OUR GLOBAL FINANCIAL CRISIS OCCURRED BECAUSE “NO-ONE TOOK AWAY THE PUNCHBOWL“.

Fifty years ago, William McChesney Martin Jr. told us that the function of a central bank was “to take away the punchbowl just when the party is getting good”. Martin was the ninth (and, to this day, longest-serving) chairman of America’s central bank, the Federal Reserve System, being in office from 1951 to 1970 under no fewer than five presidents, starting with Harry S. Truman and Dwight D. Eisenhower.

In making this declaration of purpose, Martin was drawing attention to the existence of economic cycles. A cycle begins when the economy emerges from recession and culminates in a puff of inflationary smoke, just as the party is “getting good”. Martin wanted the central bank to leap into action towards the end of this period by raising interest rates, with the object of inducing a short, sharp recession to kill off the incipient inflation. Since electorates in general tend to punish any party-in-power which creates a recession, this approach brought him into conflict with his presidents. A future president, Richard Nixon, would blame Martin for causing him to lose to J.F Kennedy in the elections of 1960.

Martin had one great successor as Chairman of the Fed: Paul Volcker, who served from 1979 to 1987 — almost as long as Martin — and is credited with ending the great stagflation of the 1970s. (Stagflation, the most intractable form of inflation, occurs when prices rise at a time of economic decline or stagnation.) In the great Martin tradition, Volcker achieved his object by hiking the Federal Funds rate (the rate at which the System lends money to commercial banks, which determines the price of the funds they lend to their customers) from an average of 11.2% in 1979 to a peak of 20% in 1981. As a consequence, inflation fell from 13.5% in 1981 to 3.2% in 1983 and healthy economic growth could resume.

What is the relevance of all this for our current Global Financial Crisis (2007- )? The answer is that we are where we are today because, in the 1990s, Volcker’s successor, Alan Greenspan, reversed the course set by his two great predecessors. By that time, Greenspan was well aware that ‘the party was getting good’. He even talked about it, although he did not use the same expression, so far as I am aware; instead, he referred to the eruption of “irrational exuberance” in the marketplace. However, he did not attempt to take away the punch bowl; instead, he threw even more stimulants into it by lowering interest rates. The “party” swung wildly out of control, creating the biggest financial bubble in the history of the world.

Why did Greenspan not behave in the manner prescribed by Martin and Volcker, when they had encountered the same kinds of problem? Presumably because he recalled how the public had reacted to the Volcker measures. These had elicited the most widespread protests in the history of the Fed, owing to the effects of high interest rates on the construction and farming sectors, culminating in the blockading of the Fed’s headquarters in Washington by heavily indebted tractor-drivers. Greenspan has offered us a somewhat lame justification for his approach, arguing that it is easier to clear up the mess resulting from the bursting of a financial bubble, than it is to pursue policies which cause it to burst. As a proposition, this is demonstrably untrue and, in any case, it misses the point; Martin’s aim had been to prick bubbles before they became dangerous; Greenspan had been chairman of the Fed during the entire period when his was forming.

In 2005, when Volcker was asked about the state of the US economy under his successor’s rule, he replied that “circumstances seem to be as dangerous and intractable as any I can remember, and I can remember quite a lot. What really concerns me is that there should be so little willingness or capacity to do much about it”. When Greenspan’s bubble finally burst in 2008, as we all know, millions were thrown out of work throughout the world. Since 2009, the economic policy of the Obama administration has consisted of throwing yet more stimulants of an ever more problematic nature into the metaphorical punchbowl of national economic policy, hoping that, somehow, the recession will go away — or, if this is not possible, that it will not turn into an outright Depression in the manner of the 1930s. This approach is known in the lingo of Washington as “kicking the can down the road”, something that all of us tend to do when we are not sure what to do; we postpone the day of wrath.

America needs a second William McChesney Martin Jr. to reform the Fed and transform the American banking system. Should he be an economist by profession? Not necessarily; Martin majored in Latin and English at college. Economists focus too much on theory, although there are exceptions like Volcker. We need common sense plus a lot of practical experience. (This post also appears in today’s Weekly Zaman, a Turkish newspaper.)

William Hopper