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<h3><span id="lblStoryTitle"><font size="5">Mr. Bailout</font></span></h3>
<h4 class="MsoNormal"><font face="Verdana" size="4">By Antony P. Mueller</font></h4>
<p class="MsoNormal"><font face="Verdana" size="2">[Posted
September 30, 2004]</font>
<p class="MsoNormal"><font face="Verdana" size="2"><img alt hspace="0" src="http://www.mises.org/images3/sorcerer.gif" align="right" border="0" width="198" height="203">Alan
Greenspan is about to retire. He has been the chairman of the Board of Governors
of the Federal Reserve System since August 11, 1987, and his final term will end
on January 31, 2006. Until then, Greenspan will have served almost two decades
at the helm of the US central bank during which he has left his mark like few
before him. With only a little more than a year left as chairman, time now is
opportune to review his performance, and at this occasion to make also an
assessment of modern central banking.</font>
<p class="MsoNormal"><font face="Verdana" size="2">Modern central banks claim
price level stability and sustainable economic growth as their main objectives.
If these goals were really the main concern, central banks would not be needed.
The gold standard would do this job much better. The real <em>raison d'ĂŞtre </em>for
modern central banking is the management of a financial system which has become
highly fragile due to fractional reserve banking and to facilitate government
expansion based on debt accumulation.</font><a id="_ednref1" title href="http://www.mises.org/manager/Articles/article.aspx#_edn1" name="_ednref1"><span lang="EN" class="MsoEndnoteReference"><font face="Verdana" size="2">[1]</font></span></a><font face="Verdana" size="2">
The function of a modern central bank is the protection of the major players in
the financial industry and to issue money based on government debt.</font>
<p class="MsoNormal"><span lang="EN"><font face="Verdana" size="2">Even when
called"independent," central banks usually conspire with their
respective governments. There are wars to be fought and government debts to be
redeemed. There is always, so it seems, a kind of"national interest"
which requires easy money. Either in a direct way or indirectly by monetizing
government debt, central banks have rarely opposed the expansion of government
or put a break on debt accumulation.</font></span>
<p class="MsoNormal"><font face="Verdana" size="2">Under Alan Greenspan's rule
at the Fed, the function of the central bank as a bailout institution has
experienced a new golden age. As head of the Federal Reserve System, Alan
Greenspan has earned the highest esteem from the central bank's main clientele.
The adoration that the chairman has earned from the financial markets and the
various governments by which he was re-appointed a total of five times has come
mainly from the expectation that he would stand ready as their bailout man.</font>
<p class="MsoNormal"><font face="Verdana" size="2">It would be a vain endeavor
to research modern mainstream economic textbooks in order to pin down the
economic theory which guides Alan Greenspan's monetary policy. The chairman of
the Board of Governors of the Federal Reserve System has let it be known that
most of these models are irrelevant. The monetary school that he represents is
the traditional model of modern central banking. It should be called"bailout
economics." It is an economic doctrine, which says that whenever and for
whatever reason the financial markets or the government should get into
financial trouble, the central bank will bail them out by providing abundant
liquidity.</font>
<p class="MsoNormal"><font face="Verdana" size="2">As soon as the asset markets—and
later on the banks and the public in general—had learned about the bailout
doctrine there was no stopping. Under such a cover, financial investing no
longer needed prudent calculation, even more so as the chairman's visionary
portraits of an imaginary world of abundance promised an oasis of prosperity on
American soil. With the bailout guarantee verbally and practically in place and
the vision of a new economic dawn firmly put forth, the shackles of fear that
had restrained excessive debt accumulation in the past have been shed.</font>
<p class="MsoNormal"><font face="Verdana" size="2">Since Alan Greenspan took
office, financial markets in the US have operated under a quasi official charter,
which says that the central bank will protect its major actors from the risk of
bankruptcy. Consequently, the reasoning emerged that when you succeed, you will
earn high profits and market share, and if you should fail, the authorities will
save you anyway.</font>
<p class="MsoNormal"><font face="Verdana" size="2">Under the protective shield
provided by the central bank, the US financial system has became tilted toward
relentless expansion. In a process that began as early as 1987, Greenspan's
monetary policy has transformed the American economy toward the predominance of
the financial sector. </font>
<p class="MsoNormal"><font size="2" face="Verdana"><span lang="EN">After just
two months in office as Fed chairman,</span> Greenspan set the standard when
