Over the last year there has been considerable debate about if, and if so, to what extent Alan Greenspan is to blame for our recent economic woes. I've pretty much sat on the sidelines on this one, feeling myself unskilled to pass judgment. But no more. Reflecting on what I've learned on monetary policy (as exercised by the Federal Reserve, or just Fed), and the role money is playing in our current slowdown and attempted rescue, I've developed some insights.
During an earlier essay I developed an outline of how a sudden, and drastic, contraction of the monetary base has influenced our current downturn. A reasonable question that can be asked is: “Proceeding the contraction, was there a visible over-expansion (bubble) of the money supply that should have triggered actions by the Fed?”
It is a reasonable query, because this is how the Fed works to regulate the money supply. When inflation is low and unemployment high, the Fed reduces interest rates in the hopes that by allowing for an increase in the money supply, production will increase, which will require hiring, which will boost the economy, leading to lower unemployment, larger profits, and a positive trade balance. If the economy heats up too much, and inflation becomes present, the Federal Reserve puts on the brakes by raising interest rates. The higher rates make it more expensive to borrow, and require an anticipation of larger spreads to make it economical to do so. Thus, lending is reduced, the rate of increase of the money supply is diminished, and inflation is controlled. This is the basic monetary policy followed by the Feds.
It's not a perfect policy, as many economists will point out. Raising interest rates has the unfortunate side effect of throwing people out of work, with difficult consequences for those individuals. And lowering the interest rate in the hopes of generating growth can be akin to 'pushing on a string' in the words of one notable economist (John K. Galbraith). Consider: Business does not borrow money just because it can, but because it anticipates a reasonable return on the investment, which predicates an increase in sales. If future sales don't seem plausible, business won't borrow, regardless of the interest rate.
It also predicates that all inflation is caused by too rapid increases in the money supply. What about energy inflation: That inflation caused because of reduced availability of the energy to drive production, and the co-commitment increase in the costs of almost everything?
Nevertheless, this is the stated policy of the Federal Reserve, and Alan Greenspan its overseer for a long time. Let's look at the events of 2000-2007, and see what was happening, and answer our question about whether Mr. Greenspan should have recognized what was occurring and taken some action.
If we look at inflation figures for the time span in question, we see that inflation is low, and remained low for the entire period. We see an Average value of 3.01% for the entire period, with it ranging from 1.07% to a high of 4.69%. However, since the median is 2.79%, there are more months under the average than above. The worst period, from May through Aug 2006, is the only period to average above 4%.
Mr. Greenspan and the Federal Reserve kept interest rates low throughout this period, and based on the inflation figures, they should have. (The Federal Funds Rate stood at 5.50% on Jan 1 2000, and after a brief raising to 6%, dropped steadily during 2001-2004 to bottom at 1% in 2003, and then climbing slightly thereafter, reaching 5.25% in June 2006, and then falling during 2007.) Mr Greenspan exonerated?
I don't think so. If the Consumer Price Index were the only place we could spot an inflating money supply, then yes. However, that is not the case. There are at least three additional areas where an inflating money supply (inflation) can be spotted, and with his background, I would argue that Mr. Greenspan should have noted all three, and taken action.
The first was the growing trade imbalance, notably with China. In a sense, there really is no trade in-balance: If goods are predominately flowing one way, then money is predominately flowing in the opposite direction. To sustain an overall import / export imbalance requires the creation of enough money to cover the difference. The US-China trade deficit (from the US standpoint) stood at $83 bn in 2000 and 2001, and then increase at over 20% yearly to end up $256 bn by 2007. That is a total increase of almost 300%. Since the US economy wasn't growing at that rate, that should have been a flag. (US GDP grew from $9817 bn in 2000 to $11539bn in 2000 dollars by 2007 – an overall increase of just 17.5%, and to $13807 in real dollars, again just 40%).
The second was vastly increasing government deficit. Recall, deficit spending effectively enters money into the economy. The greater the deficit, the greater the increase in money supply. As the budget surpluses of the 1990's ended, and grew to yearly deficits approaching $400bn, something was going on.
The third indicator of inflating money supply was the rapid run up of housing prices, well above trend levels. Data compiled by Robert Shiller of Yale shows that housing increasing by over 10% per year, when historically it ran much closer to the CPI value – just 4% per annum during 1980-2000. Of course, this makes sense: The banks were making housing loans at an unprecedented rate, pushing up the rate of money increase, and driving housing prices proportionally. Additionally, housing prices historically run 3 to 1 on income. By 2004 they had risen to 4 to 1, and beyond in some markets. A clear flag something was amiss.
It becomes clear that the Federal Reserve should have been much more aggressive in raising interest rates during the time period. A rapid run up of interest rates would have possibly slowed the housing growth, perhaps even pushing the 'bad' loans into foreclosure at a faster rate, and revealed the weakness of the Collateralized Mortgage Backed Securities. Perhaps an aggressive stance vis a vis the interest rate would have unwound the unsupportable Credit Default Swaps before the companies got too far into them.
That's not all the Fed could have done. Recognizing the problem would have allowed Mr Greenspan to speak out on it – to use his pulpit as the nation's foremost economist to warn, stridently, about what was going on and the unsustainability of it all. But, he didn't do that either.
Of course, if no-one had recognized the issues, we could let Mr Greenspan off the hook. But, read this from 2004, and convince yourself that Mr Greenspan couldn't see what was going on.
So. Mr. Greenspan is the villain many say he is. All very neat and tidy.
But, there is a catch with foisting the blame on Mr. Greenspan's shoulders. Can you see what it is?
Sources:
http://inflationdata.com/inflation/Inflation_Rate/CurrentInflation.asp
http://www.the-privateer.com/rates.html
http://www.uschina.org/statistics/tradetable.html
http://www.bea.gov/national/index.htm#gdp
http://www.econ.yale.edu/~shiller/data.htm
http://www.globalpolicy.org/socecon/crisis/tradedeficit/tables/budgetdeficit.htm
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