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Twist? Again?

September 26, 2011

Tags The FedInterventionism

Do you remember when,
Things were really hummin',
Yeaaaah, let's twist again,
Twistin' time is here!

So crooned that 1960s social philosopher, Chubby Checker, hoping to extend the popularity of the dance craze he started in a follow-up song urging the kiddies buying his music to do it again for another year. It was a successful twist on the Twist; his sequel, "Let's Twist Again" won the Grammy for best rock recording.

They twisted like crazy in 1961. And it wasn't just Chubby and his followers.

William McChesney Martin, the epitome of the boring-by-design Fed chairman, came up with a twist of his own. His "Operation Twist" involved purchasing long-term bonds with the proceeds resulting from the sale of short-term bonds during the first year of the Kennedy administration. Essentially rearranging the Fed's portfolio, the arch-Democrat, whose father helped write the Federal Reserve Act for Woodrow Wilson, attempted to thwart the effects of his monetary expansions on long-term interest rates.

A Yale student at the height of Irving Fisher's fame, Martin knew one of the effects of monetary inflation is an upward pressure on interest rates. Lenders tend to require higher rates of return when they expect the price level to rise. After all, they loan purchasing power and want to be paid back with at least the same amount of purchasing power in the future.

So when I loan you a dollar today, I am actually loaning you the goods you can buy with that dollar. However, I am worse off if the dollar paid back can be exchanged for fewer goods because prices have risen. That's why, if I expect prices to rise, I am more likely to require a higher rate of interest.

But I'd have a harder time charging a higher rate if the Fed is able to force down rates by buying up a bunch of loans in the same category as mine. Such actions counter the "Fisher effect" we teach in macroeconomics. It states that there is a positive relationship between expected inflation and nominal interest rates.

"Clearly, Bernanke's policy gun is out of bullets."

By twisting the Fed's portfolio, Martin attempted the monetary equivalent of having one's cake and eating it too. He wanted the Fed to engage in the inflation desired by the political class — to finance the 1960s version of welfare and warfare spending — without inflicting on the country the adverse effects that follow money printing, including rising rates.

The verdict of the economics establishment on this episode is that Martin's time would have been better spent practicing the Twist than implementing Operation Twist. The research indicates a small effect on interest rates. One paper coauthored by future Nobel laureate Franco Modigliani argued that the purchases were too small and spread out over too long of a time period to have a significant effect on long-term rates.

This literature is well-known to Ben Bernanke. The current Fed chair included it in a 2004 paperDownload PDF he coauthored studying possible Fed policies at a time when normal open-market operations are hindered by a zero lower bound federal funds rate. Yet, 50 years later, twistin' time is here again. Buoyed by new researchDownload PDF by San Francisco Fed economist Eric Swanson, Bernanke plans on selling about $400 billion in short-term Treasuries and buying longer-term Treasuries with the proceeds, within the next nine months.

Clearly, Bernanke's policy gun is out of bullets. His grasping at a new Operation Twist underscores the sense of impotence of Fed policies that have today brought low growth, high unemployment, and a 7.2 percent increase in producer prices over the last 12 months. Its attempts at stabilization have instead wrought chaos both in the United States and overseas, reflecting what happens when, on the outset of a recession, policies are implemented to avoid correction with an infusion of trillions of dollars of new money.

Similar massive interventions, especially on the fiscal side, are what caused a market correction in 1929 to drag into a 17-year contraction. The powers responsible for that episode also tried to mask their impotence with Twist-like gimmicks as well.

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It's possible that today the public is catching on. We are far away from 1961. For proof, consider the scrutiny placed on Bernanke's job performance compared to that received by William McChesney Martin.

Martin, of course, was virtually unknown in the popular mind, thanks in part to a large establishmentarian media characterized by three television networks. Bernanke, in contrast, has to deal with the fact that even MSNBC was so underwhelmed by his Twist that it decided to discuss it with Chubby Checker himself.

"The Twist has always meant money for everybody," the 69-year old gushed to his hosts, presumably referring to the song, not the Fed policy tool. If not, then Checker's confusion of money with real wealth suggests he has more in common with central bankers than he realizes.


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