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.
