It Wasn't His Fault
David R. Henderson and Jeffrey Hummel say that we shouldn't blame Alan Greenspan for the easy money that preceded the crash. In a new Cato paper, they argue that the critics misinterpreted low interest rates as a sign of excess liquidity.
Certainly worthy of contemplation by others who know more about this topic than I!
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Bill Woolsey - 11/4/2008
I think there are two sensible ways to look at macroeconomics. With either approach, we can explain how it isn't necessarily Greenspan's fault.
One approach looks at the natural and market interest rates. The natural interest rate depends on saving and investment--time preference and expectuations about the profitablity of purchases of capital goods. If we assume monetary equilibrium, then the market interest rate is always equal to the natural interest rate.
(In Rothard's version of Austrian monetary economics, the market interest rate equals the natural interest if the quantity of money changes with the supply of gold. I don't agree with either that approach or the slightly more sensible one that has the market interest rate equaling the natural interest rate if the quantity of money is unchanged.)
In the absence of monetary equilibrium, market interest rates can deviate from the natural interest rate. By creating monetary disquilibrium or correcting monetary disquilibrium created from other sources, a central bank can manipulate market interest rates. They cannot control market interest rates and maintain gold convertibility, the foreign exchange value of the currency, the price level, unemployment, or anything else. Those who claim that international capital markets limit the central bank bascially assume that there are limits to how far the central bank will allow the foreign exchange rate to change. The only absolute limits is that nominal interest rates can't fall below the cost of storing currency (without getting really fancy with currency reform) The other limit is for people to stop using the currency-- a hyper inflationary crack up. Or for the quantity of the monetary base to fall to zero. If there is none of the money the central bank controls or else it is worth nothing, there is no market interest rate in terms of that money.
Anyway, if the natural interest rate fell, perhaps because the Chinese saved a large portion of their growing incomes (global savings glut,) then keeping the market interest rate equal to the natural interest rate requires the central bank to lower its target for the interest rate. If the central bank failed to do so, it could keep market interest rates above the lower natural interest rate by creating monetary disquilibrium. The market process that would correct this would be deflation. (Though with a inflation target of 2%, that would actually be disinflation.) By continuing perverse intervention of maintaining monetary disquilibrium the central bank could stubbornly keep the market interest rate above the natural interest rate.
The other way of looking at matters is the supply and demnad for money. You can use whatever measure you want, but always remember that the financial intruments you don't count as part of the money supply are going to be impacting money demand as close subsitutes.
The amount of money people choose to hold can change. A central bank can adjust the supply of money to match that demand. During the ninties, there was a large drop in the M1 measure of the money supply. There was no deflationary crisis, presumably because this change in money supply was matched by a decrease in money demand. (Perhaps people were instead holding other financial instruments that are not counted as being part of the money supply using this approach.)
Anyway, if the money supply is adjusted to money demand, then interest rates depend on supply and demand for various credit instruments. These supplies and demands reflect time preference and expectations of future profitability.
To make a long story short, there is no way to look at interest rates or meaures of the money supply to determine whether a central bank has somehow managed to get it right.
This is especially true of expremely narrow measures of the money supply, like the monetary base or bank reserves.
In my view, the demnand for bank reserves dropped off rapidly during the last decade. It was caused by a decease in the supply of checkable deposits. That decreae in the supply of checkable deposits for the most part matched a decrease in the demand for checkable deposits (because many people were able to hold funds in savings accounts at night when these things are actually measured due to the introduction of sweet accounts.) The supply of bank reserves dropped.
However, if the Federal Reserve failed to decrease bank reserves enough, then there was an excess supply of money. That is, the Fed failed to prevent monetary disequilibrium created by a switch from checkable deposits to other sorts of financial intruments.
I believe that the Henderson/Rummel article failed to emphase the importance of redeemability between vaious sorts of money, which is how control over the quantity of base money allows a central bank to maintain control. However, the other side of that coin is that there is no particular reason to assume that it isn't necessary to decrease the monetary base to prevent inflation. The demand for "money" given this narrow definition, could easily fall. And, if that occured, I would expect that market interest rates would be below the natural interest rate. That is, there is too much money and interest rates are too low... Because the central bank failed to decrease base money enough.
William J. Stepp - 11/4/2008
The authors make a number of good points in their Cato paper, including the fact that the Fed can't control interest rates (or anything else).
Thus, if the Fed sets a Fed-funds rate target of 1.5%, but the underlying fundamentals call for short-term market rates to be, say, 2.5%, the monetary planners are likely to be disappointed as they watch the rate rise above the target.
