confirmed by 

loon the role of government in adding to the severity of the Great Depression 

and,delaying recovery, see Gene Smiley, "Can Keynesianism Explain the 1930s?: 

Reply to Cowen," Critical Review 5, no. 1(Winter 1991): 81-114 and Richard K. 

Vedder and Lowell E. Gallaway, Out of Work (New York: Holmes and Meier, 1993), 

pp. 74-149. 'The term "zombie S&Lsn was coined by Edward J. Kane in the context of the 

savings-and-loan crisis, which was a precursor to the crisis in the banking industry 

and subsequent recession. See Edward J.Kane, "Dangers of Capital Forbearance: 

The Case of the FSLIC and the 'Zombie' S&Ls," Contemporary Policy Issues 5, no. 

1 (January 1987): 77-83. For a healthy perspective on RTC policy and DIP 

financing, see Stephen Delos Wilson, The Bankruptcy of America (Germantown, 

Tenn.: Ridge Mills Press, 19921, pp. 81-96 andpassim. 

experience in the early 1990s, it would have been easier to draw 

resources out of idleness than to draw them away from the RTC. 

Asset managers of the RTC, trying to avoid spoiling markets 

that dumping real assets at fire-sale price would entail, stock- 

piled them instead, creating a huge "overhang" which added 

significantly to the uncertainties in the private sector. Also, 

solvent firms and would-be upstarts, who would have to raise 

their own capital to expand or enter the market, are not eager to 

compete with bankrupt firms or with privately operated but 

RTC-owned businesses whose revenues do not have to cover the 

costs of capital. Considerations of these sorts help to explain why 

the government's recent recourse to monetary stimulation in the 

form of exceedingly low discount rates has met with such little 

success. 

Third, the unemployment currently being experienced has a 

distinctly different composition from that of the 1930s. It is 

widely reported that white-collar workers are disproportionately 

affected in the current recession as compared to earlier cyclical 

downturns. The time-preferencelrisk-preference frame of analy- 

sis makes this composition difference readily understandable. 

The boom in the 1920s involved resources allocated dispropor- 

tionately to capital-intensive projects, such as steel mills and 

manufacturing plants. The labor complement to heavy industry 

tends to be predominantly blue-collar. The boom in the 1980s 

involved resources allocated to speculative development, such as 

commercial real estate and financial services. The labor comple- 

ment to this kind of capital tends to be predominantly white-col- 

lar. In both episodes, the composition of unemployment matches 

the pattern of capital misallocation. 

Finally, macroeconomic policy after the bust reveals a critical 

difference between the current situation and that of the 1930s. 

When further monetary expansion, which sustained the boom of 

the 1920s for nearly a decade, could sustain it no longer, both the 

monetary expansion and the boom came to an end. The public's 

increased demand for currency relative to checking-account 

money, coupled with the increased reluctance on the part of 

commercial banks to lend, swamped the Federal Reserve's efforts 

to re-inflate.12 Despite the further padding of the monetary base, 

the dynamic of the bust itself was an effective check against 

continued monetary expansion. By contrast, when further deficit 

spending and risk externalization, which sustained the boom of 

''see Smiley, "Can Keynesianism Explain the 1930s?" p. 88. 

the 1980s, could sustain it no longer, the boom ended, but the 

deficit spending and risk externalization escalated. In fact, de- 

creased tax revenues and increased payments of entitlements, 

both associated with recession, led to still more government 

borrowing. The dynamic of the bust, then, provided increased 

scope for the very kind of irresponsible fiscal policy that made the 

bust inevitable.

How Little "We" Know

The failure at the dawn of the last decade to extend deregulation 

to the provision of deposit insurance and the absence of any 

market check against the Treasury's fiscal excesses provide dra- 

matic illustration of the general fallacy of the mixed economy. 

Privatized profit seeking coupled with socialized risk bearing 

undergirded both the bull market of the 1980s and the harsher 

economic realities of the 1990s. The risks assumed by lenders and 

borrowers, savers and investors, hedgers and leveragers are ren- 

dered inconsistent with the actual risk preferences of wealth 

holders in the marketplace by the FDIC subsidy to risk bearing 

and by the Fed-backed Treasury, whose power to issue risk-free 

debt imposes risks on the private sector. 

Researchers at the Federal Reserve are just two steps away 

from recognizing the problem of deficit-induced uncertainties 

as evidenced by a recent article entitled "How Little We Know 

About Deficit Policy ~ffects."'~ Macroeconomic data as illumi- 

nated by several sophisticated modeling and econometric tech- 

niques have led two economists at the Minneapolis Federal Re- 

serve Bank to conclude with confidence that "Deficit policies may 

matter, and then again they may not. Existing studies really don't 

tell us much about their effects."14 The first step from this 

disturbingly limp conclusion to a healthy understanding of the 

deficit problem is to recognize that the "We" in the title of the 

article, intended to mean "We Economists," can be extended to 

mean "We Lenders-Borrowers-Savers-Investors-Hedgers-Lever- 

agers" or simply "We Market Participants." Market participants 

do not know how deficit accommodation will affect future market 

conditions, so they have to make guesses. And if they guess 

131'reston J. Miller and William Roberds, "How Little We Know About Deficit 

Policy Effects," The Federal Reserve Bank of Minneapolis Quarterly Review 16, no. 1 

(Winter 1992): 1-12. 141bid.,p. 8'''  wrong, they may lose big. The second step is to recognize that the "We" may also refer to the holders of Treasury securities. Accord- 

ingly, the title phrase should be amended to read "How Little We 

Know or Care about Deficit Policy Effects." The potential for debt 

monetization, as manifested by the Federal Reserve in its stand- 

by capacity, has absolved the Treasury's creditors of any inclina- 

tion to care. Externalizing risk has precluded any possibility that 

the reluctance of creditors will provide an effective check against 

the excesses of the Treasury. The tripling of federal government indebtedness since the 

beginning of the 1980s' bull market stands as testimony to the 

capacity of the Treasury to issue its artificially risk-free debt. The 

banking legislation of 1980 has shown us its capacity for blinding 

the banking industry and the private sector to the black cloud of 

debt gathering above it. Together, the actions of the fiscal and 

monetary authorities have demonstrated once again how public 

institutions ostensibly devoted to stability and prosperity are, in 

the end, responsible for crises and decay.