Anyone with a sense of history must watch the Federal Reserve's current effort to rein in the raging economy with fascination and some foreboding. Since June 1999, the Fed has progressively raised overnight interest rates from 4.75 to 6.5 percent. The idea is to control a speculative boom without causing a recession or condoning higher inflation. It's a daunting challenge _ and history is littered with many failures. The problem is not that the Fed is inept. It is the unavoidable instability of speculative booms.
Every speculative boom will, if left alone, ultimately collapse. Prices (typically of stocks or land) that once seemed reasonable are recognized as outlandish. People become poorer, as real estate or stock portfolios lose value. But efforts to dampen the boom may prove ineffective (speculative fever is too intense) or, perversely, simply accelerate an economic downturn.
The Fed faces a dilemma. If it acts, it may fail; it if doesn't act, it may fail. Its ultimate target must be consumer spending _ not the stock market. In 1999, American consumers spent $6.26-trillion, almost 68 percent of the economy's output. For seven years, consumer spending has increased faster than consumer income. Americans have spent more of their incomes because the strong stock and job markets have bolstered wealth and confidence. This spending has driven the boom and now risks inflation.
In theory, higher interest rates could temper consumer spending just enough to minimize inflation and avoid recession. But in practice? Everything is related. In 1992, consumers spent about 91 percent of their disposable income and saved the rest. By 1999, they spent almost 98 percent of income. Strong consumer spending has increased corporate profits. High profits have raised stocks and business investment. Suppose weaker consumer spending put the whole process into reverse. Would the economy and market drop with a thud? Or might it drift into a period of stagnation? Inevitably, the Fed is flirting with trouble.
History provides scant comfort. Countless speculative booms have ended badly. Asia's financial crisis of 1997-98 is only the latest. Banks over-lent for office buildings and factories that could not generate the income to repay loans. But while it lasted, the lending pushed stock prices higher and unemployment lower. The same happened in Japan in the 1980s. Even now, the Japanese stock market is only about half its 1989 peak.
America also has had its speculative busts. Of course, there's the 1920s. Economist Allan Meltzer of Carnegie Mellon University has compared stock price increases (adjusted for inflation) then and now. "They lie almost on top of each other," he says. In 1929, the Fed raised interest rates. "The argument was that there was a speculative boom and it had to be broken."
What fed the boom, paradoxically, was faith in the Fed itself. Until the early 20th century, bank panics had plagued America. In 1913, Congress created the Fed to avoid them. By the late 1920s, it seemed to be succeeding. "All the talk is of how the Fed has figured out how to maintain prosperity and low inflation _ just like now," says Meltzer. The Great Depression of the 1930s stopped the talk.
Less well known is the land boom of the 1830s. Farm prospects looked great. From 1830 to 1836, cotton and wheat prices increased by two-thirds. Federal land sales boomed. In 1830, they were 2-million acres; by 1836, they were 20 million.
Then the boom imploded. President Andrew Jackson tried to halt land speculation with his Specie Circular of 1836. This decreed that only gold and silver coin ("specie") _ and not paper money _ could be used to pay for federal land. In 1837 and 1839 there were bank panics. The ensuing slump was one of the nation's nastiest. Farm prices plunged. Factories shut.
What's common to all these booms is euphoria. In the 1830s, states were so optimistic that they madly issued bonds to build railroads and canals that would bring farm products to market faster. By 1842, eight states had defaulted on their bonds. In the 1980s, Japan was the wave of the future. Before the Asian crisis, there was the "Asian miracle." The future always seemed boundless. Sound familiar?
History need not repeat itself. The country long ago left the gold standard, which caused the Great Depression. The economy is growing so fast that it could slow considerably without stopping. If it slows too much, the Fed could cut interest rates. For optimists, there are reasons to remain optimistic.
Still, history casts a shadow. What the Fed tried in 1929, notes economic historian Peter Temin of the Massachusetts Institute of Technology, "was a surgical operation." It would curb speculation without crushing the economy. This is "really hard to do," he says. The Fed "is trying to do it again today, and it's still hard to do." No one can quarrel with that.
Robert J. Samuelson is a columnist for Newsweek.
Washington Post Writers Group