The lessons of the US experience

Critique of Central Banking

By
Henry C K Liu

Part I:       Monetary theology
Part II:     The European Experience
Part III-a:   The US Experience
Part III-b:   More on the US experience
Part III-c: Still More on the US Experience

Part III-d: The lessons of the US experience

This article appeared in AToL on December 21, 2002

Hyper-inflation is destructive to the economy generally but it hurts wage earners more because of wage stickiness and inelasticity, causing wages to fall constantly behind the hyper-inflation rate. Hyper-inflation keeps prices rising so fast that it tends to reduce the volume of business transactions and to restrain economic activities. Hyper-inflation has brought down many government throughout history, and thus monetary-policy makers have developed a special sensitivity toward it. For private business, loss of sales under hyper-inflation can sometimes be temporarily compensated by inventory appreciation if the interest rate is below the inflation rate, but under such conditions credit to finance inventory would soon dry up.

Moderate inflation benefits both the rich and the poor, though not equally, because it not only keeps asset prices rising, of which the rich own more, it also equalizes wealth distribution, making the rich less privileged. Moderate inflation enables the middle class to raise its standard of living faster through borrowing that can be paid back with depreciated dollars, as most homeowners in the United States have done in recent decades. Lenders would continue to lend under moderate inflation even if real interest rates yield a narrower or even a slightly negative spread over the inflation rate, because idle money would suffer more loss under moderate inflation and because moderate inflation reduces the default rate, thus making even a narrow spread between interest rate and inflation rate profitable to lenders. Moderate inflation also stimulates growth, which means a larger economic pie for all even if the slice of the pie for lenders may be smaller. Moderate inflation negates the fatalistic American folklore that the rich get richer and the poor get poorer, and enables the American dream of social and economic mobility.

Deflation increases the purchasing power of money, but it puts upward pressure on unemployment and downward pressure on aggregate income. Thus, given a choice between deflation and hyper-inflation, owners of real assets tend to prefer hyper-inflation, under which wage earners are forced to into lower real wages after inflation. Policy makers always hope that hyper-inflation can be brought back under control within a short period of crisis management, before political damage sets in. Central banks in desperate times would look to hyper-inflation to "provide what essentially amounts to catastrophic financial insurance coverage," as US Federal Reserve Board chairman Alan Greenspan suggested in a November 19 address on International Financial Risk Management to the Council on Foreign Relations (CFR) in Washington.

Over the past two and a half years, since February 2000, the draining impact of a loss of US$8 trillion of stock-market wealth (80 percent of gross domestic product, or GDP), and of the financial losses associated with September 11, 2001, has had a highly destabilizing effect on the aggregate debt-equity ratio in the US financial system, and has pushed the ratio below levels conventionally required for sound finance. Total debt in the US economy now runs to $32 trillion, of which $22 trillion is private-sector debt. This private debt now is backed by $8 trillion less in equity, an amount in excess of one-third of the debt. Greenspan attributed the system's ability to sustain such a sudden rise of debt-to-equity ratio to debt securitization and the hedging effect of financial derivatives, which transfer risk throughout the entire system. "Obviously, this market is still too new to have been tested in a widespread down-cycle for credit," Greenspan allowed.

In recent years, the rapidly growing use of more complex and less transparent instruments such as credit-default swaps, collateralized debt obligations, and credit-linked notes has had a net effect of transferring individual risks to systemic risk. Greenspan acknowledged that derivatives, by construction, are highly leveraged, a condition that is both a large benefit and an Achilles' heel. It appears that the benefit has been reaped in the past decade, leading to a wishful declaration of the end of the business cycle. Now we are faced with the Achilles' heel: "the possibility of a chain reaction, a cascading sequence of defaults that will culminate in financial implosion if it proceeds unchecked. Only a central bank, with its unlimited power to create money, can with a high probability thwart such a process before it becomes destructive. Hence, central banks have, of necessity, been drawn into becoming lenders of last resort," explained Greenspan.

Greenspan asserted that such "catastrophic financial insurance coverage" should be reserved for only the rarest of occasions to avoid moral hazard. He observed correctly that in competitive financial markets, the greater the leverage, the higher must be the rate of return on the invested capital before adjustment for higher risk. Yet there is no evidence that higher risk in financial manipulation leads to higher return for investment in the real economy, as recent defaults by Enron, Global Crossing, WorldCom, Tyco, Conseco and sovereign Argentine credits have shown. Higher risks in finance engineering merely provided higher returns from speculation temporarily, until the day of reckoning, at which point the high returns can suddenly turn in equally high losses.

The individual management of risk, however sophisticated, does not eliminate risk in the system. It merely passes on the risk to other parties for a fee. In any risk play, the winners must match the losers by definition. The fact that a systemic payment-default catastrophe has not yet surfaced only means that the probability of its occurrence will increase with every passing day. It is an iron law understood by every risk manager. By socializing their risks and privatizing their speculative profits, risk speculators hold hostage the general public, whose welfare the Fed now uses as a pretext to justify printing money to perpetuate these speculators' joyride. What kind of logic supports the Fed's acceptance of a natural rate of unemployment to combat inflation while it prints money without reserve to bail out private speculators to fight deflation created by a speculative crash?

It has been forgotten by many that before 1913, there was no central bank in the United States to bail out troubled commercial or investment banks or to keep inflation in check by trading employment for price stability. The House of Morgan then held the power of deciding which banks should survive and which ones should fail and, by extension, deciding which sector of the economy should prosper and which should shrink. At least the House of Morgan used private money for its predatory schemes of controlling the money supply for its own narrow benefit. The issue of centralized private banking was part of the Sectional Conflict of the 1800s between America's industrial North and the agricultural South that eventually led to the Civil War. The South opposed a centralized private banking system that would be controlled by Northeastern financial interests, protective tariffs to help struggling Northeast industries and federal aid to transportation development for opening up the Midwest and the West for investment intermediated through Northeastern money trusts.

Money, classical economics' view of it notwithstanding, is not neutral. Money is a political issue. It is a matter of deliberate choice made by the state. The supply of money and its cost, as well as the allocation of credit, have direct social implications. Policies on money reward or punish different segments of the population, stimulate or restrain different economic sectors and activities. They affect the distribution of political power. Democracy itself depends on a populist money policy.

The concept of a Federal Reserve System was first championed by Populists, who were ordinary citizens, rather than sophisticated economists or captured politicians or powerful bankers. In 1887, a group of desperate farmers in Lampasas county, Texas, formed the Knights of Reliance to resist impending ruin by "more speedily educating themselves" about the day when "all the balance of labor's products become concentrated into the hands of a few". It became the Farmers Alliance, which by 1890 had flowered into the Populist Movement. The Populist agenda was a major reform platform for more than five decades, giving the nation a progressive income tax, federal regulation of railroads, communications and other public utilities, anti-trust regimes, price stabilization and credit programs for farmers. Lyndon B Johnson was the last president with strong populist roots but tragically his populist domestic vision of the Great Society was torpedoed by the Vietnam quagmire.

The core issue behind the Populist Movement was money. Populists attacked the "money trusts", the gold standard, and the private centralized banking system. The spirit of this brief movement was captured by Lawrence Goodwyn in his book Democratic Promise: The Populist Movement in America. Falling prices of farm produce were the catalyst of protest. Falling prices were also inevitably accompanied by usurious interest rates. Both flowed from one condition: a scarcity of money. Most Americans today do not remember what historians call the Great Deflation that lasted three decades between 1866 and 1896. The Great Deflation worked in reverse of inflation. Inflation puts the rich at a disadvantage and spreads wealth more widely, allowing the middle class to grow and to enjoy higher standards of living. Deflation reconcentrates wealth and reduces the living standard of the middle and working classes. Borrowers face ballooning nominal debts from falling prices and wages.

Fernand Braudel (1902-1985) in his epic chronicle of the rise of capitalism showed that cycles of price inflation and deflation were recurring rhythms in the world's economies long before the founding of the United States. The very discovery of America was a great inflationary development by the increase of money supply in Europe through the plundering of Inca gold mines. Gold inflation lasted three centuries and was instrumental to the rise of Europe.

