Can Alan Save The Day Again?

These are times of shattered illusions. The attacks of Sept. 11 destroyed our sense of invulnerability, and now the mythology of the "New Economy" is receding before the reality of declining jobs and profits. To this list may soon be added the Federal Reserve's presumed power, which--during the reign of Alan Greenspan as Fed chairman--has grown to immense proportions in the popular imagination. People began thinking that the Fed had achieved what "fine tuning" (a concept discredited in the 1970s) had promised. By well-timed changes in interest rates, the Fed can steer the economy along a path of low inflation, high employment and rapid growth.

It is doubtful whether Greenspan ever bought this line. He has seen too many business cycles to harbor a false sense of control. But the success of his stewardship has inspired unrealistic expectations, even among economists, about the power of monetary policy--changes in interest rates and money supply orchestrated by the Fed and other government central banks. We may soon be disabused of this pleasing faith.

The Fed has cut interest rates nine times this year. The Fed funds rate has dropped from 6.5 percent in January to 2.5 percent, the lowest level since 1962. Yet the economy was still deteriorating even before Sept. 11. To state the obvious: even with the usual "lags," the Fed's cuts weren't powerful enough to offset the ill effects of faltering investment, employment and confidence.

Japan is exhibit A in the limits of monetary policy. In 1999 the Bank of Japan lowered its official interest rate to zero. It is still zero, though the BOJ temporarily raised it back to a whopping 0.25 percent (that's a quarter of 1 percent). All the while, Japan's economy sputtered. It is now in recession. Low interest rates are supposed to spur more lending and borrowing. But in Japan, total bank lending has declined for 45 consecutive months, reports The Japan Daily Digest. Some economists describe this situation as a "liquidity trap," a phrase coined by John Maynard Keynes. The academic jargon is a veil for ignorance. It evades the harder and more relevant question: why aren't there willing borrowers and lenders?

In Japan, government overregulation and bad banking practices have left devastating legacies. So much of the economy has been protected from competition by regulation, subsidies and cartels that it's hard for new companies and industries to get started. This shrinks the pool of potential borrowers. Meanwhile, Japan's banks still suffer from all the poor loans they made in the "bubble economy" of the late 1980s and early 1990s. Saddled with massive losses, they aren't eager to make new loans. Consumers aren't eager to borrow, either, because years of economic stagnation--now compounded by fears of joblessness--have fed their pessimism.

The point is that even zero interest rates can't reinvigorate the economy if other conditions are sufficiently unhealthy. Monetary policy is not some magical potion that can erase any disagreeable problem. What we call "the economy" is simply the baffling amalgam of businesses, financial markets, government regulations, cultural attitudes (toward, among other things, work and risk), popular moods and foreign trade. Monetary policy is only one part and influence. This is true in Japan and, no less, the United States.

Just because the Fed is lowering interest rates does not mean that businesses and consumers will borrow more. Although the U.S. economy is more flexible than Japan's, the Fed is still hostage to the aftereffects of the longest boom in American history. Reflecting a slowdown in "expansion plans," banks' commercial and industrial loans have dropped $27 billion in 2001, reports Kamalesh Rao of Moody's Investors Service. The story is similar for consumer borrowing. In 2001 it rose 9.3 percent, but since June it's stagnated. One reason is that monthly debt payments (including home mortgages) were near a record level. For now, lower interest rates may mostly help consumers and businesses pay down debts.

Moreover, the Fed's power over interest rates is, to put the matter charitably, loose. If you ask what the Fed does, the answer is underwhelming. It buys and sells U.S. Treasury securities on the open market. When it buys, it adds to the money supply. The funds it uses to pay for securities increase the reserves that banks can use to make loans. As a result, interest rates tend to drop. (When the Fed sells securities, it withdraws funds and interest rates tend to rise.) But through this process, the Fed directly sets only one market interest rate: the Fed funds rate. It's the rate on overnight loans, mainly among banks.

All other rates respond--haphazardly and inconsistently. On mortgages and bonds, the effect is small. In September 2000, conventional mortgage rates were roughly 8 percent; now they're a bit below 7 percent. Because mortgages and corporate bonds are long-term loans, their interest rates reflect investors' views of future inflation and risk. By contrast, some bank lending rates follow the Fed closely. This year banks' "prime rate" (which sets rates on many business loans) has dropped from 9.5 percent to 5.5 percent. But credit-card rates have hardly moved. Banks say this lending involves higher administrative costs.

In the wake of the terrorism, we've been told to be patient. This will take time, it's said. The same advice applies to the economy: recovery may take time. Although the Fed's actions also influence the economy through other channels (the stock market, housing prices, the dollar's exchange rate), these connections are even more inexact and unpredictable than the borrowing-lending channel. Over the past decade, all the gritty and inconvenient details have been lost in the adulation for Alan. The Fed is presumed to be able to avert almost any economic danger. This is, alas, an illusion.