Blaming the Fed

It is surely more shameful to lose a good reputation than never to have had one. During the great equity bubble of the 1990s Alan Greenspan acquired an illustrious reputation as the world's greatest central banker and staunch guardian of the U.S. dollar. His admirers in the U.S. Congress never tired of applauding him and Queen Elizabeth of the United Kingdom joined them by knighting him. But since the collapse of the bubble and the $8 trillion decline in equity wealth since 2000 he may have lost some of his repute. A few critics now hold him and his Fed colleagues responsible for it all.

With his reputation at stake the Federal Reserve chairman is rejecting all such charges. In a recent speech to the money managers around the world Mr. Greenspan assured them that there was nothing he could have done to prevent the bubble and its collapse. It is beyond the ability of central bankers or anyone else, he asserted, to know with certainty that a bubble actually exists. And even if they knew, neither tough talk nor tight margin requirements would have been effective. Even boosts in interest rates would have worked only if they had produced a recession. Surely no one could expect him to kill the patient with the cure.

Most Americans probably agree with the Chairman. They believe him because he led and encouraged them in a decade of feverish financial activity and soaring stock prices; they trust him because he always consults the thermometer of public opinion. Most economists probably are in accord with him because they embrace financial theories and doctrines similar to those that guide the Chairman. If called upon, they would gladly follow in his footsteps.

The few critics who hold him and his Fed colleagues responsible for the financial instability disagree with the Chairman on every issue. They are astounded by his inability to know with certainty that a bubble actually exists. Economic bubbles have plagued the American economy ever since the First United States Bank opened its doors in Philadelphia in 1791. They preceded and led to many financial crises and even depressions, which have been an important object of economic research and voluminous writing ever since.

Searching for the causes of the equity bubble and its painful aftermath, the critics immediately point to the Fed's very mandate "to regulate the national money supply." The mandate obviously elevates Fed regulations over all laws and principles of the market, which, as all economists know, would destabilize and impede the smooth functioning of any and all economic activities. In equity markets the visible symptoms are extravagant price-earnings ratios. The historic P/E ratio of the DOW stocks hovers around 12; it soared to more than 50 during the 1990s and after a precipitous decline still stands at 20.86 today, November 1, 2002. Surely, when stock prices sell at four times their historic values, the suspicion of a feverish market should arise. Earlier this year Intel was selling at 160.7 times earnings, Disney at 142.6 and Eastman Kodak at 118.1; it is difficult to overlook such ratios or justify them with prospects of wondrous profits in the future. The bubble ratios of the National Association of Securities Dealers Automated Quotations system (NASDAQ), which provides price quotations for securities traded Over the Counter as well some New York Stock Exchange listed securities, were and continue to be even more extreme. Over-the-Counter securities generally represent high-risk investments in new ventures which command rather low price/earnings ratios. In calm times they may trade at a ratio of ten or less; during the 1990s many prices soared to several hundred times their earnings. Yet the Chairman speaks of the inability to know with certainty that a bubble actually exists.

Soaring levels of commercial and industrial indebtedness also pointed to the growth of a financial bubble. Between 1995 and 2000 such loans nearly doubled, rising from some $600 billion to more than $1.1 trillion. The funds were used primarily to repurchase corporate stock in order to create the appearance of improved earnings per share or to finance mergers and acquisitions which served to cut costs and raise share prices. Many American corporations busily depleted their liquidity and even embarked upon massive borrowing in order to finance the mergers and acquisitions. At the same time, domestic savings sank to an all-time low while consumer indebtedness and foreign trade deficits rose to all-time highs. All such symptoms clearly signaled the growth of a financial bubble and looming danger to the economy; unfortunately the Fed Board of Governors persisted in ignoring or misinterpreting the signs.

He who does not recognize a bubble obviously does not search for its causes. While stock prices soared to lofty heights the Chairman repeatedly expressed his admiration for the "new economy" and rising productivity which, in his eyes, justified the soaring stock prices. But even if there had been a visible bubble, he assures us, tough talk would have been ineffective.