The US Federal Reserve System was founded in 1913 presumably to represent the financial interest of all Americans. In its obsessive phobia of inflation, the Fed has betrayed its original mandate. The chairman of the Fed in a true democracy should be a member of the common folks, supported by a technically competent but ideologically neutral staff, not a Wall Street economist who applauds "creative destruction" as a preferred path for growth. Greenspan himself allowed the view of an European leader in his November address: "What is the market? It is the law of the jungle, the law of nature. And what is civilization? It is the struggle against nature."

The creation of the Federal Reserve System was the result of a confluence of political pressures. Fundamental among these pressure was the new awareness, as Braudel hinted, of a heretical proposition that capitalism cannot sustain price stability through market forces. That proposition may not be valid, but centuries of experimentation and innovation have yet to devise a monetary system that can provide permanent market price stability. It was increasingly recognized that the process of capital accumulation inherently produces periodic cycles of fluctuating money value: inflationary "easy money" stimulating economic growth, spreading wealth from the top down, followed by its depressant opposite "tight money" slowing down growth, reconcentrating wealth. Just as there is a business cycle in a market economy, there is a monetary cycle in a capitalistic system.

This peculiar nature of capitalism was allowed to work untamed until the arrival of political democracy. Any government adopting any money system that makes stable money a permanent feature would eventually confront political upheaval. There were no golden means of money value where all economic participants could be treated equally and justly. Technically, the rules of capitalism decree that money that is fixed in perpetual equilibrium is a formula for permanent stagnation.

The tight money in the United States at the beginning of the 20th century was caused by the restoration of the full gold standard (the Gold Standard Act of 1900) from the bimetallism that had been used in the US through much of the 19th century. Bimetallism had the fault of "bad money driving out good" as stated in Gresham's Law, named after Sir Thomas Gresham (1619-79), although it was controversial as to whether he in fact formulated the concept. The law states that the metal that is commercially valued at less than its face value tends to be used as money, and the metal that is commercially valued at more than its face value tends to be used as metal, and thus is withdrawn from circulation as money. It is an indirect confirmation of the validity of fiat money, as all commodities with intrinsic value would not be used as money given the option.

Permanent tight money means permanent high interest rates. And the money supply based on the gold standard after 1900 was inflexible for meeting the fluctuating demands of the economy. The resultant illiquidity rendered the financial system inoperative. The liquidity squeeze typically started in the South and the West when farmers brought their crops to market and traders and merchants needed short-term loans to finance a seasonal ballooning of trade. Rural banks were forced to turn to New York for additional funds. Country bankers and their farm clients learned from experience that life-or-death decisions over the economies of Kansas, Texas and Tennessee resided in the Wall Street offices of the likes of J P Morgan. Thus the term "money trusts" was no radical sloganeering or activist hysteria. It was a very mainstream term that everyone in the West and the South understood in the 1900s.

The Populists first proposed a solution to the money question in August 1886 at Cleburne, Texas, where the Farmers Alliance held a convention. The "Cleburne Demand" borrowed from the Greenback Party, which in the previous decade had fought against the gold standard and defended president Abraham Lincoln's fiat money, known as greenbacks, backed not by gold but by government credit, on which the North won the Civil War. Among the "radical" demands were federal regulation of the private banking system and a national fiat currency not retrained by gold.

The Populists distrusted both Wall Street and Washington and wanted an independent institution to carry out this task. They were openly inflationist, and advocated an expanding money supply to serve the growing economy and a federal issue to replace all private banknotes. Their slogan, "legal tender for all debts, public and private", appears today on Federal Reserve notes. Orthodox economists of the day scoffed at the proposals. A return to a populist monetary policy today would be a very constructive alternative to Greenspan's distortion of Schumpeterean creative destructionism.

The Fed has always considered it its sacred duty only to fight inflation. Still, there was a time it forced on the economy the pains of fighting inflation only after inflation had appeared, as then chairman Paul Volcker did in the early 1980s. But the Greenspan Fed in the late 1990s was shadow-boxing phantom inflation based on a theoretical anticipation of inflation from the wealth effect of an equity-market bubble that was at least producing a benefit of having unemployment trending below the so-called natural rate. The Greenspan bubble was actually accompanied by pockets of deflation, most visibly in the manufacturing and commodity sectors, mostly caused by excess investment that led to global overcapacity that fed low-priced imports to the US economy. Deflation has practically destroyed the farming and several other commodity and basic-material sectors in the past decade, including steel. It has eliminated much of US manufacturing. The deflation that faced selected sectors of the US economy in the past decade had not been market-induced as much as it was policy-determined. The Fed's fixation on driving inflation lower, regardless of economic consequences, has caused untold damage to the economy and forced its restructuring toward an unsustainable debt bubble.

It is an economic truism that low inflation for a large, complex economy can only be achieved by driving certain sectors into deflationary levels. Businesses in these unfortunate sectors are held in a state of protracted if not perpetual loss to face bankruptcy and liquidation. This detachment of profit from real production and the dubious linkage of profit to financial speculation and manipulation Greenspan accepts happily as Schumpeterean "creative destruction" (from economist Joseph A Schumpeter, 1883-1950). Pockets of deflation and bankruptcy are integral parts of systemwide disinflation that inevitably produces losers who allegedly made wrong business bets. It turned out that these wrong bets were not against market forces as much as they were against Fed policy bias. The stable value of money is to be maintained at all cost, except for speculative growth, which is translated to mean ever-rising share prices. Rising share prices, unlike rising wages, are not viewed by the Fed as inflation, a rationale hard to understand.

But the negatives of selective deflation are considered by the Fed as secondary and acceptable systemwide. These losses at various deflationary phases have included the farmer belt, the oil patch, the timber industry, the mining sector, steel, the manufacturing sector, transportation, communication, high technology and even defense. In 1984-85, deflation had became a fundamental disorder in the economy. Income loss and shrinking collateral squeezed debtors in deflationary sectors facing fixed nominal levels of debt that required appreciated dollars to repay. Raw-material prices fell by 40 percent from their peaks in 1980. It was a repeat of the 1920s' selective economic damage. Overall prices throughout the 1980s as reflected by the Consumer Price Index (CPI) remained around 3 percent and the economy expanded moderately and continuously. What actually happened was a structural shift of wealth distribution toward polarization of rich and poor. A split-level economy was instituted by government policy, between the favored and the dispensable. In the 1880s and again the 1890s, similar developments produced political agrarian revolts that historians call American Populism.

In 1830, there were only 32 miles (51 kilometers) of railroads in the United States. By 1860, at the start of the Civil War, there were more than 30,000 miles. The three decades after the Civil War was called the Railroad Age by historians, a period that saw a fivefold increase in rail mileage. The rail sector dominated the investment market and was the chief source of new wealth and baronial fortunes. The Age of Robber Barons, represented by the likes of Cornelius Vanderbilt (railroads), Andrew Carnegie (steel), John D Rockefeller (oil) and Morgan (finance), with the birth of big monopolistic corporations and interlocking holding companies, was inseparable from railroad expansion.

The private railroads received free public land in amounts larger than the size of Texas. The scandalous Credit Mobilier, which built the Union Pacific, paid a dividend of 348 percent in one year to watered-down shares given to corrupt members of Congress and state officials, a hundred times that of convention, even after having billed the company double for runaway construction cost. The price-fixing and selective price-gouging, government corruption, stock and business fraud, cost-padding, stock-watering and manipulation such as insider trading and sweetheart loans of the Railroad Age made the so-called crony capitalism of which the United States now accuses a developing Asia looks like child's play.

Notwithstanding the disingenuous neo-liberal claim that the Asian financial crises of 1997 that devastated the economies in the region were the inevitable result of Asian crony capitalism, and not of unregulated market fundamentalism, the scandalous railroad boom of the 1860s in the United States did not hurt the US economy. Far from it, it heralded in the age of finance capitalism. The difference was that in the 1860s, the US opposed free trade and adopted high protective tariffs, government support of industrial policy and infrastructure development and national banking. But most important of all, the US of the 1860s was not victimized by the tyranny of a foreign-currency hegemony, as Asia is today by dollar hegemony. Just as pimples are the symptoms of hormone imbalance and not the cause, corruption is often the symptom of fast growth.

