[Congressional Record Volume 148, Number 103 (Thursday, July 25, 2002)]
[Extensions of Remarks]
[Pages E1399-E1400]
From the Congressional Record Online through the Government Publishing Office [www.gpo.gov]




                           MONETARY PRACTICES

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                             HON. RON PAUL

                                of texas

                    in the house of representatives

                        Thursday, July 25, 2002

  Mr. PAUL. Mr. Speaker, as the attached article (``A Classic Hayekian 
Hangover'') by economists Roger Garrison and Gene Callahan makes clear, 
much of the cause for our current economic uneasiness is to be found in 
the monetary expansion over most of the past decade. In short, 
expansion of the money supply as made possible by the policy of fiat 
currency, leads directly and inexorably to the kind of problems we have 
seen in the financial markets of late. Moreover, if we do not make the 
necessary policy changes, we will eventually see similar problems 
throughout the entire economy.
  As the authors point out, our ability to understand the linkage 
between inflated money supplies and subsequent economic downturns is 
owing to the ground breaking work of the legendary economists of the 
Austrian school. This Austrian Business Cycle (or ``ABC'') theory has 
long explained the inevitable downside that attends to a busting of the 
artificial bubble created by inflationary fiat monetary practices.
  In the current instance, the fact that there has been nearly a decade 
of significant increases in the seasonally adjusted money supply, as 
measured by MZM (as shown by the chart included with the article), 
serves as a direct explanation for the over capitalization and excess 
confidence which we have seen recently leaving financial markets. In 
short, as this article shows, the Austrian theory alone understands the 
causes for what has been termed ``irrational exuberance'' in the 
financial markets.
  Mr. Speaker, I wish to commend the authors of this fine article as 
well as to call it to the attention of my colleagues in hopes that we 
will not merely understand its implications but also that we find the 
courage to change monetary policy so that we will not see a repeat 
performance of this year's market volatility.

                      A Classic Hayekian Hangover

                 (By Roger Garrison and Gene Callahan)

       Are investment booms followed by busts like drinking binges 
     are followed by hangovers? Dubbing the idea ``The Hangover 
     Theory'' (Slate, 12/3/98), Paul Krugman has attempted to 
     denigrate the business-cycle theory introduced early last 
     century by Austrian economist Ludwig von Mises and developed 
     most notably by Nobelist F. A. Hayek.
       Yet, proponents of the Austrian theory have themselves 
     embraced this apt metaphor. And if investment is the 
     intoxicant, then the interest rate is the minimum drinking 
     age. Set the interest rate too low, and there is bound to be 
     trouble ahead.
       The metaphorical drinking age is set by--and periodically 
     changed by--the Federal Reserve. In our Fed-centric mixed 
     economy, the understanding that ``the Fed sets interest 
     rates'' has become widely accepted as a simple institutional 
     fact. But unlike an actual drinking age, which has an 
     inherent degree of arbitrariness about it, the interest rate 
     cannot simply be ``set'' by some extra-market authority. With 
     market forces in play, it has a life of its own.
       The interest rate is a price. It's the price that brings 
     into balance our eagerness to consume now and our willingness 
     to save and invest for the future. The more we save, the 
     lower the market rate. Our increased saving makes more 
     investment possible; the lower rate makes investments more 
     future oriented. In this way, the market balances current 
     consumption and economic growth.
       Price fixing foils the market. Government mandated ceilings 
     on apartment rental rates, for instance, create housing 
     shortages, as is well known by anyone who has gone apartment 
     hunting in New York City. Similarly, a legislated interest-
     rate ceiling would cause a credit shortage: The volume of 
     investment funds demanded would exceed people's actual 
     willingness to save.
       But the Fed can do more than simply impose a ceiling on 
     credit markets. Setting the interest rate below where the 
     market would have it is accomplished not by decree but by 
     increasing the money supply, temporarily masking the 
     discrepancy between supply and demand. This papering over of 
     the credit shortage hides a problem that would otherwise be 
     obvious, allowing it to fester beneath a binge of investment 
     spending.
       An artificially low rate of interest, then, sets the 
     economy off on an unsustainable growth path. During the boom, 
     investment spending is excessively long-term and overly 
     optimistic. Further, high levels of consumer spending draw 
     real resources away from the investment sector, increasing 
     the gap between the resources actually available and the 
     resources needed to see the long-term and speculative 
     investments through to completion.
       Save more, and we get a market process that plays itself 
     out as economic growth. Pump new money through credit 
     markets, and we get a market process of a very different 
     kind: It doesn't play itself out; it does itself in. The 
     investment binge is followed by a hangover. This is the 
     Austrian theory in a nutshell. (Ironically, it is the theory 
     that Alan Greenspan presented forty years ago when he 
     lectured for the Nathaniel Branden Institute.) We believe 
     that there is strong evidence that the United States is now 
     in the hangover phase of a classic Mises-Hayek business 
     cycle.
       In recent years money-supply figures have become clouded by 
     institutional and technological change. But in our view, a 
     tale-telling pattern is traced out by the MZM data reported 
     by the Federal Reserve Bank of St. Louis. ZM standing for 
     ``zero maturity,'' this monetary aggregate is a better 
     indicator of credit conditions than are the more narrowly 
     defined M's.
       After increasing at a rate of less than 2.5% during the 
     first three years of the Clinton administration, MZM 
     increased over the next three years of the Clinton 
     administration, MZM increased over the next three years 
     (1996-1998) at an annualized rate of over 10%, rising during 
     the last half of 1998 at a binge rate of almost 15%.
       Sean Corrigan, a principal in Capital Insight, a UK-based 
     financial consultancy, has recently detailed the consequences 
     of the expansion that came in ``. . . autumn 1998, when the 
     world economy, still racked by the problems of the Asian 
     credit bust over the preceding year, then had to cope with 
     the Russian default and the implosion of the mighty Long-Term 
     Capital Management.'' Corrigan goes on: ``Over the next 
     eighteen months, the Fed added $55 billion to its portfolio 
     of Treasuries and swelled repos held from $6.5 billion to $22 
     billion . . . [T]his translated into a combined money market 
     mutual fund and commercial bank asset increase of $870 
     billion to the market peak, of $1.2 trillion to the 
     industrial production peak, and of $1.8 trillion to date--
     twice the level of real GDP added in the same interval'' 
     (http://www.mises.org/fullarticle.asp?control=754).
       The party was in full swing, and the Fed kept the good 
     times rolling by cutting the fed funds rate a whole basis 
     point between June 1998 and January 1999. The rate on 30-year 
     Treasuries dropped from a high of over 7% to a low of 5%. 
     Stock markets soared. The NASDAQ composite went from just 
     over 1000 to over 5000 during the period, rising over 80% in 
     1999 alone. With abundant credit being freely served to 
     Internet start-ups, hordes of corporate managers, who had 
     seemed married to their stodgy blue-chip companies, suddenly 
     were romancing some sexy dot-com that had just joined the 
     party.
       Meanwhile consumer spending stayed strong--with very low 
     (sometimes negative) savings rates. Growth was not being 
     fueled by real investment, which would require forgoing 
     current consumption to save for the future, but by the 
     monetary printing press.
       As so often happens at bacchanalia, when the party entered 
     the wee hours, it became