facing the stock market crash of October 19th, 1987, and he famously declared: "The
Federal Reserve, consistent with its responsibilities as the nation's central
banker, affirmed today its readiness to serve as a source of liquidity to
support the economic and financial system."</font>
<p class="MsoNormal"><font size="2" face="Verdana">Greenspan's prime monetary
policy rule has remained the same since then. It is a rule which he formulated
when referring to the response to the stock market debacle in 1987:<o:p>
</o:p>
"It wasn't a question of whether you would open up the taps or not open
up the taps. It was merely how you would do it, not if."<a id="_ednref2" title href="http://www.mises.org/manager/Articles/article.aspx#_edn2" name="_ednref2"><span class="MsoEndnoteReference">[2]</span></a><o:p>
</o:p>
</font>
<p class="MsoNormal"><span lang="EN"><o:p>
</o:p>
</span>
<p class="MsoNormal"><font size="2" face="Verdana">As Greenspan explained in his
testimony <span lang="EN">before the U.S. Senate Committee on Banking, Housing,
and Urban Affairs, on February 2, 1988</span>, it is the"crucial role"
of the central bank to respond to"<span lang="EN">episodes of acute
financial distress."</span></font>
<p class="MsoNormal"><span lang="EN"><o:p>
</o:p>
</span>
<p class="MsoNormal"><font size="2" face="Verdana"><span lang="EN">The chairman
has lived up to that promise.</span> Greenspan fulfilled his mission in the wake
of the 1987 stock market debacle. He made sure that the government could easily
finance two wars in the Middle East. He did his bailout job by saving the
creditors of the LTCM hedge fund; he did it in face of an expected Y2K liquidity
squeeze, and he is doing it now by fabricating the housing bubble.</font>
<p class="MsoNormal"><span lang="EN"><font face="Verdana" size="2">What
Greenspan has accomplished is fully in line with the original intentions of the
act that established the Federal Reserve System in 1913.</font></span><a id="_ednref3" title href="http://www.mises.org/manager/Articles/article.aspx#_edn3" name="_ednref3"><span class="MsoEndnoteReference"><font face="Verdana" size="2">[3]</font></span></a><font size="2" face="Verdana">
<span lang="EN">This legislation was put forth with the pretense that protecting
the major players of the financial industry from default means saving the
system. By making the financial system more"elastic," governments
received the prospect that from now on golden fetters no longer would curb their
encroachment.</span></font>
<p class="MsoNormal"><font size="2" face="Verdana"><span lang="EN">By func</span>tioning
as a"lender of the last resort" in order to guarantee"financial
system stability," central banks willingly provide a safety net for their
debt-ridden governments and accordingly for the big players in the financial
industry. This provision establishes an incentive for the governments to expand
without end and for the financial intermediaries to opt for size at the cost of
prudence in order to become"too big to fail." As bailout institutions
with the promise of unlimited liquidity, it the central banks themselves that
lay the groundwork for"financial distress" to emerge—not just as
"episodes," but in a way that makes the modern financial system
permanently fragile.</font>
<p class="MsoNormal"><span lang="EN"><font face="Verdana" size="2">There were
recessions and changes of money values before the ascendancy of modern central
banking, but these were usually short and relatively mild and most of the time
they resulted from external factors such as bad harvests and wars. With modern
central banking, hyperinflations and"great" depressions emerged. With
all anchors severed that would curb debt expansion, modern central banks are
supposed to create the permanent boom, but while aiming at this illusory goal,
they prepare the conditions for the eruption of the slumps.</font><a id="_ednref4" title href="http://www.mises.org/manager/Articles/article.aspx#_edn4" name="_ednref4"><span lang="EN" class="MsoEndnoteReference"><font face="Verdana" size="2">[4]</font></span></a></span>
<p class="MsoNormal"><font size="2" face="Verdana"><span lang="EN">Modern
central banks function as the prime instigators for the emergence of
unsustainable booms, then they show up as the saviours of the bust. While
imposing as the navigators, they act as the prime instigators of the very
instability they are called to fight.</span> Greenspan has played this game in
all its virtuosity. With a masterful hand, the current chairman has wielded the
levers of monetary stimuli. He has given the financial markets what they want: a
lender of the last resort that could be banked on. When one debt-driven boom had
turned into bust, he managed to make sure that another one would begin.</font>
<p class="MsoNormal"><font face="Verdana" size="2">The key to the power of a
central bank is maintaining the illusion that fiduciary money is wealth. It is a
con game, and in this respect there can be few doubts that Alan Greenspan has
been a master at this game. Under his rule, the arcane machinery of the central
bank has turned into a fountain of cheap money, which has inundated the globe.