The point here is not to apologize for corruption but to point out that corruption is part and partial of finance capitalism, as the savings and loan (S&L) crisis, the Milken junk-bond scandal and Enrontitis of recent times continue to show clearly. The real culprit was not corruption but deregulation. The Telecommunications Act of 1996, for example, which aimed to create competitive markets for voice, data and broadband services, unleashed a flood of investment in wireless licenses, fiber-optic cable networks, satellites, computer switches and Internet sites, and accounted for much of the new capital that poured into the economy through Wall Street's equity and credit markets. The same was true in the energy sector. But the biggest culprit was financial deregulation.

The deregulation program under the administration of president Ronald Reagan phased out federal requirements that set maximum interest rates on savings accounts. This eliminated the advantage previously held by savings banks in financing home ownership. Checking accounts that paid interest could now be offered by savings banks. All depository institutions could now borrow from the Fed in time of need, a privilege that had been reserved for commercial banks. In return, all banks had to place a certain percentage of their deposits at the Fed. This gave the Fed more control over state chartered banks, but diluted the Fed's control of the credit market. The Garn-St Germain Act of 1982 allowed savings banks to issue credit cards, make non-residential real-estate loans and commercial loans - actions previously only allowed to commercial banks.

Deregulation practically eliminated the distinction between commercial and savings banks. It caused a rapid growth of savings banks and S&Ls that now made all types of non-homeowner-related loans. S&Ls could then tap into the huge profit centers of commercial-real-estate investments and credit-card issuing and unsavory entrepreneurs looked to the loosely regulated S&Ls as a no-holds-barred profit center.

As the 1980s wore on, the US economy appeared to grow. Interest rates continued to go up as well as real-estate speculation. The real-estate market was in a bubble boom. Many S&Ls took advantage of the lack of supervision and regulations to make highly speculative investments, in many cases lending more money then the value of the projects, in anticipation of still-rising prices. When the real-estate market crashed dramatically, the S&Ls were crushed. They now owned properties that they had paid enormous amounts of money for but weren't worth a fraction of what they paid. Many went bankrupt, losing their depositors' money. In 1980, the US had 4,600 thrifts; by 1988, mergers and bankruptcies left 3,000. By the mid-1990s, fewer than 2,000 survived. The S&L crisis cost US taxpayers $600 billion in "bailouts". The indirect cost was estimated to be $1.4 trillion.

Money supply is a complex issue and at this moment in history it is a term of considerable chaotic meaning. The official definition by the Federal Reserve of M1, 2 and 3 is clear (see note 1), but its usefulness even to the Fed is as limited as it is clear. Greenspan, at the 15th Anniversary Conference of the Center for Economic Policy Research at Stanford University on September 5, 1997, with Milton Friedman in the audience, in defense of the accusation that Fed policy failed to anticipate the emerging inflation of the 1970s and, by fostering excessive monetary creation, contributed to the inflationary upsurge, and the claim that some monetary-policy rules, such as the Taylor rule, however imperfect, would have delivered far superior performance, admitted that the Fed's (indeed economics') knowledge of the full workings of the system is quite limited, so that attempts to improve on the results of policy rules will, on average, only make matters worse. Greenspan observed that the monetary policy of the Fed has involved varying degrees of rule-based and discretionary-based modes of operation over time. Very often historical regularities have been disrupted by unanticipated change, especially in technologies, both hard and soft. The evolving patterns mean that the performance of the economy under any rule, were it to be rigorously followed, would deviate from expectations. Such changes mean that we can never construct a completely general model of the economy, invariant through time, on which to base our policy, Greenspan asserted. It was an apology for muddling through.

Greenspan admitted that in the late 1970s, the Fed's actions to deal with developing inflationary instabilities were shaped in part by the reality portrayed by Friedman's analysis that ever-rising inflation rate peaks, as well as ever-rising inflation rate troughs, followed on the heels of similar patterns of average money growth. The Fed, in response to such evaluations, acted aggressively under the then newly installed chairman Paul Volcker. A considerable tightening of the average stance of policy, based on intermediate M1 targets tied to reserve operating objectives, eventually reversed the surge in inflation. Greenspan was careful not to draw attention to the high cost of the reversal.

The 15 years before the Asian financial crises that began in 1997 had been a period of consolidating the gains of the early 1980s and extending them to their logical end, ie, the achievement of price stability. Although the ultimate goals of monetary policy have remained the same over the past 15 years, the techniques used by the Fed in formulating and implementing policy have changed considerably as a consequence of vast changes in technology and regulation. The early Volcker years focused on M1, and following operating procedures that imparted a considerable degree of automaticity to short-term interest-rate movements, resulting in wide interest-rate volatility.

But after nationwide NOW (negotiable order of withdrawal) interest-bearing checking accounts were introduced, the demand for M1, in the judgment of the Federal Open Markets Committee (FOMC), became too interest-sensitive for that aggregate to be useful in implementing policy. Because the velocity of such an aggregate varies substantially in response to small changes in interest rates, target ranges for M1 growth, in the FOMC's judgment, no longer were reliable guides for outcomes in nominal spending and inflation. In response to an unanticipated movement in spending and hence the quantity of money demanded, a small variation in interest rates would be sufficient to bring money back to path but not to correct the deviation in spending.

As a consequence, by late 1982, M1 was de-emphasized and policy decisions per force became more discretionary. However, in recognition of the longer-run relationship of prices and M2, especially its stable long-term velocity, this broader aggregate was accorded more weight, along with a variety of other indicators, in setting the Fed policy stance.

By the early 1990s, the usefulness of M2 was undercut by the increased attractiveness and availability of alternative outlets for saving, such as bond and stock mutual funds, and by mounting financial difficulties for depositories and depositors that led to a restructuring of business and household balance sheets. The apparent result was a significant rise in the velocity of M2, which was especially unusual given continuing declines in short-term market interest rates. By 1993, this extraordinary velocity behavior had become so pronounced that the Fed was forced to begin disregarding the signals M2 was sending.

Greenspan recognized that, in fixing on the short-term rate, the Fed lost much of the information on the balance of money supply and demand that changing market rates afforded, but for the moment the Fed saw no alternative. In the current state of knowledge, money demand has become too difficult to predict. In the United States, evaluating the effects on the economy of shifts in balance sheets and variations in asset prices have been an integral part of the development of monetary policy.

In recent years, for example, the Fed expended considerable effort to understand the implications of changes in household balance sheets in the form of high and rising consumer debt burdens and increases in market wealth from the run-up in the stock market. And the equity market itself has been the subject of analysis as the Fed attempted to assess the implications for financial and economic stability of the extraordinary rise in equity prices, a rise based apparently on continuing upward revisions in estimates of US corporations' already robust long-term earning prospects. But, unless they are moving together, prices of assets and of goods and services could not both be an objective of a particular monetary policy, which, after all, has one effective instrument: the short-term interest rate. The Fed chose product prices as its primary focus on the grounds that stability in the average level of these prices was likely to be consistent with financial stability as well as maximum sustainable growth. History, however, is somewhat ambiguous on the issue of whether central banks can safely ignore asset markets, except as they affect product prices. Greenspan discovered that he had been very wrong about the "robust" long-term earning prospects of US corporations by 2000.

Greenspan also admitted that over the coming decades, moreover, what constitutes product price and, hence, price stability will itself become harder to measure. In the years 1997 through 2000, M3 increased by about 460, 600, 500 and 600 billions per year, respectively. In 2001 M3 expanded much more rapidly - by about $1.1 trillion - to a total of about $8 trillion. The surge in the money supply since the attacks on September 11, 2001, was equal to about $300 billion, which significantly represents about 3.0 percent of GDP, this after the Fed injected $1 trillion into the banking system in the days following the terrorist attacks in New York and on the Pentagon. Since the beginning of 2000, $8 trillion of stock market wealth has vanished, that is 80 percent of annual GDP, or the entire M3 in 2001. Another way to look at these figures is that the entire face value of the US money supply has vanished through market correction.

Market participants look at money supply differently. To M1, 2 and 3, they add L, which is M3 plus all other liquid assets, such as Treasury bills, saving bonds, commercial paper, bankers' acceptances, non-bank eurodollar holdings of non-US residents and, since the 1990s, derivatives and swaps, generally coming under the heading of structured finance instruments. The term MZM (money with zero maturity) came into general use. The Fed has poor, if any, information on L and it does not seem to want to know as it persistently declines to support its regulation or reporting on it. Over-the-counter (OTC) derivatives now are estimated to involve notional values of more than $150 trillion. No one knows the precise amount.

