All New Dealers Now?
by Donald Devine
Issue 104 - March 26, 2008

In the wake of the Federal Reserve bailout of Bear Stearns, the generous debt guarantee to J.P. Morgan Chase and the opening of direct Fed credit lines to investment firms, progressive theorist E.J. Dionne Jr. could not contain himself: “Never do I want to hear again from my conservative friends how brilliant capitalists are, how much they deserve their seven-figure salaries and how government should keep its hands off the private economy.”

He must have some strange conservative friends, since from Adam Smith to Joseph Schumpeter and forward, free-marketers have been very aware that capitalists are often the greatest danger to capitalism. They do not so much deserve their pay as bargain for it. But he does have a point. Virtually every supply-side, free market (to say nothing of progressive) voice is calling for the Federal Reserve and U.S. Treasury to intervene to rescue financial markets. Only no one knows how to regulate them, including Dionne, whose “solution” is to decry that “Wall Street titans” have become “welfare clients” but then agreeing they should be bailed out as long as they “foot some of the bill” and are contrite.

For the first time, 71 percent of economists are saying the U.S. is already in recession. The February data show a loss of 63,000 jobs, consumer demand measured by retail sales down 0.6 percent and capital in short supply for financial institutions due to the rolling effects of the sub-prime mortgage crisis. But it is not just a recession for, at the same time, prices have zoomed 4.3 percent, with the Consumer Price Index near a 17 year high and the dollar sunk to historic lows against gold, oil, the Euro, yen, Canadian dollar and other commodities and currencies, with key currencies linked to the dollar spreading the inflation worldwide.

In other words, we are back to “stagflation”--economic stagnation and monetary inflation. While unemployment is lower, the 4.3% price inflation (not just the core) is at the precise level that led Richard Nixon to impose wage and price controls and break the dollar link to gold in 1971.Wage and price controls are discredited these days but the other policies that led to full scale stagflation under Jimmy Carter are very much alive. George Bush has already signed a “stimulus” program into law to spur demand, the Federal Reserve is pushing “liquidity” to increase the supply and availability of capital and, with the Treasury, is jawboning investment and bank restructuring and consolidation.

Will it work? Treasury Secretary Henry Paulson sounds unsure. On Fox Morning News, after defending the Federal Reserve’s actions, he also agreed a correction “is inevitable. You’re going to see a correction. Can we outlaw the forces of gravity? You know—what can the government do?”

Yes, what can the government do? Dionne and other progressives can only point to Franklin Roosevelt taming the Great Depression, without mentioning it took a decade and a world war to end it and that the Fed may have caused it in the first place. He conveniently ignores the Carter stagflation years, the $250 billion Savings and Loan bank failure crisis of the mid 1980s, the commercial banking crisis of the late 1980s when 905 banks failed, the Mexican peso crisis or the late 1990s Asian financial crisis. The Federal Reserve not only did not solve these, the solutions led to the end of the commercial banking regime the Fed was created to regulate, now down to a mere 30 percent of capital lending. These crises were met with some minor bailouts but primarily by the private sector creating new financial instruments and institutions and turning the Fed’s inflation machine off. Those new investment house and hedge fund institutions and “securitized” instruments that saved the day then are now under stress themselves. That is how the market works, through cycles of growth and correction.

With an election eight months away, no politician is willing to tell the voters the truth about business cycles. Almost no one expects the “stimulus” to work but it is “doing something.” While dismissing the stimulus, supply-side guru and former Dallas Fed chairman Bob McTeer presents the case for the ultra-optimists. The U.S. has not resorted to controls, the gold window has been long closed, and supply, demand and productivity are all more robust than in the 1970--so stagflation is unlikely, although he ends by admitting, “I could be wrong.” While he supported Federal Reserve Chairman Ben Bernanke’s additional rate reductions and liquidity activities, he did concede they will increase inflation.