This policy of repeated bailouts and the provision of unlimited funding for
government expansion in the face of a decreasing savings rate and a shrinking
productive sector is the way toward an economic Armageddon. By functioning <span lang="EN">as
bailout agents central banks use the power to create money as a power to destroy. </span></font>
<p class="MsoNormal"><o:p>
</o:p>
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</o:p>
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<p class="MsoNormal"><o:p>
<font size="2" face="Verdana">Antony Mueller is a professor of economics at the
Universidade de Caxias do Sul (UCS) in Brazil and an adjunct scholar of the
Ludwig von Mises Institute. <span lang="PT">E-mail: <font color="#3333cc">antonymueller@terra.com.br</font>.
See his <font color="#333399">archive</font>.
Post comments on the <font color="#333399">blog</font>.</span></font></o:p>
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<div id="edn1">
<p class="MsoNormal"><a id="_edn1" title href="http://www.mises.org/manager/Articles/article.aspx#_ednref1" name="_edn1"><span lang="PT" class="MsoEndnoteReference"><font face="Verdana" size="2">[1]</font></span></a><font size="2" face="Verdana">"The
flexible standard is an instrument for the engineering of inflation. The
only reason for its acceptance was to make reiterated inflationary moves
technically as simple as possible for the authorities." Ludwig von
Mises, <em>Human Action</em>. Auburn: The Ludwig von Mises Institute 1998,
p. 783. <o:p>
</o:p>
</font>
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<div id="edn2">
<p class="MsoEndnoteText"><a id="_edn2" title href="http://www.mises.org/manager/Articles/article.aspx#_ednref2" name="_edn2"><span lang="PT" class="MsoEndnoteReference"><font face="Verdana" size="2">[2]</font></span></a><font size="2" face="Verdana">Quoted
in David B. Sicilia and Jeffrey L. Cruikshank: <em>The Greenspan Effect.
Words that Move the World's Markets</em>. New York et al.: McGraw-Hill,
2000, p. 11.<o:p>
</o:p>
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<div id="edn3">
<p class="MsoEndnoteText"><a id="_edn3" title href="http://www.mises.org/manager/Articles/article.aspx#_ednref3" name="_edn3"><span lang="PT" class="MsoEndnoteReference"><font face="Verdana" size="2">[3]</font></span></a><font size="2" face="Verdana">See
Murray N. Rothbard, <em>A History of Money and Banking in the United States</em>,
Auburn: The Ludwig von Mises Institute, 2000, p. 179.<o:p>
</o:p>
</font>
</div>
<div id="edn4">
<p class="MsoEndnoteText"><a id="_edn4" title href="http://www.mises.org/manager/Articles/article.aspx#_ednref4" name="_edn4"><span lang="PT" class="MsoEndnoteReference"><font face="Verdana" size="2">[4]</font></span></a><font size="2" face="Verdana">It
was Alan Greenspan who once wrote that it was"limited gold reserves
that stopped the unbalanced expansions of business activity, before they
could develop into the post-World War I type of disaster." In
Greenspan's view,"the process of cure was misdiagnosed as the disease"
by the promoters of the central bank. Under the true gold standard the
"readjustment periods were short and the economies quickly
re-established a sound bases to resume expansion." The new
system of unlimited loan money in the form of paper reserves that began with
the institutionalization of the Federal Reserve System, however, led to an
overly easy money policy in the late 1920s triggering the speculative mania
and providing the conditions for the depression of the 1930s. <em>Alan
Greenspan: Gold and Economic Freedom</em>, pp. 99. Originally in <em>The
Objectivist</em> July 1966. Reprinted in: <em>Ayn Rand: Capitalism: The
Unknown Ideal</em>. New York: Signet Penguin Books 1967, pp. 96-101.
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