The Office of Controller of Currency (OCC) quarterly report on bank derivatives activities and trading revenues is based on call-report information provided by US commercial banks. The notional amount of derivatives in insured commercial bank portfolios increased by $3.1 trillion in the third quarter of 2002, to $53.2 trillion. Generally, changes in notional volumes are reasonable reflections of business activity but do not provide useful measures of risk. During the third quarter, the notional amount of interest-rate contracts increased by $3 trillion, to $45.7 trillion. Foreign-exchange contracts increased by $27 billion to $5.8 trillion. The number of commercial banks holding derivatives increased by 17, to 408. Eighty-six percent of the notional amount of derivative positions was composed of interest-rate contracts, with foreign exchange accounting for an additional 11 percent. Equity, commodity and credit derivatives accounted for only 3 percent of the total notional amount.

Holdings of derivatives continue to be concentrated in the largest banks. Seven commercial banks account for almost 96 percent of the total notional amount of derivatives in the commercial banking system, with more than 99 percent held by the top 25 banks. OTC and exchange-traded contracts comprised 87.9 percent and 12.1 percent, respectively, of the notional holdings as of the third quarter of 2002.

The notional amount is a reference amount from which contractual payments will be derived, but it is generally not an amount at risk. The risk in a derivative contract is a function of a number of variables, such as whether counterparties exchange notional principal, the volatility of the currencies or interest rates used as the basis for determining contract payments, the maturity and liquidity of contracts, and the creditworthiness of the counterparties in the transaction. Further, the degree of increase or decrease in risk-taking must be considered in the context of a bank's aggregate trading positions as well as its asset and liability structure. Data describing fair values and credit risk exposures are more useful for analyzing point-in-time risk exposure, while data on trading revenues and contractual maturities provide more meaningful information on trends in risk exposure.

Monetary economists have no idea if notional values are part of the money supply and with what discount ratio. As we now know, creative accounting has legally transformed debt proceeds as revenue. With the telecoms, the Indefeasible Right of Use (IRU) contracts, or capacity swaps, were perfectly legal means to inflate revenue. The now disgraced and defunct Andersen White Paper in 2000, well known in telecom financial circles, defined IRU swaps between telecom carriers by accounting each sale as revenue and each purchase of a capital expense which is exempted from operating results emphasized by Wall Street analysts and investors. While common sense would see this as inflation of revenue by hiding underlying true cost, Andersen argued that these capacity exchanges are not barter agreements, but are sales of operating leases and purchases of capital leases. Thus by creative accounting logic, swaps are not acquisition of "equivalent interests" because risks and rewards of buying a capital lease are greater than those of an operating lease. Since operating leases are not similar assets as capital leases, there is logic in booking revenues over the life of a contract when they are fully paid at closing. It can also be argued that such accounting logic on the operating leases misleadingly strengthens the value of the capital assets. Which was exactly what happened.

GE Capital on March 13, 2002, launched a multi-tranche dollar bond deal that was almost doubled in size from $6 billion to $11 billion, making it the largest-ever dollar-denominated corporate bond issue. Officially the bond sale was explained as following the current trend of companies with large borrowing needs, such as GE Capital, locking in favorable funding costs while interest rates are low. On March 18, Bloomberg reported that GE Capital was bowing to demands from Moody's Investors Service that the biggest seller of commercial paper should reduce its reliance on short-term debt securities. The financing arm of General Electric, then the world's largest company, sought bigger lending commitments from banks and replacing some of its $100 billion in debt that would mature in less than nine months with bonds. GE Capital asked its banks to raise its borrowing capacity to $50 billion from $33 billion.

Moody's, one of two credit-rating companies that have assigned GE Capital the highest "AAA" grade, has been increasing pressure on even top-rated firms to reduce short-term liabilities since Enron filed the biggest US bankruptcy to that date in December. Moody's released reports analyzing the ability of 300 companies to raise money should they be shut out of the commercial paper market. GE Capital and H J Heinz Co said they responded to inquiries by Moody's by reducing their short-term debt, unsecured obligations used for day-to-day financing. Concerns about the availability of such funds have grown this year after Qwest Communications International Inc, Sprint Corp and Tyco International Ltd were suddenly unable to sell commercial paper.

Moody's lowered a record 93 commercial paper ratings last year as the economy slowed, causing corporate defaults to increase to their highest in a decade. One area of concern for the analysts is the amount of bank credit available to repay commercial paper. While many companies have credit lines equivalent to the amount of commercial paper they sell, some of the biggest issuers do not. GE Capital, for example, has loan commitments backing 33 percent of its short-term debt. American Express has commitments that cover 56 percent of its commercial paper. Coca-Cola supports about 85 percent of its debt with bank agreements, according to Standard & Poor's, the largest credit-rating company, which said it is also focusing more attention on risks posed by short-term liabilities, though it hasn't yet decided whether to issue separate reports.

Companies have sold $107 billion of investment-grade bonds in the first half of this year, up from $88 billion during the same period in 2001. The amount of unsecured commercial paper outstanding has fallen by a third to $672 billion during the past 12 months. GE Capital, which has reduced its commercial paper outstanding from $117 billion at the beginning of the year, plans to continue to reduce short-term debt. It took one step in that direction last week when it sold $11 billion of long-term bonds, some of which will be used to reduce its outstanding commercial paper. As part of the sale, GE Capital sold 30-year bonds with a coupon of 6.75 percent. The company usually swaps some or all of those fixed-rate payments for floating-rate obligations. Last year, GE Capital paid on average 3.23 percent for its floating-rate, long-term debt, 70 basis points more than on its commercial paper, according to a company filing.

The bottom line of all this is that the funding cost of GE Capital will go up, which will hit GE Capital profit, which constitutes 60 percent of its parent's profit. This in turn will hit GE share prices, which in turn will force rating agencies to pressure GE further to shift from low-cost commercial papers to bonds or bank loans, which will further reduce profit, which will further increase rating pressure, and so on. PIMCO (Pacific Investment Management Co), the world's largest bond fund, having dumped $1 billion in GE commercial paper from its holdings, publicly criticized GE for carrying too much debt and not dealing honestly with investors. GE announced it might sell as much as $50 billion in bonds only days after investors bought $11 billion of new bonds in the biggest US sale in history. PIMCO director Bill Gross disputed GE's contention that the new bond sales were designed not to capture low rates, but because of troubles in its commercial paper market. If the GE short-term rate rises because of a poor credit rating, the engine that drives GE earnings will stall. Gross dismissed GE earning growth as not being from brilliant management, former GE chairman Jack Welch's self-aggrandizing books not withstanding, but from financial manipulation, selling debt at cheap rates and using inflated GE stocks for acquisition. GE had $127 billion in commercial paper as of March 11, 2002, according to Moody's. This amounts to 49 percent of its total debt. Banks' credit line only covers one-third of the short-term exposure.

The erosion of market capitalization value does impact money supply. Asset valuation is the collateral for debt. As asset value falls, credit ratings fall, which affect interest costs, which affect profits, which affect asset value. Moreover, a major counterparty default in structured finance will render the Fed helpless in keeping the money supply from sudden contraction, unless the Fed is prepared to depart from its traditional practice of relying solely on interest-rate policy to effectuate monetary ease, a move Greenspan apparently has served notice he is prepared to make.

The logic of fighting inflation by raising interest rates is mere conventional wisdom. Furthermore, interest-rate policy is merely a single instrument that cannot possibly be relied upon to play the complexity of a symphony like the economy. The debate on whether a high interest rate is inflationary or deflationary seems to be a puzzling controversy in economics. Within the current international financial architecture, interest rates cannot be fully understood without taking into account their impact on exchange rates and credit markets. Nor can inflation be understood in isolation.

In a globalized financial market, if the exchange rate is artificially sustained by high interest rates, there is little doubt that the impact would be deflationary on the local economy. This logic is also supported by empirical data in recent years. Yet many astute economists insist that a high interest rate causes inflation, at least in the long run. Perhaps this can be true in closed economies, but it is no longer necessarily true in open economies in a globalized financial market.

