The primary basis for today's belief in perpetual prosperity and inflation with perhaps an occasional recession is what I call the "potent directors" fallacy. It is nearly impossible to find a treatise on macroeconomics today that does not assert or assume that the Federal Reserve board has learned to control both our money and our economy. Many believe that it also possesses immense power to manipulate the stock market.
The very idea that it can do these things is false. A few years ago, before the House and Senate Joint Economic committee, then-Chairman Alan Greenspan himself called the idea that the Fed could prevent recessions a "puzzling" notion, chalking up such events to exactly what causes them: "human psychology." In August 1999, he even more specifically described the stock market as being driven by "waves of optimism and pessimism." He's right on this point, but no one is listening.
The Chairman also expressed the view that the Fed has the power to temper economic swings for the better. Is that what it does? Politicians and most economists assert that a central bank is necessary for maximum growth. Is that the case?
This is not the place for a treatise on the subject, but a brief dose of reality should serve. Real economic growth in the United States was greater in the 19th century without a central bank than it was in the 20th century with one. Real economic growth in Hong Kong during the latter half of the 20th century outstripped that of every other country in the entire world, and it had no central bank. Anyone who advocates a causal connection between central banking and economic performance must conclude that a central bank is harmful to economic growth.
For recent examples of the failure of the idea of efficacious economic directors, just look around. Since Japan's boom ended in 1990, its regulators have been using every presumed macroeconomic "tool" to get the Land of the Sinking Sun rising again. The World Bank, the International Monetary Fund, local central banks and government officials were "wisely managing" Southeast Asia's boom until it collapsed spectacularly in 1997. Prevent the bust? They expressed profound dismay that it even happened. Argentina's economy crashed despite the machinations of its own presumed "potent directors." I say "despite," but the truth is that directors, whether they are Argentina's, Japan's or America's, cannot make things better and have always made things worse. It is a principle that meddling in the free market can only disable it.
People think that the Fed "managed" the economy brilliantly in the 1980s and 1990s. Most financial professionals believe that the only potential culprit of a deviation from the path to ever greater prosperity would be current-time central bank actions so flagrantly stupid as to be beyond the realm of possibility. But the deep flaws in the Fed's manipulation of the banking system to induce and facilitate the extension of credit will bear bitter fruit in the next depression. Economists who do not believe that a prolonged expansionary credit policy has consequences will soon be blasting the Fed for "mistakes" in the present, whereas the errors that matter most reside in the past.
Regardless of whether this truth comes to light, the populace will disrespect the Fed and other central banks mightily by the time the depression is over. For many people, the single biggest financial shock and surprise over the next decade will be the revelation that the Fed has never really known what on earth it was doing.
Attributed to Robert Prechter’s Market Perspective 7/6/2006
Special thanks to Jimbo from San Diego for recommending this article
