May 15, 1997

Demigods in Pinstripes

By JAMES GRANT

ext week, when a Federal Reserve Board committee meets behind closed doors to discuss interest rates, the press will be expectantly crouched by the keyhole. Is there another governmental planning body, in this country or the former Soviet Union or points in between, whose deliberations inspire even a small charge of electricity, let alone reverence?

The veneration of central banks is the idolatry of the 1990's. Enjoying ultra-low unemployment in the United States, Americans worship and fall down. Yet -- strange to tell -- Germans seem to think no less of their own central bank despite record-high unemployment in Germany. It strains belief that the Fed could, by imposing a single interest rate on an increasingly deregulated financial system, cause a $7.9 trillion economy to move obediently in the desired direction -- or keep an $8 trillion stock market from falling out of the sky.

The most trenchant technical criticism of central economic planning was that the planners couldn't know enough to see into the future. The same holds with equal force about central banking.

Yet in this heyday of free markets, central bankers and the currencies they manage have never been more trusted. The stupendous bull market, the apparently endless economic expansion and the historically moderate inflation rate are things of wonder. Well, somebody must have caused them. Somebody, certainly, would be blamed if they went up in smoke. These days, praise or blame seems to fall on one head more than any other, that of the Fed's chairman, Alan Greenspan.

And so it goes around the world. There is a global bull market in the institution of money management. An "independent" monetary authority has become the intercontinental ideal. Independence, in this context, means liberation not only from gold bullion, which used to anchor the dollar, but also from politics. Even the politicians are prepared to believe that central bankers know best (or, at the least, that it would be inexpedient to suggest that they don't). Certainly, there are enough central banks: 171 in all, not forgetting those of Tonga, São Tomé and Príncipe and the Solomon Islands.

When, in its fourth day of existence, Britain's Labor Government conferred on the Bank of England a new measure of autonomy in setting British interest rates, it cast its lot with governments around the world. Central banks, the Laborites implied, should be above petty politics. Drinking in the news, the London financial markets surged.

Likewise, the Japanese Government is moving to confer a measure of independence on the Bank of Japan. And the nations of a possible European Monetary Union are said to envision a future European central bank along the lines of the fiercely independent German Bundesbank.

There is just one thing wrong with this monolithic consensus about the omniscience and omnipotence of central banks: It is almost certainly wrong.

The only certainty about 20th-century monetary arrangements is their changeableness.

No monetary system has lasted much longer than a quarter century. The classical gold standard died in World War I. Its successor, the road-show gold standard (the so-called gold exchange standard), sputtered out during the Great Depression. A still more free-form gold standard, Bretton Woods, came a cropper in the inflation of the early 1970's. The current pure paper standard -- in the Fed's case, a system based on the manipulation of a single interest rate, the Federal funds rate -- can therefore be considered almost long in the tooth.

Yet it, too, seemed to have no future at all on Aug. 6, 1979, the day Paul Volcker took over the apparently thankless job of leading the Fed. Inflation was then shortening the shelf life of money the world over. By the fall of 1981, long-term United States bonds had to yield 15 percent to find any buyers.

Then, a miracle: the high interest rates set by the Fed brought inflation down.

What is largely ignored, however, is that the high rates did not bring about an actual fall in prices. Historically, rising prices had generally been followed by falling ones. In the 1980's, there was no deflation, but rather "disinflation," merely a slower rate of price increases.

The Volcker Fed inherited an inflationary mess, but by 1987, when Mr. Greenspan took over, it bequeathed one of another sort: asset inflation, caused in part by a series of Fed-engineered interest rate deductions in 1986.

Mr. Greenspan was faced with a case of overblown prices in the stock market (and in the real estate and art markets) rather than at the checkout counter.

The excesses, which cropped up globally, were most vividly on display in Japan. Falling interest rates and a depreciating dollar (the latter helpfully engineered by the Reagan Administration) contributed to one of the zaniest and ultimately most destructive speculative episodes in history. Japan, its banks devastated by bad loans, is still trying to recover.

So is the world. In the 1990's, a kind of deflationary undertow tugs at many countries' economies almost eight years after the Japanese crackup. Central banks, complicit in the asset inflation of the 1980's, are now the not wholly deserving beneficiaries of the disinflation of the 1990's.

To be sure, consumer price inflation is setting new low readings almost everywhere.

Before giving unconditional thanks for this blessing, however, we might pause to reflect on its probable future costs.

In central banking, as in so many other human endeavors, underdoing it leads to overdoing it, and vice versa. In Germany, Japan and Switzerland, central banks have pushed interest rates down to record, or near-record, postwar lows. It is telling that these heroic measures -- modeled in part on the Fed's efforts -- have so far failed to revive their moribund economies.

What central banks can do is to manipulate domestic interest rates. What they can't do is what American entrepreneurs have so often successfully done: create jobs, build software companies, rehabilitate office buildings that should never have been built in the first place.

The suppression of interest rates, of course, can be highly inflationary -- both for the prices of financial assets and the reputations of central bankers. "Remember the glut of Japanese bank money that swept the world in the 1980's and led to the staggering bad loan problem that now hobbles the nation's banks?" The Wall Street Journal asked the other day. "Well, the Japanese banks are at it again -- this time in Asia." Despite clear signs of a new lending riot, there is no shortage of economists who are prepared to reassure us that the business cycle is dead.

Anything is possible, of course. It seems to me, however, that the new idolatry has already changed the behavior of individuals and corporations in ways that will contribute to the next downturn.

Believing devoutly in central banks, investors have assumed more risk than they would have taken in a more suspicious frame of mind. Seizing on their ability to borrow at low rates, corporations have overspent on capital projects ranging from automobile plants to semiconductor factories. Trusting implicitly in paper money, bankers and bondholders have apparently failed to draw any alarming, or even cautionary, conclusions from the recent plunge in the dollar exchange rate.

Only a Puritan could quarrel with easy credit, sky-high stocks and vintage champagne. But there should be no mistaking these time-honored symptoms of lax monetary policy with the permanent genius of central bankers.

James Grant, editor of Grant's Inter est Rate Observer, is the author of ``The Trouble With Prosperity: The Loss of Fear, the Rise of Speculation and the Risk to American Savings.'