Interest rates are the prices for the use of money over time. These prices do not always track the purchasing power of money, which is the monetized expression of the market value of commodities (the transaction price) at a specific time. The purchasing power of money fluctuates over time, expressed by the prices of futures and options, which are functions of the uncertain elasticity between interest rates and inflation rates.

As the price for the use of money over time rises, the general effect will be deflationary if money is viewed as a constant store of value. Otherwise, money will forfeit its function as a constant store of value. On the other hand, if money is viewed as a medium of exchange, the ultimate liquidity agent, then rising price for its use over time is inflationary as a cost.

Now, in any economy, money tends to play both roles, though not equally and not consistently over time. For market participants, depending on their positions (borrower or lender) at specific points of the economic cycle (expanding or contracting liquidity), they will find different views of money (exchange medium or value storer) to be to their financial advantage. Thus borrowers generally consider a high interest rate as leading to cost inflation (bad), and lenders consider a high interest rate as leading to asset deflation (good up to a point). Asset deflation offers good buying opportunities for those who have money or have access to credit, but bad for those who hold assets but need money, and the pain is proportional to asset illiquidity. Since most holders of ready cash also hold assets, deflation has only a limited and short-term advantage for them. For inflation to be advantageous, continued expansion of credit is required to keep asset appreciation ahead of cost inflation.

The problem is further complicated by the fact that inflation is defined mostly by mainstream economics only as the rising price of wages and commodities, and not by asset appreciation. When it costs 10 percent more to buy the same share of a company than it did yesterday, that is considered growth - good economic news. When wages rise 5 percent a year, that is viewed as inflation - bad economic news by the Fed, despite the fact that the aggregate purchasing power is increased by 5 percent. Therein lies the fundamental cause of a bubble economy - growth and profit are generated by asset inflation rather than by increased aggregate demand stimulating aggregate supply.

Thus the relationship of interest rate to inflation is dependent on the definition of money, which raises questions about the Fed preoccupation with interest-rate policy as a tool to achieve price stability. But that is not the end of the story. Under finance capitalism, inflation is not merely too much money chasing too few goods, as under industrial capitalism. Under financial capitalism, two elements - credit availability and credit markets - have overshadowed the traditional goods and equity markets of industrial capitalism. This makes it necessary to re-examine the traditional relationship of interest rate and inflation.

In a bull market, the buyer has the advantage because the buyer has the final upside. In a bear market, the seller has the advantage because the buyer is left holding the downside bag. Of course one must avoid buying at the peak and selling at the bottom. And such strategies have self-fulfilling effects, as technical analysts can readily testify. These effects are magnified in long-run bull or bear markets, which are represented by a rising or falling sine curve. However, the buyer's advantage in a bull market may be neutralized by the inflation that usually accompanies bull markets. Thus a true bull market must yield net capital gain after inflation and real interest cost, ie, interest cost after inflation. And in a deflationary bear market, the seller's advantage is reinforced by deflation, for he can repurchase at a later date with only a fraction of his realized cash from what he sold previously. Not only would the seller avoid additional loss of holding the unsold asset in a falling market, the cash from the sale appreciates in purchasing power with every passing day in a bear market.

Thus money plays a passive role as a medium of exchange and an active role as a store of value on the movement of prices. The conventional view that inflation is caused by, or is a result of (the two are connected but not identical), too much money chasing too few goods then is not always operative. This is because the availability of credit and the operational rules of credit markets can distort the traditional relationship. Credit markets, which have expanded way beyond traditional credit intermediated by the banking system, operate on the theory that money generally must earn interest, whether it is actually put to use or not.

There are of course abnormal times when money actually earns negative interest because of government policy or foreign exchange constraints, as in Hong Kong in the early 1990s and Japan since 2000. When idle money earns no interest, credit reserve dries up, because it creates greater incentive to put money to work, ie, investing it in productive enterprises. For money to remain idly waiting for better opportunity, the interest rate must equal or exceed the opportunity cost of idle cash. Interest then acts as a penalty for idle money. When idle money earns interest, the interest payment comes ultimately from the central bank, which alone can create more money with no penalty to itself, though the economy it lords over is not immune. Since late 1999, the Japanese monetary authorities have repeatedly reaffirmed their commitment to maintaining their zero-interest-rate policy until deflationary forces have been dispelled. The result is a great deal of idle money in Japanese banks with no creditworthy borrowers, for no one is interested in borrowing money to buy one widget that needs to be paid back with appreciated money that could buy two widgets in the future. Japanese savers are forgoing interest income for the increasing purchasing power of their idle money in an unending deflationary spiral.

Efficiency in the credit markets pushes money toward the highest use and willingness to pay the highest interest. Thus when the central bank tightens money supply, the market will drive up interest rates and vice versa. Thus interest rate is a credit market index. When central banks such as the Fed use interest-rate policy to manage the money supply, they are in fact using a narrow market index to manipulate the broader market. It is not different from the Fed fixing the Dow Jones Industrial Average (DJIA) by buying or selling blue-chip shares to influence the broad S&P.

When prices fall, one reason may be that consumers do not have money to buy with, as in most recessions with high unemployment. Or it may be the result of potential consumers withholding their money for still lower prices, as in Japan now and in some degree in China in 1998-2000. So deflation is caused by too many goods trying to attract too little money entering the market, but not necessarily too little money in the economy.

But if every seller can realize a cash surplus in a subsequent repurchase in a bear market, where does all the surplus money go? Obviously it goes to pay interest on the idle money waiting for a cheaper price, reducing the central bank's need to issue more money to carry the interest cost on idle money. The net effect is a removal of money from the market and an increase in the amount of idle money in the economy. So deflation actually pushes up interest rates without necessarily altering the aggregate money supply. The effect is that until prices fall at a lesser rate than the interest rate on idle money, there is no incentive to buy. Thus a deflation-driven rising interest rate creates more deflationary pressure in a bear market. High interest rates move more wealth from borrowers to lenders and from bottom to top in the wealth pyramid. Moreover, the impact of a high interest rate modifies economic behavior differently in different groups and even on different activities within the same individual. When the prime rate at leading banks exceeded 20 percent in 1980, credit continued to expand explosively. The opposite happened when the Bank of Japan reduced the interest rate to zero. High rates only work to slow credit expansion if the rates are ahead of inflation. And zero rate only works to stimulate credit expansion if there is no deflation. So raising interest rates to combat inflation or lowering rates to combat deflation can be self-defeating under certain conditions.

Now if two economies are linked by floating exchange rates, free trade and free investment flows, the one with a high rate of inflation will see the exchange rate of its currency fall. But a fall in its currency will increase the cost of its imports, thus adding to its inflation rate, and the further rise in the inflation rate will push up interest rates further. But a rise in domestic interest rates will stop or slow the fall of its currency and attract more fund inflows to buy its goods and assets. It also increases its exports, which reduces the supply of goods and assets in the domestic market, thus pushing up domestic prices, while pushing down the price of imports. The net inflation/deflation balance will then depend on the trade balance between exports and imports. This had been given by the European Central Bank (ECB) as the logic of raising euro interest rates to fight inflation. But this effect does not work for the United States because of dollar hegemony, which enables the US to run a recurring trade deficit with moderating inflation impacts. That is why the policies of the ECB and the Fed are constantly out of sync.

The availability of financial derivatives further complicates the picture, because both interest rates and foreign-exchange rates can be hedged, obscuring and distorting the fundamental relations among interest rates, exchange rates and inflation. The recurring global financial crises in the past decade were manifestations of this distortion.

The theory of market equilibrium asserts that a market tends to reach "natural" equilibrium as it approaches efficiency, which is defined as the speed and ease with which equilibrium is reached. Equilibrium is an abstract concept like infinity. It is a self-extending conceptual end state that has no definitive form or reality. Yet the market is complex not only because the relationship of market elements is poorly defined or even undefinable, but also the very instruments designed to enhance market efficiency tend to create wide volatility and instability. Thus a "natural" equilibrium state can in fact be defined as the actual state of the fluctuating market at any moment in time.

With 24-hour trading, the notion of a milestone moment of equilibrium is problematic. Further, the very financial instruments created to enhance market efficiency toward its "natural" equilibrium state make the equilibrium elusive. Such instruments are mainly designed to manage risk generated by both broad market movements and momentary disequilibrium. Structured finance mainly involves unbundling financial risks in global markets for buyers who will pay the highest price for specific protection. Because users of these instruments look for special payoffs through unbundling of risk, the cost of managing such risk is maximized. The disaggregating renders the notion of market equilibrium not unifiable. The unbundled risks are marketed to those with the biggest appetite for such risks, in return for compensatory returns.

