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Why the Fed Can't Head Off Recessions

By Editorial Staff Tue, 05 Feb 2008 10:45:00 ET	Email |  Print  |  RSS |  My Updates	Bookmark and share It!

This week, the Federal Reserve took emergency measures to cut the federal funds rate by 75 basis points – the largest amount in recent history. Since this move came on the heels of a global stock market meltdown on Monday, January 18, the Fed looked like it was panicking. Action like this begs the question: Does the Fed really know what it's doing? It seems like that's the fairy tale that most people want to believe. But for years now, Bob Prechter has been warning people not to believe in that fairy tale. Here's what he wrote back in 2003 about why the Fed can't head off recessions and save the economy. 

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Excerpted from Conquer the Crash: You Can Survive and Prosper in a Deflationary Depression by Robert Prechter, published in 2003 by John Wiley & Sons, Ltd.

The primary basis for today's belief in perpetual prosperity and inflation with perhaps an occasional recession is what I call the "potent directors" fallacy. It is nearly impossible to find a treatise on macroeconomics today that does not assert or assume that the Federal Reserve Board has learned to control both our money and our economy. Many believe that it also possesses immense power to manipulate the stock market.

The very idea that it can do these things is false. [A few years ago] before the House and Senate Joint Economic committee, then Chairman Alan Greenspan himself called the idea that the Fed could prevent recessions a "puzzling" notion, chalking up such events to exactly what causes them: "human psychology."

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This is not a place for a treatise on the subject, but a brief dose of reality should serve. Real economic growth in the United States was greater in the nineteenth century without a central bank than it has been in the twentieth century with one. Real economic growth in Hong Kong during the latter half of the twentieth century outstripped that of every other country in the entire world, and it had no central bank.

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It is a principle that meddling in the free market can only disable it. People think that the Fed has "managed" the economy brilliantly in the 1980s and 1990s. Most financial professionals believe that the only potential culprit of a deviation from the path to ever greater prosperity would be current-time central bank actions so flagrantly stupid as to be beyond the realm of possibility. But the deep flaws in the Fed's manipulation of the banking system to induce and facilitate the extension of credit will bear bitter fruit in the next depression. [emphasis added]

Economists who do not believe that a prolonged expansionary credit policy has consequences will soon be blasting the Fed for "mistakes" in the present, whereas the errors that matter most reside in the past. Regardless of whether this truth comes to light, the populace will disrespect the Fed and other central banks mightily by the time the depression is over.

For many people, the single biggest financial shock and surprise over the next decade will be the revelation that the Fed has never really known what on earth it was doing. The spectacle of U.S. officials lecturing Japan on how to contain deflation will be revealed as the grossest hubris. Make sure that you avoid the disillusion and financial devastation that will afflict those who harbor a misguided faith in the world's central bankers and the idea that they can manage our money, our credit or our economy.

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Tags: Federal Reserve, Fed, recession