Alan Greenspan isn't the "Maestro". He's Oz - working behind the curtains, leaning into the microphone, pressing buttons that blow smoke and fire, but not really having much power at all. Scarecrow already has a brain. For the past several years, commercial and industrial loans and consumer credit exploded quite simply because rabidly eager borrowers were able to find rabidly eager lenders. And now, both forms of credit (as well as commercial paper issuance) are declining because borrowers are saturated with debt and lenders are increasingly skittish of credit risk.
The Fed certainly played an important psychological role in recent years, and certainly has a role to play during bank runs and other crises where the demand for monetary base soars. But the rest of the time, open market operations are almost completely sterile. In recent years, the irrelevance of open market operations has also been argued (for slightly different reasons) by academic economists renown for their work in the theory of “rational expectations”, including Thomas Sargent and John Muth.
Inflation follows unproductive government spending
One might respond that even if the Fed doesn't affect credit, surely changes in the monetary base affect inflation. But if you look at the statistical evidence, the relationship between monetary growth and inflation is very weak. Instead, our research indicates that inflation is primarily the result of growth in unproductive forms of government spending (basically defense spending, entitlements and other expenditures that fail to stimulate the supply of goods). The evidence both from the U.S. and other countries clearly demonstrates this relationship.
As Milton Friedman has noted, the burden of government is not measured by how much it taxes, but by how much it spends . The impact is particularly severe when growth in entitlements is high and growth in productivity is low. This is why inflation exploded after the late 60's, and why it came down after the early 1980's. This is why the Germans suffered hyperinflation after World War I when its government decided to keep paying workers who had gone on strike.
Always and everywhere, rapid inflation is produced by excessive creation of government liabilities without a corresponding increase in the amount of goods produced by the economy. The Fed doesn't control this. It doesn't even matter much what form the liabilities take. If the Germans had decided to issue bonds to striking workers instead of money, bond prices would have been driven to ridiculously low levels, driving interest rates to extremely high levels, creating an unwillingness to hold non-interest bearing money, resulting in a rapid deterioration in the value of money, and hyperinflation just the same.
Except for the Federal Funds rate, the Fed does not determine short-term interest rates. Most of the time, it simply follows them. Statistically, the Federal Funds rate consistently lags market interest rates such as Treasury bill yields. Indeed, changes in market rates have far more predictive power to forecast the Federal Funds rate than vice versa.
The main exception is the Prime Rate. Changes in the Prime Rate follow changes in the Federal Funds rate largely because 1) competition forces equality of lending rates; 2) the Fed Funds rate tracks other short term rates, and; 3) changing Prime in unison at any other time than a discrete Fed move would be considered evidence of collusion among banks.
So don't place too much faith in the Federal Reserve. Again, in a banking panic, where the demand for the monetary base soars, the Fed is essential . But here and now, the Fed is, and probably will be, hopelessly ineffective.
In his recent testimony to Congress, Alan Greenspan described his job as difficult. In our view, he might as well have quoted Prime Minister Giovanni Giolitti. When asked in the early 1900's whether it was difficult to govern Italy, Giolitti replied, “Not at all, but it's useless.”
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