Thus market equilibrium is not any more merely a large pool of turbulent transactions with a level surface. It is in fact a pool of transactions with many different levels of interconnected surfaces, each serving highly disaggregated specialty markets. Equilibrium in this case becomes a highly complex notion making the impact and prospect of externalities highly uncertain. That uncertainty caused the demise of Long Term Capital Management (LTCM), for a while the world's most successful hedge fund based on immaculate quantitative logic. Interest swaps, for example, are not single-purpose transactions for managing interest-rate risks. They can be structured as inflation risk hedges, or foreign-exchange risk hedges, or any number of other financial needs or protection. And the impact is not limited to the two contracting counterparties, since each party usually hedges again with a third counterparty who in turn hedges with another counterparty. That is what makes hedging systemic. A further irony is that the very objective of insuring against volatility risk by covering the market broadly increases risks of illiquidity.

Monetary-policy decision makers in the past decade have tended to be fixated on preventing inflation. Some questions come to mind over this fact. Is inflation the worst of all economic evils; and specifically, is current US monetary policy consistent with maintaining a low rate of inflation, assuming a low inflation rate is desirable? Or, to put it another way, is there any empirical evidence that inflation can be controlled by the central bank at a cost less than that exacted by inflation itself? Would the establishment of price stability as the Fed's sole objective hinder long-run growth prospects for the US and the global economy? The answers to these questions are critical for the assessment of monetary policy.

Two Nobel laureates from the Chicago School, Milton Friedman and Robert Lucas, have influenced mainstream economics on these issues. Friedman, the 1976 Nobel economist, emphasized the role of monetary policy as a factor in shaping the course of inflation and business cycles. In the popular press, he also was known for his advocacy of deregulated markets and free trade as the best option for economic development. Lucas, the 1995 Nobel economist, also made fundamental contributions to the study of money, inflation, and business cycles, through the application of modern mathematics. Lucas formed what came to be called a theory of "rational expectations". In essence, the "rational expectations" theory shows how expectations about the future influence the economic decisions made by individuals, households and companies. Using complex mathematical models, Lucas showed statistically that the average individual would anticipate - and thus could easily undermine - the impact of a government's economic policy. Rational expectation theory was embraced by the Reagan White House during its first term, but the doctrine worked against the Reagan voodoo economic plan instead of with it.

In 1976, the long-run relationship between inflation and unemployment was still under debate in mainstream economics. During the 1960s, mainstream economics leaned toward the belief that a lower average unemployment rate could be sustained at the cost of a permanently higher (but stable) rate of inflation.

Friedman used his Nobel lecture to make two arguments about this inflation-unemployment tradeoff. First, he advanced the logic of why short-run tradeoff would dissolve in the long run. Expanding nominal demand to lower unemployment would lead to increases in money wages as firms attempted to attract additional workers. Firms would be willing to pay higher money wages if they expected prices for output to be higher in the future due to expansion and inflation. Workers would initially perceive the rise in money wages to be a rise in real wages because their "perception of prices in general" adjusts only with a time lag, so nominal wages would be perceived to be rising faster than prices. In response, the supply of labor would increase, and employment and output would expand. Eventually, workers would recognize that the general level of prices had risen and that their real wages had not actually increased, leading to adjustments that would return the economy to its natural rate of unemployment.

Yet Friedman only described a partial picture of the employment/inflation interaction. Events since 1976 have shown the relationship to be much more complex. Friedman neglected the possibility of increased productivity and quantum technological innovation resulting from more research and development (R&D) in an expanding economy in containing price increases. Higher wages do not necessarily cause inflation in an economy with expanding production or overcapacity. He also did not foresee the effects of globalization, ie, the shift of production to low-wage regions, on holding down domestic inflation in the core economies.

Friedman's second argument was that the Phillips Curve slope might actually be positive - higher inflation would be associated with higher average unemployment. He argued that only low inflation would lead to a natural rate of unemployment. This for policy makers was the equivalent of "when unemployment is unavoidable, relax and enjoy it".

At the core of modern macroeconomics is some version of the famous Phillips Curve relationship between inflation and unemployment. The curve serves two purposes for economists and policy makers: 1) In theoretical models of inflation, it provides the "missing equation" to explain how changes in nominal income divide into price and quantity components; and 2) on the policy front, it specifies conditions contributing to the effectiveness of expansionary/disinflationary policies.

The idea of an inflation/unemployment tradeoff is not new. It was a key component of the monetary doctrines of David Hume (1752) and Henry Thornton (1802), and identified in 1926 by Irving Fisher, who saw causation as running from inflation to unemployment (but not low unemployment causing inflation, as most modern central bankers do). It was stated in the form of an econometric equation by Jan Tinbergen in 1936 and again by Lawrence Klein and Arthur Goldberger in 1955. It was not until 1958 that modern Phillips Curve analysis began when A W Phillips published his famous article in which he fitted a statistical equation w = f(U) to annual data on percentage rates of change of money wages (w) and the unemployment rate (U) in the United Kingdom during 1861-1913, showing the response of wages to the excess demand for labor as proxied by the inverse of the unemployment rate. Zero wage inflation occurred at 4.5 percent of unemployment historically.

In the pre-globalized 1970s, many economies were experiencing rising inflation and unemployment simultaneously. Friedman attempted to provide a tentative hypothesis for this phenomenon. In his view, higher inflation tends to be associated with more inflation volatility and greater inflation uncertainty. This uncertainty reduces economic efficiency as contracting arrangements must adjust, imperfections in indexation systems become more prominent, and price movements provide confused signals about the types of relative price changes that indicate the need for resources to shift.

Three reasons contributed to the wide acceptance of Phillips' curve, despite critics' attack that it was a mere empirical correlation masquerading as a tradeoff. First, the curve shows remarkably temporal stability of the relationship, fitting both the pre-World War I period of 1861-1913 and the post-World War II period of 1948-57. Second, the curve can accommodate a wide variety of inflation theories. While the curve explains inflation as resulting from excess demand that bids up wages and prices, it remains neutral about the cause of that phenomenon. Both demand-pull and cost-push theorists can accept the curve as offering insights into the nature of the inflationary process while disagreeing on the causes of and therefore the appropriate remedies for inflation. Finally, policy makers like it because it provides a convenient and convincing rationale for the failure to achieve full employment with price stability, twin goals that were thought to be compatible before the advent of Phillips Curve analysis. Also, the curve, by offering a menu of alternative inflation/unemployment combination from which the authorities could choose, provided a ready-made justification for discretionary central bank intervention and activist fine-tuning, not to mention the self-interest of the economic advisors who supply the cost-benefit analysis underlying the central bank's choices.

Yet the Phillips Curve is now widely viewed as offering no tradeoff, thus it supports the notion of policy futility. Unemployment then is considered a natural phenomenon with no long-term cure. It is an amazing posture for the economic profession given that even as conservative a profession as medicine has not accepted the existence of any incurable diseases. All the "scientific" pronouncements on the natural rate and inevitability of unemployment fall into the same category of insight as that by US president Calvin Coolidge: "When large numbers of people are unable to find work, unemployment will result."

The parallel correlation between inflation and unemployment that Friedman noted was subsequently replaced by an opposite correlation as the early 1980s saw disinflations accompanied by recessions. After that, many economists would view inflation and unemployment movements as reflecting both aggregate supply and aggregate demand disturbances as well as the dynamic adjustments the economy follows in response to these disturbances. When demand disturbances dominate, inflation and unemployment will tend to be opposingly correlated initially as, for example, an expansion lowers unemployment and raises inflation. As the economy adjusts, prices continue to increase as unemployment begins to rise again and return to its natural rate. When supply disturbances dominate (as in the 1970s), inflation and unemployment will tend to move initially in the same direction.