They go on to echo Milton Friedman’s back-handed praise for the Maestro, and exonerate him for the tech bubble of the late 1990s and bust of the early 2000s, as well as the post-tech round trip housing boom and the recent housing bust.
Along the way, they claim that focusing on interest rate changes will mislead observers seeking to understand economic changes that make up the stuff of business cycles. Instead, they argue, it’s better to look at changes in money supply aggregates, such as MZM, M1, and M2, and their presumed effects on economic activity.
They cite some historical examples, such as very low interest rates in the Great Depression, and very high ones during the Great Inflation of the 1970s. The only problem with these stylized facts is that, while they are true for nominal rates, they get real rates inside out. Nominal rates were very low during the 1930s and very high during the 1970s (they peaked in the third quarter of 1981, when Paul Volcker was trying to “kill” inflation). However real rates were at all-time highs during the early 1930s (which is the primary reason investment demand collapsed—that and the “regime uncertainty” under King Franklin). Here I would refer you to a fine graph in Ken Fisher’s book _The Wall Street Waltz_, which shows just how high they were in real terms. During the 1970s, nominal rates were high, but real rates were considerably lower, although no where near all-time lows.
As for the monetary aggregates, Frank Shostak showed at the Mises website that the definitions of MZM and M2 have lots of problems, such as double counting money market funds. (Frank Shostak, “Making Sense of Money Supply Data,” 12/17/03.)
The Fed threw in the towel on M3 a couple years ago and stopped compiling data for that number.
More to the point, since when are Austrians monetarists? Monetarists fixate on aggregates such as money supplies and price levels (when they aren’t misunderstanding the history and theory of free banking, and fixating on the anti-libertarian fallacy of fix vs. float in foreign exchanges), and side issues such as rational expectations. Therefore they can’t understand the microeconomics of the business cycle. But that brings us back to interest rates, and the crucial coordinating role they play, which was emphasized in the writings of Mises, Hayek, and Rothbard, among others, and more recently the in the writings of contemporary free banking economists, such as Selgin and White, and the underappreciated contributions of the Austrian-educated James Grant, in his biweekly and well-named _Grant’s Interest Rate Observer_.
According to a _Business Week_ article a while back, in recent years banks have supplied a declining portion of credit for investment purposes. I forget the number, but 30% sticks out in my mind, and I about fell out of my chair when reading that. The balance came from non-banks and the shadow banking system—credit unions, pension funds, private equity funds, hedge funds, etc. When the Fed cut rates after 9/11, and then lowered them in 2003 and 2004 to a point where real rates were negative, this fueled a credit boom, which in turn caused the housing and mortgage boomlet to morph into a full-fledged boom. This also fed the developing commodities boom, and the options and futures boom associated with it. It also fueled the growth of mortgage-backed securities and derivatives, and CDOs, SIVs, and credit default swaps issued by banks and insurance companies. Common shares of banks, and commodity- and housing-related firms rose to unsustainably high levels. When the boom ended, banks and a few insurers were shown to be short of the capital they needed to complete their investment projects. So were some overly-leveraged builders and mortgage owners.
So were some leveraged commodities producers and investors, including some hedge funds. This led to some forced selling of assets and bankruptcies.
Economics is a coordination problem, as O’Driscoll wrote in his book on Hayek. The business cycle is what happens when the government interferes first and foremost with interest rates. When a central bank pushes rates below the free market rate (the rate which would be determined by people’s time preferences), at some point this will cause
an investment boom and a business cycle, with a reversal of the boom and a resulting bust. When rates are too low, the economic calculations of entrepreneurs (this includes traders at banks, in addition to home builders, mortgage lenders, and commodities producers) are distorted. They value the cash flows of their investments for more than they are worth in a free market; and they invest (i.e. malinvest) too much in them. This causes economic discoordination in the form of a structure of production that is too long for the pool of real capital resources available to complete them called forth by the real rate of interest.
This is what happened when the Fed cut rates, in my view. There was a huge credit boom, the existence and effects of which cannot be understood by an appeal to monetary aggregates and other monetarist paraphenalia.
The authors plead agnosticism as to the causes of business cycle.
The question is: is central bank interference with interest rates a necessary and sufficient condition for the business cycle to exist? I think it’s obvious that it’s a necessary condition. Is it a sufficient condition? I vote yes—early and often.
The only way to end business cycles is to adopt Hayek’s 1976 call for free trade in money, which I have just been rereading. The authors are right in calling for this reform and for bank deregulation. Bring on the rule of law, and consign the bank regulators—and the central bankers--to the dustbin of history.
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