The dirty secret about Fed intervention is that Bernanke really has only one tool in his kit, creating additional liquidity—and that means inflation. By granting direct borrowing to the new financial institutions, Bernanke has in effect expanded his regulatory reach (without legislation) but that just infuses liquidity and inflation further into the economy. The Fed Chairman recognizes the inflation danger but he expects lower growth to control it. McTeer believes a long term decline in the dollar is inevitable given foreign dollars holdings from past trade and the fact that balances are redeemable. If this is gradual, all will be well. The danger is that Fed liquidity policy will exacerbate the flow. “The more the dollar depreciates, the sooner it will be expected to reverse, and the sooner foreign investors will resume their participation in the most dynamic, creative economy in the world.” Translation: current Fed policy delays a recovery, which is pretty much what Paulson was saying too.

Even perpetual optimists like the Wall Street Journal editors, who first called recent actions “the Fed’s best policy course,” although adding that “these are loans or swaps designed to be a short-term source of liquidity and it’s important that they continue to be temporary.” Indeed, “there is some genuine moral hazard” to the policy and it might encourage Congress to bailout mortgagees directly. If Fed policy is short term and works “maybe the Fed won’t continue to run the risk of tempting inflation and a dollar rout with ever easier monetary policy.” A few days later, their patience exhausted, the editors demanded the closing of the Fed’s credit spigot and ending the weakening of the dollar, correctly noting that “The Feds main achievement so far has been to stir a global lack of confidence in the greenback.”

The truth is even the most optimistic supply side economists (and even most progressive ones) know a correction must take place to solve the crisis over the long run. Brian Wesbury and Robert Stein conclude:

We believe the Fed has already provided the economy with more than enough liquidity to grow at a robust rate later this year.  However, igniting that boost from growth due to lower interest rates requires the Fed to convince the market it is finishing up its rate cuts.  Otherwise, as long as consumers and businesses foresee much lower rates ahead, they have an incentive to postpone activity.

Ignoring the pleas, a few days later the Fed increased the discount rate again, first by a quarter and then by three-quarters of a point (although acknowledging an inflation risk and with two regional chairman now dissenting), resulting in an immediate stock market rally but then a reaction from foreign markets fearing more inflation and an even weaker dollar.

Allowing the market to self correct is extremely difficult politically in a democracy but it is the only way. Inflation is politically safer—but also more economically stagnating. Regulation is easy to prescribe but the new financial instruments are so complex the regulators are more confused than the hedge experts, just exposing themselves to more unknown risk. Even the supposedly free market Journal editors called for “a more aggressive and pre-emptive regulatory role for the Fed,” without specifying what the government regulator could do. For, contrary to Dionne, if the government regulator has already lost confidence, how can it provide what it does not possess or understand? There is a legitimate central bank function to stabilize money growth but that is precisely what it is not doing.

The sad fact is, the market must be allowed to hit bottom or neither the economy nor the dollar will recover. The market will have to weed out weaknesses and allow a solution by those bearing the risks. The reason the Great Depression was so “great,” i.e. lasted so long, was that the government would not let it hit bottom. That was the whole purpose of the Roosevelt economic program, to avoid a correction. Fighting gravity did not work then and it will not now. It is sharp pain for a short time (that can be cushioned but not eliminated) or long-term stagnation, one or the other. Ask Japan, which has been in a New Deal-like decade-and-a-half long slump because it will not allow the market to correct.

When even the pro-market supply-siders at the Journal and its allies are willing to accept the government as the market regulator of last resort—even while acknowledging the need for a correction—are we all New Deal central planners now? The only recent politician to have the intelligence and wisdom to let a recession correct stagflation was Ronald Reagan and even he suffered two years of low public opinion ratings for his courage. But he ended up as the most popular recent president, with two decades of prosperity and even Barak Obama and Hillary Clinton reluctantly singing his praises.

Donald Devine, the editor of Conservative Battleline Online, was the director of the U.S. Office of Personnel Management from 1981 to 1985 and is the director of the Federalist Leadership Center at Bellevue University.