In the 1990s, a new phenomenon known as the wealth effect came into play in extending the business cycle. As credit became liberalized and risk socialized, asset prices began to outstrip both earnings and wages. Consumption became driven by capital gain rather than rising income from wages. Inflation, which mainstream economics never defined as including capital gain, remained unrealistically low as wages fell behind asset appreciation. Yet the Fed was unable to prevent the bubble expansion by a monetary tightening because inflation was mysteriously low while both share and real-estate prices doubled yearly. When the Fed finally launched in 1999 its preemptive fight against potential inflation, the result was a drastic deflation of the equity markets and a hard landing for the bubble economy.

A sizable number of economists have followed Friedman in accepting that there is no long-run tradeoff that would allow permanently lower unemployment to be traded for higher inflation. And a part of the reason for this acceptance is the contributions of Lucas.

In his Nobel lecture, Lucas noted that some evidence exists that average inflation rates and average money growth rates are tightly linked: "The observation that money changes induce output changes in the same direction receives confirmation in some data sets but is hard to see in others. Large-scale reductions in money growth can be associated with large-scale depressions or, if carried out in the form of a credible reform, with no depression at all." Lucas drew this conclusion largely from work on episodes of hyper-inflations in which major institutional reforms had been associated with large changes in inflation; when major reforms are not involved, the evidence shows a more consistent effect of monetary policy expansions and contractions on real activity. Recent International Monetary Fund (IMF) insistence on punitive "conditionalities" for financial bailouts of distressed sovereign debt is strongly influenced by Lucas's "credible reform" notion. Pain is extracted as proof of commitment.

While Friedman also stressed that the real effects of changes in monetary policy would depend on whether they were anticipated or not, Lucas demonstrated the striking implications of assuming that individuals form their expectations rationally. Lucas abandoned Friedman's notion of a gradual adjustment of expectations based on past developments and instead stressed the forward-looking nature of expectations. Expectations of future monetary easing or tightening will affect the economy now. And this means that the real effects of an increase in money growth could, in principle, be expansionary or contractionary, depending on the public's expectations. Nowadays this phenomenon is visible every day in the equity markets. The Fed's interest-rate moves have become a cat-and-mouse game with market participants and are one of the prime factors behind market volatility.

One consequence of this insight has been a new recognition of the importance of credibility in policy; that is, a credible policy - one that is explicit and for which the central bank is held responsible - can influence the way people form their expectations. Thus, the effects of policy actions by a central bank with credibility may be quite different from those of a central bank that lacks credibility. Even though the empirical evidence for credibility effects was weak in the past, the emphasis on credibility has been one factor motivating central banks to design policy frameworks that embody credible commitments to low inflation. In this respect, it is a puzzlement why the Fed insists on keeping its interest-rate policy a suspenseful surprise for market participants, leading to increased market volatility and uncertainty. Moreover, if a credible long-term price-stability policy produces no tradeoff in unemployment, it follows that the reverse may be true: that a credible policy goal of full employment may not even lead to long-term inflation.

Some economists have begun to question the natural unemployment rate result that Lucas's work helped to promote. They argue that even credible low-inflation policies are likely to carry a cost in terms of permanently higher unemployment and that a stable Phillips Curve tradeoff exists at low rates of inflation. They argue that employee resistance to money wage cuts will limit the ability of real wages to adjust when the price level is stable. But the influence of Friedman and Lucas has clearly shifted the debate since the early 1970s. Now it is the proponents of a tradeoff who represent the minority view.

There are some who uses the TINA (there is no alternative) argument against efforts to reform the Fed's approach to monetary policy. Yet it is clear that the very structure of the Fed leans toward a particular political theory of inflation that seems out of phase with reality.

The Fed, while independent within government, has seen its legislative mandate for monetary policy change several times since its founding in 1913. The most recent revisions were in 1977 and 1978 (Humphrey-Hawkins), which require the Fed to promote both price stability and full employment. The past changes in the Fed's mandate appear to reflect both economic events in the United States and advances in understanding of how the economy functions. In the two decades since the Fed's mandate was last changed, there have been further important economic and financial developments made possible by shifts in economic thought that have been ideologically influenced, and these raise the issue of whether the goals for US monetary policy need to be modified once again in view of current data. Indeed, a number of other countries - notably those that adopted the euro as a common currency - having accepted price stability as the original primary goal of their unified monetary policy, are raising similar questions. Japan, having suffered a decade-long recession that begins to look perpetual, has been pushing its central bank to undertake drastic stimulative policies.

The Federal Reserve Act of 1913 did not incorporate any macroeconomic goals for monetary policy, but instead required the Fed to "provide an elastic currency". This meant that the Fed should help the economy avoid the financial panics and bank runs that plagued the 19th century by serving as a "lender of last resort", which involved making loans directly to depository institutions through the discount windows of the Reserve Banks. During this early period, most of the actions of monetary policy that affected the macro-economy were determined by the US government's adherence to the gold standard.

The trauma of the Great Depression, coupled with the insights of John Maynard Keynes, led to an acknowledgment of the obligation of the US government to prevent recessions. The Employment Act of 1946 was the first legislative statement of these macroeconomic policy goals. Although it did not specifically mention the Fed, it required the federal government in general to foster "conditions under which there will be afforded useful employment opportunities ... for those able, willing, and seeking to work, and to promote maximum employment, production, and purchasing power". Therein lies the fundamental flaw in the wisdom of the political independence of the Federal Reserves. Congress has never legislated unemployment as a legitimate tool to fight inflation, economic theory notwithstanding. There is a whole list of antisocial programs that, if made legal, could lead to economic efficiency, such as terminating unproductive life, genetic engineering to raise intelligence-quotient (IQ) scores or to eliminate costly genetic diseases, selective education opportunities based on potential economic performance, etc. Yet societal value condemns such programs. Why is unemployment an exception?

The Great Inflation of the 1970s was a major US economic dislocation. This problem was addressed in a 1977 amendment to the Federal Reserve Act, which provided the first explicit recognition of price stability as a national policy goal. The amended act states that the Fed "shall maintain long-run growth of the monetary and credit aggregates commensurate with the economy's long-run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates". The goals of "stable prices" and "moderate long-term interest rates" are related because nominal interest rates are boosted by a premium over real rates equal to expected future inflation. Thus, "stable prices" will typically produce long-term interest rates that are "moderate".

The objective of "maximum" employment remained intact from the 1946 Employment Act; however, the interpretation of this term may have changed during the intervening 30 years. Immediately after World War II, when conscription and price controls had produced a high-pressure economy with very low unemployment in the United States, some perhaps believed that the goal of "maximum" employment could be taken in its mathematical sense to mean the highest possible level of employment. However, by the second half of the 1970s, it was well understood that some "frictional" unemployment, which involves the search for new jobs and the transition between occupations, is a necessary accompaniment to the proper functioning of the economy in the long run.

This understanding went hand in hand in the latter half of the 1970s with a general acceptance of the natural rate hypothesis, which implies that if policy were to try to keep employment above its long-run trend permanently or, equivalently, the unemployment rate below its natural rate, then inflation would be pushed higher and higher. Policy can temporarily reduce the unemployment rate below its natural rate or, equivalently, boost employment above its long-run trend. However, persistently attempting to maintain "maximum" employment that is above its long-run level would not be consistent with the goal of stable prices.

Thus, in order for maximum employment and stable prices to be mutually consistent goals, maximum employment should be interpreted as meaning maximum sustainable employment, referred to also as "full employment". Moreover, although the Fed has little if any influence on the long-run level of employment, it can attempt to smooth out short-run fluctuations. Accordingly, promoting full employment can be interpreted as a countercyclical monetary policy in which the Fed aims to smooth out the amplitude of the business cycle.

This interpretation of the Fed's mandate was later confirmed in the Humphrey-Hawkins legislation. As its official title - the Full Employment and Balanced Growth Act of 1978 - clearly implies, this legislation mandates the federal government generally to "... promote full employment and production, increased real income, balanced growth, a balanced federal budget, adequate productivity growth, proper attention to national priorities, achievement of an improved trade balance ... and reasonable price stability ...". Besides clarifying the general goal of full employment, the Humphrey-Hawkins Act also specified numerical definitions or targets. The act specified two initial goals: an unemployment rate of 4 percent for full employment and a CPI inflation rate of 3 percent for price stability. These were only "interim" goals to be achieved by 1983 and followed by a further reduction in inflation to 0 percent by 1988; however, the disinflation policies during this period were not to impede the achievement of the full-employment goal. Thereafter, the timetable to achieve or maintain price stability and full employment was to be defined by each year's Economic Report of the President.

