Andrew Mellon, who served as Treasury secretary under Presidents Harding, Coolidge and Hoover, summed up the reaction to the 1929 stock market crash and ongoing recession as "liquefy stocks, liquefy bonds, liquefy real estate. Liquefy, liquefy, liquefy."

This flight from risk into cash can be seen today in the burgeoning assets of money market mutual funds -- from $1.704 trillion to $2.078 trillion within the past year -- and in a relentless outflow from riskier stocks and bonds into the safety of Treasury securities.

The three 50 basis-point cuts in the federal funds rate in 2001 have been remarkably ineffective in restoring any sort of risk-seeking behavior.

The spread between low-grade BB- corporate bonds and 10-year Treasuries is wider now than it was at the time of the first rate cut, noted on the chart below, and the relative performance of the Nasdaq Composite to the S&P 500 has continued to deteriorate.

The Fed continues to fear inflation, but this argument is increasingly lame. For one, the price indices fail to take key features of consumer behavior into account. The consumer price index, for example, assumes no technological improvements in its underlying market basket and does not allow for either substitution or price elasticity of demand. As a result, the CPI can be pushed higher quickly by jumps in certain components, even while most of us do not feel the inflationary impact.

Worse, our economic data system is still geared toward the manufacturing economy of the 1950s and 1960s. We can count automobiles with great precision, but we are less adept at measuring intellectual property, the cornerstone of the 1990s boom.

The shock to the economy of the loss of a generation of young entrepreneurs may not be as great as the loss of a generation in wartime, but the concept is parallel. How can we measure the loss to the economy from what will be years of risk-averse behavior? It is often said that economic forecasting is like driving in the rearview mirror; we are now doing this with a broken speedometer to boot.

If inflationary pressures were a problem, they would show up in the commodity and currency markets. After all, if each dollar is worthless, then it stands to reason that both commodities and foreign currencies should be worth more. This has hardly been the case over the past year. The trade-weighted dollar index has gained 11.4%, while the Bridge/CRB commodity index has fallen 0.5% from year-ago levels. The commodity plunge would look far weaker without the explosive increase in natural gas prices.

It All Comes Down to Money

The monetary base is the total amount of money in circulation, plus reserve deposits at central banks. While it's not a perfect measure of total liquidity -- no such measure exists in an open global economy with free capital flows -- it is indicative of the resources available to support both real and financial asset prices.

Its growth rate slowed markedly from mid-1993 to mid-1996; the Asian crisis began a year later. A flood of liquidity prompted by the Asian and then Russian crises of 1998 led to the global financial inflation of the late 1990s. The culmination of this process was the Fed's flood of money in anticipation of Y2K problems, proof positive that belief in the occult did not die in the ancient times.

Less Money, More Problems A drop in the monetary base growth rate exacerbated other problems within the economy

Once Y2K was out of the way, the Fed slammed on the brakes and produced a rather precipitous drop in the monetary-base growth rate; it actually contracted between December 2000 and January 2001. This contraction exacerbated the effects of high energy prices, the Nasdaq shock and our fiscal surplus. Small wonder the economy is contracting and the stock market just completed its worst quarter in more than a generation.

Unless the Fed forgets its inexplicable fixation on a nonexistent inflation and its delusion that the economy, as measured by outdated statistics, is doing just fine, we're going to be in serious macroeconomic trouble.