Not since the Depression of the 1930s has a single event caused such financial upheaval as the Federal Reserve's conversion to practical monetarism. Exactly three years after being reborn in the religion of fighting inflation, the Fed's faith appears to be wavering.
The Fed's conversion, like St. Paul's, was largely involuntary. Inflation was soaring, the dollar was falling, and the remnant of the Fed's credibility was disappearing fast. By October 1979, strong pressures at home and abroad forced the reluctant Fed to exchange its failing policy for one with a better chance of success.
The Fed can control either the quantity of money or its price in terms of interest rates, but not both. For decades the Fed kept interest rates fairly stable, leaving the money supply to fluctuate with a strong upward bias. Beginning three years ago, the Fed abandoned its policy of controlling interest rates and adopted a new policy of controlling the growth of the money supply.
In theory, the Fed's new policy allows interest rates to become more volatile. In practice, almost no one anticipated how volatile they would become on the upside once the Fed's lid was removed. Long-term Treasury bonds rose above 15 percent and the prime rate charged by banks broke the 20 percent barrier, a level once associated only with Mafia loan sharks. Both were records by a wide margin for the two centuries of our nation's history.
Even more significant than the record level of nominal interest rates was the record level of inflation-adjusted real interest rates. After being flat to negative for most of the last 40 years, real interest rates went to about 10 percent and stayed there, causing a revolutionary shift in the world's financial balance of power from borrowers to lenders.
Financial power shifted from young couples who pay extraordinary rates on their borrowings to older couples who enjoy those extraordinary rates on their savings. Poor nations view high real interest rates as a costly and unwanted export from rich nations. Industrial companies now pay over 50 percent of their pretax profits in interest charges. Borrowers of all kinds -- personal, national, and industrial -- are discovering that high real interest rates are a powerful vehicle for transferring their income and wealth to lenders.
Few rational borrowers would go on borrowing at today's high real interest rates if they had any choice. Mexico and Brazil both have $80 billion in largely short-term debt which they have no prospect of repaying in the near future, so they must go on rolling over their maturing loans regardless of how high interest rates stay. Chrysler and International Harvester borrow to survive, not because they have an abundance of profitable investment opportunities. The British, who are farther down the road to financial perdition than we are, have an understated but accurate term for borrowers whose debts are now a matter of present survival rather than future profits: distress borrowing.
Much of the distress for borrowers today comes from the world-wide recession, itself partially a result of high interest rates. Industrial companies such as steels and autos, which would be very profitable if they produced at 90 percent of capacity, are dying now at 50 percent of capacity.
Less developed countries would be better able to service their debts with exports if their markets in the developed nations were not closed by recession and protectionism. Unemployment is climbing into double digits in many developed countries, leaving millions of unemployed workers unable to pay their debts.
The distress extends to economists who are confused and upset by the Fed's new policies. In six of the eight quarters in 1980-81, the consensus of economic forecasts at the beginning of a quarter turned out to be wrong not only about the size of the change in real gross national product (GNP) during the following three months, but about its direction as well. Their failure to recognize whether the economy was going up or down illustrates the economists' confusion over how to estimate the impact of the Fed's new policy.
Far from delighting economists of the monetarist school, the Fed's version of practical monetarism has left them upset. They point to convulsive fluctuations in money supply growth as proof that the Fed's conversion to monetarism is only partial, not complete. While taking fire from the true believers who think it has not gone far enough, the Fed also has come under fire from the old guard of Keynesians who have lost the power and influence they enjoyed in the 1960s and 1970s. Hell hath no fury like an economist whose advice has been ignored.
Criticism of the Fed's new policy comes from all sides, but little of it is constructive. The Fed adopted practical monetarism because its old policy clearly failed to slay the dragon of inflation. The recent decline of inflation from double digits into mid-single ones demonstrates that the Fed's new policy does work, despite (perhaps because of) its painful side effects of high unemployment, lost industrial production, and distressed borrowers. Criticism of the Fed's policies would be more convincing if it offered a better formula for reducing inflation faster and with less pain, but economic theory is notably weak on that subject.
The effects of the Fed's new policy are more obvious than its likely duration. Every time a recession became painful during the past generation, the Fed rushed to the rescue with a massive increase in the money supply which later became a massive increase in inflation. When unemployment rose above 10 percent a week ago, the Fed took actions such as lowering the discount rate which the soaring stock market took to mean a shift in the Fed's priorities from fighting inflation to fighting recession and unemployment.
Fed Chairman Paul Volcker denied the Fed was moving toward easier money and pointed to unusual technical factors such as maturing All Savers certificates. His denials were met with skepticism at best on the part of investors, who have heard it all before. Today's Fed officials appear to be sincere and determined in their zeal to crush inflation, but are burdened by the legacy of past Fed officials whose actions failed to match their rhetoric.
Most federal policies quickly develop a consistency that supports their continuation, and practical monetarism is no exception. Millions of savers who enjoy today's high rates of interest oppose a return to the ancien re'gime that fleeced them with federal policies that regulated and taxed the interest rates banks paid them while other federal policies drove inflation far above those regulated interest rates. Money market funds and a rapidly deregulating financial services industry now give savers at least a reasonable chance of earning a real return on savings.
Arrayed against the beneficiaries of practical monetarism are borrowers who find today's interest rates uncomfortable and tomorrow's rates uncertain. Being uncomfortable and uncertain is unpleasant, so borrowers pressure the Fed to fix interest rates at concessionary levels below the rate of inflation. Borrowers are always more numerous than lenders, so the long-run weight of political power is on their side.
Buffeted by criticism and pressure groups, the Fed is doing its best to steer between the Scylla of uncontrolled depression and the Charybdis of massive inflation. Steering would be easier if the Fed had a single, clearly defined money supply to steer toward, but money is a protean concept in a world of credit cards, NOW accounts, and money market funds.
Winston Churchill once observed that democracy is the worst possible form of government, except for all the others. The damage inflicted by practical monetarism would be intolerable if there were any other way to cure the inflation that has addicted Western economies for 20 years. Withdrawal from any addiction is painful, and no latter-day Keynes has arisen to make withdrawal from inflation pleasant.