The Fed, then, has two main legislated goals for monetary policy: promoting full employment and promoting stable prices. The transparency of goals refers to the extent to which the objectives of monetary policy are clearly defined and can be easily and obviously understood by the public. The goal of full employment will never be very transparent because it is not directly observed but only estimated by economists with limited precision. For example, the 1997 Economic Report of the President (which has authority in this matter from the Humphrey-Hawkins Act) gives a range of 5-6 percent for the unemployment rate consistent with full employment, with a midpoint of 5.5 percent. Research suggests that there is a very wide range of uncertainty around any estimate of the natural rate. Price stability as a goal is also subject to some ambiguity. Recent economic analysis has uncovered systematic biases, say, on the order of 1 percentage point, in the CPI's measurement of inflation.

In fact, it would not be far wrong to conclude that the Fed has a policy to keep unemployment from falling below 4 percent, as evident in Greenspan's raising the Fed Funds Rate in the late 1990s in response to falling unemployment. The Wall Street Journal on October 3, 2000, reported that the Fed had come under the influence of Johan G K Wicksell (1851-1926) on the relationship among interest rates, growth and inflation. The Fed had pushed inflation-adjusted real rates historically high. Monetarists, who have dominated the Fed throughout its history, subscribe to the theory that inflation can only be prevented either by high rates to contain growth or by high unemployment to depress wages, which are two faces of the same coin. Wicksell argued that monetary policy works best at containing inflation by pegging interest rates to investment returns rather than money supply. That theory provides a needed cover for Greenspan's high-interest-rate policy at the height of the debt bubble. Of course, the Treasury, with the patriotic support of the Fed, has repeatedly declared that a strong dollar is in the US national interest. And a strong dollar requires high US interest rates in the international finance architecture. But now, in addition to national-interest justifications, a scientific theory has been resurrected to support Greenspan's policy. Field data have demolished the claim that low unemployment (below 6 percent) causes inflation. Greenspan calls his high rates "equilibrium interest rates".

The Fed, notwithstanding its intellectual pretense, has always been a political institution. The politics of economics repeatedly resurrects from the intellectual wasteland, the theoretical Siberia as it were, new gurus to support its latest ideology. Nobel winners are proponents of theories that explain "scientifically" last year's political expediency. The list includes Friedrich von Hayek (free market), Friedman (monetary theory), Robert Mundell (global capital), Schumpeter (creative destruction) etc. Wicksell makes it respectable for Greenspan to abdicated his responsibility as Fed Chairman, by pretending to follow the market, to treat interest rates as prices of money set by market forces, and not as a tool to promote employment or growth, an if necessary only as a tool to bail out banks in distress.

The embarrassing question of why then the United States needs a Federal Reserve is never asked. The fact is that the monetarists at the Fed are fervently intervening in the market - the only difference between monetarists and Keynesians is that monetarists intervene to safeguard the value of capital while Keynesians intervene to protect labor from unemployment and low wages. As post-Keynesians economist Paul Davidson said, everyone has an income policy; they just don't like the other fellow's income policy but claim their own as "free" market determined.

This creates rethinks on Wall Street. Traders and investors may have to reverse their knee-jerk reaction to sell when the Fed raises rates. Unless, of course, corporate profit falls amid rising rates, as they are beginning to.

Wicksell was born in Stockholm. His book Value, Capital and Rent (1893) was not translated into English until 1954. His Lectures on Political Economy (two volumes, 1901-06) and Selected Papers on Economic Theory (1958) were read only by professionals. Wicksell did rigorous work on the marginalist theory of price and distribution and on monetary theory. Lectures on Political Economy has been aptly called a "textbook for professors". In an unusually checkered career (including a brief spell of imprisonment for exercising his right of free speech) he wrote and lectured tirelessly of radical issues, which did not figure among the qualities that Greenspan admired. He was an advocate of social and economic reforms of various kinds, most notably neo-Malthusian population controls. In his later years he was revered by the new generation of economists, who became known as the Stockholm School. They developed his ideas on the cumulative process into a dynamic theory of monetary macroeconomics simultaneously with but independently of the Keynesian revolution.

Greenspan's selective use of other people's idea is notorious. His fondness of Schumpeterean "creative destruction", which he cites in every speech, always leaves out the second half of Schumpeter's conclusion: that creative destruction tends to encourage monopolies (a la Microsoft) and accelerates the coming of socialism.

Paul Volcker's monetary policy was identical to that of Benjamin Strong, who was president of the all-powerful New York Fed, and whose stewardship of which was hailed by Friedman as the era of "high tide" for the Fed. The policy was: save the banking system at all cost, including the health of the economy. Depressions will eventually recover, but a banking system is like Humpty Dumpty, all the king's men cannot put it together again once it collapses. The stable value of money is a defining ingredient of economic order, a sine qua non. Both times, the Fed not only forced deflation on parts of the economy to maintain overall low inflation, it managed monetary policy to ensure perpetual surplus capacity to suppress prices and wages. In the 1980s, one of the high-growth areas of the service sector was bankruptcy law and distress debt restructuring. Vulture funds such as Apollo, corporate raiders such as Carl Icahn and LBO (leveraged buyout) firms such as KKR prospered. Post-bankruptcy DIP (debtor in possession) financing was highly profitable and the bank that pioneered it, Chemical of New York, became such a powerhouse from its dominance in this lucrative activity that it was eventually able it to take over Manufactures Hannover and Chase and J P Morgan to become JP Morgan/Chase.

Yet stable money is ultimately an illusion, a statistical artifact. In the quest for monetary order, stable money in reality creates economic disorder in the real economy. Within the conservative political context of capitalism, stable money produces a complacency of moral satisfaction. The winners are credited with financial genius and rewarded with the right to practice conspicuous consumption, taking on celebrity status. The losers are condemned for their mistakes. It fits neatly into Spencerian Social Darwinism of survival of the fittest, notwithstanding that the criteria for fitness have been defined by policy. The tilted market is hailed as the indiscriminate crucible of perpetual economic revitalization, while in fact a handful of men in the paneled boardroom of the Fed play God to decide who lives and who dies.

Deflationary pressure does force management to downsize and cut costs, cutting out the weak and the marginal. But the central effect is the consolidation of ownership through mergers and acquisition. M&A, the legal process of wealth concentration, has been the driving force of the growth of capitalism since the late Middle Ages. With globalization, we are heading toward an economic order in which every sector can accommodate only five megafirms, two real players, market leaders as they are called, in a carefully choreographed condominium that appears to be managed competition to stay on the good side of antitrust laws, with three minor players permitted to survive for appearance' sake.

The essence of monetary policy, like all policies, despite technical complexities, is ultimately reduced to social values that determine goals and priorities. It comes down to welfare economics and power politics. Yet the Fed operates on ideology exclusively. As Preston Martin, Fed vice chairman, declared more than once in the '80s: a growth recession is a real threat.<>

Global capital will stay in the United States for the same reason that people stay in jobs they don't like: there are no better alternatives. The euro reinforced that sentiment. The last joyride with the yen ended with much pain in 1998. One cannot predict when capital flight will hit the United States, because US hegemony deprives any incentive to move capital elsewhere and global prosperity cannot revive without US prosperity. There is the catch 22.

Yet despite the abundance of capital funds, the system can implode. The only uncertainty is when, not if. Global capital now treats local markets as parking lots only and increasingly unlike physical parking lots, for financial virtual parking, the one nearest to your office is not necessarily the most convenient. If the United States will lower interest rates, regulate credit allocation, permit a higher rate of inflation, and raise wages substantially to keep up purchasing power, both domestically and globally, the boom may last another decade. But US policy makers are not yet on this track. The disparity of income will doom this debt economy.

Note 1 The three customary monetary aggregates are: M1 = currency in circulation, commercial bank demand deposits, NOW (negotiable order of withdrawal) and ATS (auto transfer from savings), credit-union share drafts, mutual-savings-bank demand deposits, non-bank traveler's checks; M2 = M1 plus overnight repurchase agreements issued by commercial banks, overnight eurodollars, savings accounts, time deposits under $100,000, money market mutual shares; M3 = M2 plus time deposits over $100,000, term repo agreements.

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