Home inFocus Learning From Feds Past

Learning From Feds Past

David Frum Summer 2008

The great Austrian free-market economists Friedrich Hayek and Ludwig von Mises toured Germany together in 1946, according to a probably apocryphal story. They witnessed the devastation of the cities, the hunger and misery of the population, and the utter demoralization of post-Nazi society. After a long look at the rubble and ruins, Mises (the story continues) turned to Hayek and said: “Fritz, do you realize that none of this would have happened if Germany had stayed on the gold standard?”

Whether this exchange ever literally occurred, it underscores something profoundly true: the supreme importance — and intense difficulty — of proper management of money and finance.

Today, the U.S. Federal Reserve faces its greatest monetary and financial challenges since at least the early 1980s.

On the one hand: a dizzying crisis in credit markets has prompted the Federal Reserve to unprecedented bold action to make cash available to troubled markets. On the other: the infusion of liquidity from the Fed is exacerbating the gathering problem of global inflation. Gold is up, oil is up, food prices are up, and base metals are up, while the U.S. dollar has plunged in value against almost every major world currency.

In many ways, the Fed faces a situation like that of a race car driver who must execute first a rapid upshift, then a quick downshift. The driver is at least as likely to strip the gears or crash the vehicle as to complete the maneuver safely and effectively. The Fed must accelerate the economy past the danger of recession; then brake to avert inflation. If it does not steer skillfully, the U.S. is very likely to succumb to both inflation and recession at the same time, also known as “stagflation.”

Learning From the Past

The last time the Fed tried to execute this upshift-downshift maneuver was the fall of 1999, at the feverish peak of the tech boom. Between then and the early spring of 2000, the NASDAQ index nearly doubled, from about 2,700 to over 5,000. The Fed raised interest rates to try to deflate the bubble. At the same time, it injected liquidity into the banking system to ensure that there was plenty of cash available if consumers ran to the banks in advance of the widely feared Y2K crisis.

That time the Fed did strip the gears, tumbling the U.S. into a recession. Happily, it was a relatively short and mild one.

This time the challenges are much more daunting. The bubble in housing was vastly larger than the tech bubble. The recessionary threat from the deflation of that bubble is also vastly greater.

Inflationary pressures are also much worse than they were in 2000. Since 2000, world food prices have risen by 75 percent. Corn, which sold for less than $2.50 a bushel as recently as 2004, has passed $6 a bushel. Prices of most varieties of rice have doubled since early 2007. And the price of a barrel of oil has more than quintupled.

Political Dangers

Fed Chairman Benjamin Bernanke faces hard choices and severe risks. His decisions may also carry political consequences. The Fed’s upshift-downshift maneuver in 2000 slowed the economy just enough to cost the incumbent Democrats the White House.

Over the course of the year 2000, consumer confidence and expectations as measured by the Conference Board took the sharpest tumble in decades. In January 2000, Gallup polls found that 69 percent of Americans believed that economic conditions were getting “better”; only 23 percent thought they were getting “worse.” By year’s end, 39 percent of Americans said that conditions were getting better and 48 percent said they were getting worse. What looked at the start like an easy election for Vice President Al Gore turned into an unexpected upset for George W. Bush.

This year, the Fed’s choices may prove even more meaningful for America, as we enter an election season. Already some 80 percent of Americans describe the country as “on the wrong track.” As of spring 2008, only 19 percent of Americans describe economic conditions as “excellent” or “good,” 39 percent say “only fair,” and 42 percent say “poor.”

If the Fed has to raise interest rates, a policy that can be expected to slow economic growth and reduce employment, those negative numbers can surely only grow. Yet if the Fed does not act to cool the economy–if inflation accelerates–then voters will likely head to the polls angry about gas and fuel prices.

Nixon’s Lessons

Of course, the U.S. economy is amazingly robust, and its long-term strength unquestioned. Elections, however, are won and lost in the short run – and in the short run, monetary policy can exert decisive effects. It was made-at-the-Fed recessions that won Democrats a huge congressional victory in 1958 and the White House in 1960—a point lamented by the loser in 1960, Richard Nixon. He wrote in his memoir, Six Crises:

Early in March, Dr. Arthur E. Burns… called on me in my [vice president’s] office in the Capitol… [and] expressed great concern about the way the economy was then acting… Burns’ conclusion was that unless some decisive governmental action were taken, and taken soon, we were heading for another economic dip which would hit its low point in October, just before the elections. He urged strongly that everything possible be done to avert this development. He urgently recommended that two steps be taken immediately: by loosening up on credit and, where justifiable, by increasing spending for national security…

In supporting Burns’ point of view, I must admit that I was more sensitive politically than some of the others around the cabinet table. I knew from bitter experience how, in both 1954 and 1958, slumps which hit bottom early in October contributed to substantial Republican losses in the House and Senate. The power of the “pocketbook” issue was shown more clearly perhaps in 1958 than in any off-year election in history…

Unfortunately, Arthur Burns turned out to be a good prophet. The bottom of the 1960 dip did come in October and the economy started to move up again in Novemberafter it was too late to affect the election returns. In October, usually a month of rising employment, the jobless rolls increased by 452,000. All the speeches, television broadcasts, and precinct work in the world could not counteract that one hard fact.

Nixon remembered this experience with pain. When it came time to choose a Fed chairman of his own, he chose Arthur Burns. And Burns, in turn, engineered a just-in-time boom for Nixon’s landslide re-election in 1972. Milton Friedman recalled in a 2000 interview warning Nixon of the likely consequences of Burns’ monetary easing:

I had a session with Nixon sometime in 1970I think it was 1970, might have been 1971in which he wanted me to urge Arthur to increase the money supply more rapidly [laughter] and I said to the President, “Do you really want to do that? The only effect of that will be to leave you with a larger inflation if you do get reelected.” And he said, “Well, we’ll worry about that after we get reelected.”

Will History Repeat?

The inflation stoked in 1970 was belatedly squelched by Fed Chairman Paul Volcker during the Reagan administration. But inflation cost President Jimmy Carter a second term. Likewise, Fed tightening probably tipped the balance against Al Gore in 2000. Will this history repeat itself in 2008?

If the Federal Reserve can manage the transition, Americans will look back on 2008 as a year of economic slowdown, not recession. If the Fed finds the right monetary policies, the increase in the price of food and fuel will not translate into a general inflation. If it does not, the economy could tumble into severe recession, while experiencing a rise in commodity prices that prompt a general inflation.

In other words, if the Fed handles its current challenges successfully, it will set the stage for a competitive election in 2008.

Fed Chairman Ben Bernanke has the skills and attributes necessary for success. He is an outstanding technical economist, with a deep understanding of the causes of the Great Depression and the Japanese slump of the 1990s.

At a tribute to Milton Friedman in 2002, on the occasion of the great monetarist’s 90th birthday, Bernanke toasted Friedman and his colleague Anna Schwartz: “Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve. I would like to say to Milton and Anna: Regarding the Great Depression. You’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again.”

The mistakes we need to avoid in 2008 are not only the mistakes of the 1930s. Modern economies are depression-resistant, but they are biased toward inflation. The lessons we need to study now are the lessons learned in the 1970s. The Fed’s success with those lessons may impact an election—and shape the prosperity of millions of Americans over the decade to come.

David Frum is a resident fellow at the American Enterprise Institute, a member of the board of directors of the Republican Jewish Coalition, and the author of Comeback: Conservatism That Can Win Again.