The Fed’s role in populism

The Federal Reserve Bank is the most powerful central bank in the world. It has a long history of successes and at times, failures in steering the U.S. economy through ups and downs. This is a story of how a well-intentioned policy has resulted in one of the worst disasters in American history.

After the stock market crash on Oct. 19, 1987, just two months after Alan Greenspan assumed the chairmanship of the Federal Reserve bank, he fired off a one-sentence statement before the start of trading on October 20th, “The Federal Reserve, consistent with its responsibilities as the nation’s central bank, affirmed today its readiness to serve as a source of liquidity to support the economic and financial system.” It was enough to turn markets around and kick off an economic expansion that lasted for ten years.

The Fed soon realized that it might be able to smooth out the bumps in the business cycle and the economy by using monetary policy. They tried and succeeded in doing so in the early 1990s to combat a credit crunch, a Russian default on government securities, and the overheating of the U.S. labor market in 1994. As a result, the decade was marked by generally declining inflation and the longest peacetime economic expansion in our nation’s history.

How exactly does the Fed work its magic? Think of monetary policy as a money spigot. When the Fed believes the economy is going to enter a slow patch, it turns on the money spigot. It turns the spigot off when it fears the economy is overheating, which could cause inflation. Simple, right?

It was a wonderful discovery. The government, through the Fed’s actions and its fiscal spending, could minimize unemployment and ensure price stability by controlling the money supply if the dollar maintained its status as the world’s preeminent currency.

However, money is distributed into the economy in a certain way — through the banking system in the form of lower interest rates. Interest rates are the cost of money when borrowed. The lower the rate, the cheaper the money. Banks offer loans to borrowers and these loans flow from the top down. Therein lies the problem.

Take a guess who gets to borrow the lion’s share of this easy money?

Corporations, of course, are followed by the wealthy who own them. The biggest, most profitable companies get to borrow the most at the lowest rates. The same top-down mentality pervades our fiscal policy efforts. Who, for example, will receive the $90 billion in new spending for Ukraine? It will be defense companies, arms suppliers, munition distributors, etc.

From the government’s and the Fed’s point of view, this is the most efficient means available to inject monetary stimulus into the economy. The Fed also realized that with their top-down efficient capital approach, monetary loosening was not by itself inflationary.

In this top-down situation, what happens to those who are at the bottom of the borrowing chain? Is this fair, and if so, how do they benefit?

Well, that is where Trickle-down Reaganomics is supposed to come in. Corporations and other wealthy borrowers, according to supply-side economists, would invest in new plants and equipment, which would bring new jobs and higher pay to the masses. Economists used the same arguments for tax cuts as well. It may have worked in the 1980s, although many have their doubts, but it didn’t work in the 1990s, or any time since then. Why?

Bill Schmick is a founding partner of Onota Partners Inc. in the Berkshires. None of his commentary is or should be considered investment advice. Email him at bill@-schmicksretiredinvestor.com.