[[Page E1400]]

     apparent that too many guys had planned on taking the same 
     girl home. There were too few resources available for all of 
     their plans to succeed. The most crucial--and most general--
     unavailable factor was a continuing flow of investment funds. 
     There also turned out to be shortages of programmers, network 
     engineers, technical managers, and other factors of 
     production. The rising prices of these factors exacerbated 
     the ill effects of the shortage of funds.
       The business plans for many of the startups involved 
     negative cash flows for the first 10 or 15 years, while they 
     ``built market share.'' To keep the atmosphere festive, they 
     needed the host to keep filling the punch bowl. But fears of 
     inflation led to Federal Reserve tightening in late 1999, 
     which helped bring MZM growth back into the single digits 
     (8.5% for the 1999-2000 period). As the punch bowl emptied, 
     the hangover--and the dot-com bloodbath--began. According to 
     research from Webmergers.com, at least 582 Internet companies 
     closed their doors between May 2000 and July of this year. 
     The plunge in share price of many of those still alive has 
     been gut wrenching. The NASDAQ retraced two years of gains in 
     a little over a year.
       During the first half of 2001, the Fed demonstrated--with 
     its half-dozen interest-rate cuts and a near-desperate MZM 
     growth of over 23%--that you can't recreate euphoria in the 
     midst of a hangover.
       It all adds up to the Austrian theory. As a final twist to 
     our story, we note that Krugman, who before could only mock 
     the Austrians, has recently given us an Austrian account of 
     our macroeconomic ills. In his ``Delusions of Prosperity'' 
     (New York Times, 8/14/01), Krugman explains how our current 
     difficulties go beyond those of a simple financial panic:
       ``We are not in the midst of a financial panic, and 
     recovery isn't simply a matter of restoring confidence. 
     Indeed, excessive confidence [fostered by unduly low interest 
     rates maintained by rapid monetary growth?--RG & GC] may be 
     part of the problem. Instead of being the victims of self-
     fulfilling pessimism, we may be suffering from self-defeating 
     optimism. The driving force behind the current slowdown is a 
     plunge in business investment. It now seems clear that over 
     the last few years businesses spent too much on equipment and 
     software and that they will be cautious about further 
     spending until their excess capacity has been worked off. And 
     the Fed cannot do much to change their minds, since equipment 
     spending [at least when such spending has already proved to 
     be excessive--RG & GC] is not particularly sensitive to 
     interest rates.''
       With Krugman on the verge of rediscovering the policy-
     induced self-reversing process that we call the Austrian 
     theory of the business cycle, we confidently claim that 
     current macroeconomic conditions are best described as a 
     classic Hayekian hangover. The Austrian theory, of course, 
     gives us no policy prescription for converting this ongoing 
     hangover into renewed euphoria. But it does provide us with 
     the best guide for avoiding future ones.

     

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