Behind Alan Greenspan's recession: the Federal Reserve Chairman's "attempt to head off recession through lower interest rates not only failed to prevent it, but actually slowed the economy's pace." - Economics - Statistical Data Included

USA Today (Society for the Advancement of Education), May, 2002 by Tim D. Kane

IN HIS FREQUENT APPEARANCES before committees of Congress, Federal Reserve Chairman Alan Greenspan has been known to caution lawmakers, always eager to address the latest social or economic malady with a blast of new legislation, to "first, do no harm." Although it originated in the medical field, this dictum perfectly expresses the philosophical constraint on government policymakers in a free market. Socialist and authoritarian governments allocate resources; set prices, and select the optimum mix of goods and services to meet the needs of their subjects. In contrast, government's role in an economy whose cornerstone is individual liberty is that of role-maker and referee. Government "of the people, by the people, for the people," as Pres. Abraham Lincoln characterized it in his Gettysburg Address, establishes ground rules for fair play, creates sanctions against the use of force and fraud in economic relationships, provides public goods that would be unprofitable for private individuals, protects private property, and generally maintains the type of environment in which free men and women can realize their potential. Within such an environment, the activities of individuals motivated by self-interest advance their welfare and that of their fellow citizens.

With the possible exception of bankruptcy lawyers, most people would agree that heading off a recession, or speeding up the recovery from one in progress, is an admirable thing to do and clearly enhances the general welfare. By steadily reducing interest rates to stimulate the economy, the Fed Chairman may have violated his own dictum, "first, do no harm." A review of the evidence on family wealth and expenditure patterns indicates that the dramatic decline in interest rates engineered by Greenspan failed to stimulate consumer spending or capital investment by business, but did cut the interest income of American families, hastening the onset of recession.

The National Bureau of Economic Research has officially designated the first quarter of 2001 as the starting point for the recession in which we currently find ourselves. Various economic indicators signaled future weakness well before that date. The Commerce Department's Index of Leading Economic Indicators, for example, had been portending an economic slowdown since November, 1998. Progressively smaller month-to-month increases in the index, which began at that point, soon gave way to absolute declines a full year before the recession officially began. The Fed was monitoring this and other economic indicators and apparently saw the handwriting on the wall. After months of behind-the-scenes deliberation with staff economists, Greenspan took action. The first in a long series of cuts in two key interest rates--the Federal Funds rate and the Federal Reserve's discount rate--began in December, 2000.

Banks maintain a certain level of "reserves" to satisfy Federal Reserve rules and provide a cushion against unanticipated customer withdrawals. On any given business day, some banks find themselves with more reserves than needed, while others discover their own reserve balances have dipped below their target levels. Those with too many reserves (the "sellers") may lend their excess reserves to banks that find themselves short (the "buyers") through a nationwide computer market operated by the Federal Reserve System. These loans are normally in units of $1,000,000 and mature the next business day. The interest rate on these overnight loans appears, at least on the surface, to be a free market one since the actual buyers and sellers establish the rate for each transaction. However, because the Federal Reserve may inject additional reserves into the system, thereby increasing the ranks of would-be sellers, or drain reserves, thus increasing the number of buyers, it effectively controls the market for Federal Funds and, through it, the Federal Funds rate.

Over the years, this Federal Funds rate has assumed greater policy significance as more and more free market rates on short maturity loans and deposits increasingly take their cue from it. Consequently, when the Federal Reserve wants to push down short-term market interest rates across the board, they simply inject additional reserves, which depresses the Federal Funds rate; other free market rates quickly follow. In December, 2000, Federal Funds were trading at 6.4%, but Greenspan's actions drove this down to 5.3% by March, 2001, and, by February, 2002, it had sunk to 1.7%--a 40-year low!

Cuts in the Federal Funds target rate were accompanied by a substantial jolt to the Federal Reserve's discount rate. The Board of Governors voted to cut this rate from six to five percent over the next two months. Subsequent votes brought the rate to a level not seen in 50 years--1.25%. The discount rate is the interest charged by regional Federal Reserve banks when they make short-term loans to fundamentally sound banks that are experiencing temporary liquidity problems. Partly because changes in the discount rate are infrequent, and partly because it is recognized as an official Federal Reserve policy weapon, such changes have a strong impact on the psychology of bankers and investors alike. An increase in the discount rate is the Fed's way of saying "There is too much lending activity going on and we're concerned the economy is in danger of overheating--we want to see less spending, and that means fewer bank loans."