Since the wheels started coming off the wagon of the U.S. financial markets in June 2007, when Bear Stearns allowed two hedge funds it managed go broke after losses on mortgage-backed securities, Federal Reserve economists have taken a curious stance.
It reminds one of a cartoon scene: An angry homeowner, baseball in hand, charges out of a house with a shattered picture window. In an adjacent vacant lot, several boys with baseball gloves and bats try hard to look nonchalant while their leader protests, “Baseball? No mister, we didn’t lose a baseball.”
The Fed officials’ version of this goes something like: “Bubble, bubble? Oh no, we didn’t have anything to do with any bubble. And, if we possibly did, there was nothing else we could have done. Nobody had the faintest idea that a bubble might cause problems!”
Outgoing Minneapolis Fed President Gary Stern thus deserves at least limited kudos for having broken ranks and, in a speech last week in Willmar, acknowledging that perhaps central banks like the Fed should take asset price bubbles into account when making decisions about the money supply and interest rates.
The idea that they should is hardly new. Nearly a century has passed since Irving Fisher, one of the finest pre-World War II U.S. economists, argued that central banks must consider increases or decreases in the broadest possible range of prices when making monetary decisions. According to Fisher, these must include the prices of real estate and financial instruments, in addition to consumer and wholesale prices.
If the money supply is allowed to grow too fast, the excess liquidity may drive up the prices of consumer products. Or it may show up in rising prices for land, buildings, stocks, bonds and other financial instruments. But sustained, greater-than-trend increases in either goods or long-term assets are not spontaneous, but result from excessive money growth.
Yet the spontaneous-generation model of bubbles is Alan Greenspan and Ben Bernanke’s implicit explanation for the sharp run-up in stock prices from 2001 to 2007 and the unprecedented boom in housing prices over the same period. Like Topsy, the slave girl in “Uncle Tom’s Cabin,” these bubbles “just grew.”
Greenspan goes further in shirking responsibility, arguing that he was powerless to slow the bubble because any slackening of money growth would have thrown the economy into recession. One can only wonder what he thinks we are in now.
One should not demonize Greenspan, however. He had only one vote of 12 on the Federal Open Market Committee that determines how fast the money supply, and thus the level of short-term interest rates, grows. But in practice a Fed chair is far more than first among equals, and fairly or not, historians will eye Greenspan more closely than anyone else. Here are some facts they will note:
Greenspan served nearly 19 years, and the contrast between his early and later years is striking.
In the first 10 years of his service, M2, a broad measure of the money supply, grew 42 percent, only slightly more than the inflation-adjusted value of national output — 35 percent. In the final eight years of his term, M2 grew 65 percent, versus real output growth of 25 percent.
In the three calendar years after the 1991 recession, the money supply grew a total of 3.4 percent. In the three years after the 2001 recession, the money supply grew 17.5 percent.
The Fed Funds rate, the interest rate targeted by Fed policy makers, was less than the rate of inflation for 35 of the last 60 months Greenspan headed the Fed. This occurred in only 88 months out of the previous 46 years.
(On a more frivolous note, those who believe Greenspan favored Republicans over Democrats with easier money may seize on the fact that the money supply grew 6.5 percent a year in the George W. Bush administration but only 4.7 percent during Clinton’s. But the “maestro” was even harder on George H.W. Bush, letting M2 grow only 3.4 percent annually.
However, those familiar with the work of economists Ulrike Malmendier of Berkeley and Geoffrey Tate of UCLA may find support for their argument that the more famous executives become, the worse their performance. In the five years before publication of “Maestro,” Bob Woodward’s fawning book about Greenspan, the money supply grew 4 percent a year. In the five years after, annual growth was 6.2 percent.)
But the upshot is that the bubble did not grow out of nothing or nowhere. It is a classic case of too-rapid money growth over too long a period.
In the long run, historians will judge the Fed’s lax money growth harshly. In the short run, until Ben Bernanke and other key Fed leaders are willing to acknowledge how badly their institution blew it, we are not likely to have prudent policies to avoid future debacles.
© 2009 Edward Lotterman
Chanarambie Consulting, Inc.