First, do no harm.(1)

In my last two posts I listed some of the problems with allowing professors to dominate economic policymaking. Here are some more.

Since almost no one at the Fed has ever had to meet a payroll or risk precious corporate capital in expanding a businesses, the Fed has to guess about what policies might actually work. Remember that what the Fed is mainly tasked with is easing the worst aspects of the business cycle.(2) But if you haven’t actually lived through such a cycle and had to make decisions about managing your business, you are just guessing.

Consider Fed policy during an ordinary recession. As the economy stagnates, the Fed reduces interest rates. It is essentially saying to businesses (and, of course, to individual economic actors) something like this: “Look, we know the economy stinks and you don’t want to risk your capital on expansionary activity. We don’t blame you. You don’t know whether the recession will be short and shallow or long and deep. But here’s a proposition for you. We’re putting interest rates on sale. If you borrow now and expand your business and the recession turns out not to be too long (in part because of people like you expanding their businesses), your profit margins will be bigger. Of course, you could wait and play it safe, but by then rates will be higher and your margins will be narrower.”

Not all businesses will accept the Fed’s offer, but some will and maybe the recession will be shorter and shallower than it would otherwise be.

Note the word “maybe.” The Fed, and most economists, believe that reducing rates shortens recessions, and it does seem likely that that’s the case. But no one actually knows, since we can’t run a controlled experiment. Maybe if the Fed did nothing, most recessions would right themselves on their own and the subsequent recoveries would be more robust. As I pointed out in footnote 1, recessions and expansions are a natural part of the economy. Maybe future economists will look back at the late 20th and early 21st Centuries and puzzle over how we could have thought there was any relationship between reduced interest rates and milder recessions.

The important point of this relates back to the “First, do no harm” issue. Under normal circumstances artificial, Fed-induced lower rates probably don’t do much harm, so why not? But sometimes they do very great harm.

In the 1990s the Fed left rates too low for too long, creating a massive bubble in the stock markets. Investors paid dearly in 2000 – 2002.

Following 9/11, the Fed reduced interest rates and then fell asleep at the switch, keeping rates low for six long years. During this period, everyone leveraged up, from investors to home buyers to bankers. The result was the worst financial crisis since the Great Depression. No harm, indeed!

But let’s leave off ordinary recessions and look at the special case of financial crises. In this, admittedly rare, example, the Fed’s proposition to businesses gets no takers. Businesses can see as well as anyone else that we’re not in an ordinary recession. They have no interest in levering up – no matter how cheap rates are – since they have no confidence they will get a return on their investment. Economic growth following financial crises tends to be very slow and recovery can take a decade or longer.

What the Fed did, then, once rates were at zero with no takers, was to switch from the supply side (supplying lower rates) to the demand side: trying to create demand via the so-called “wealth effect.” Known as “quantitative easing,” the idea was to reduce the advantages of owning lower risk assets, forcing investors to buy riskier assets. As more and more people did this, those assets (stocks, junk bonds, farmland) rose in value. People were supposed to feel wealthier and spend more and this increased demand would cause businesses to feel more confident and borrow and expand.

So went the professors’ theory. But the reality has been very different, as we’ll see in my next post, making it clear that the principle, “First, do no harm” doesn’t exist at the Fed.


(1) Primum non nocere. The phrase doesn’t actually appear in the Hippocratic Oath, contrary to popular belief. The closest we get to it is in the Hippocratic Corpus, where we find the phrase, “The physician must … have two special objects in view with regard to disease, namely, to do good or to do no harm.” The Fed should adopt a similar policy.

(2) The business cycle – natural expansions and contractions in economic activity – are a natural and inevitable part of free market economies, just as Bull and Bear Markets are a natural and inevitable part of capital markets. This happens not because there is any defect in free market economies or of capital markets, but because there are defects in  human beings.

Next up: Professors, Free Markets & The Fed – Part Four

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Please note that this post is intended to provide interested persons with an insight on the capital markets and is not intended to promote any manager or firm, nor does it intend to advertise their performance. All opinions expressed are those of Gregory Curtis and do not necessarily represent the views of Greycourt & Co., Inc., the wealth management firm with which he is associated. The information in this report is not intended to address the needs of any particular investor.

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