We readily agree with the Chairman that "tough talk" or even vague threats are rather empty without action. His well-known critical observation of "irrational exuberance" in December 1996 was a timely remark which frightened exuberant investors for a day or two, but, unaccompanied by Federal Reserve action, was soon disregarded. On the other hand, the Chairman's frequent references to the "new economy" and its admirable productivity said a lot to anyone willing to listen; they made him a cheerleader and backstop of the bubble market.

The Chairman wants us to believe that tighter margin requirements would have been ineffective in deflating the equity bubble. These are minimum amounts of cash which a buyer of stock must deposit in a margin account. Throughout the bubble years the Fed's Regulation T had pegged the minimum at $2,000 or fifty percent of the purchase price of eligible securities. The Board obviously did not see fit to raise the required margin because it did not perceive the bubble. But it is rather surprising to be told now that any boost in margin requirements would have had no effect anyway. Surely, a boost to seventy or even one hundred percent would have dampened the enthusiasm of most speculators immediately. It would not have removed the driving force of the bubble, the credit expansion, but probably would have limited or prohibited the use of credits in the stock market, which would have affected stock prices. The credits created by the Fed and the bank credits resting on the Fed funds undoubtedly would have found other uses and created other investment bubbles, such as in real estate, precious metals, or objects of art and collection. The stock market, thus circumscribed by Fed Regulation T, might have been spared the sick fever of a bubble.

Aware of a stock bubble, the Chairman and his Board could also have raised the reserve requirements mandating that member banks must keep cash and other reserve assets as a percentage of demand deposits and time deposits. They decide how much money banks can lend, thus setting the pace at which the banks can expand their credits. The higher the reserve requirements, the tighter the limits of expansion.

The very raison d'être of the Federal Reserve System, as perceived by its founders and sponsors, is to promote economic stability by influencing the flow of money relative to the flow of goods and services. The System has no direct control over the flow of money but it indirectly exerts its influence over commercial bank loans and deposits through the requirement of bank reserves. Its major tools which may be used to determine the cost and availability of reserves are the discount rate, open-market operations, and changes in reserve requirements. They are powerful tools which the Board has used continually ever since the U.S. Congress created them. Mr. Greenspan, at the helm of the Fed since 1987, has used them sparingly to restrain bank credit expansion but frequently to expand its scope and volume. As stock prices were soaring, his Board eased credit because currency crises were wracking Asia in 1997. And again in the fall of 1998 it chose to expand rapidly when Russia defaulted and Long-Term Credit ran into difficulties. Between June 1999 and May 2000, at the top of the boom, finally, it tightened six times by raising the discount rate. But as soon as the economy began to stagnate and readjust in the first quarter of 2001, the Fed reacted by lowering its rate no fewer than eleven times during the year.

The Chairman was always fearful of killing the patient with the cure. He obviously was more averse to any slowdown than to the irrational exuberance he observed. We may understand his feelings and actions because they conformed completely with public opinion. A host of media commentators, market analysts, and vocal politicians never tire clamoring for ever more money and lower interest rates; they instantly would vent their wrath against the Chairman if he would raise the discount rate and withhold the credits. It would take great courage of conviction to confront public opinion and its vocal spokesmen. In this age of fanaticism and terrorism it may even be dangerous to life and limb for a central banker to sanction a recession. The Chairman was never in danger; he enjoyed the bright light of popularity, laboring to prolong the boom indefinitely.

His critics are fully aware that the Federal Reserve System, which he and his fellow governors are supposed to manage, is a creature of politics. It sprang from the most revolutionary single piece of legislation in American currency and banking history, the Federal Reserve Act of 1913. It meant to improve the earlier financial system created by the National Banking Act of 1863 which placed the federal government in the very center of American money and banking. Both Acts were designed to reform the market order which was deemed to be unstable and unresponsive to the needs of the federal government and the national economy. Actually, they constituted early steps toward a hybrid fiat system which in time spread to all corners of the world. It is neither a command system in the manner of radical socialism nor a market order on a gold standard; it probably is the most unstable financial system conceivable which no human being, no matter how brilliant and distinguished, could manage satisfactorily.

The American money and credit system now resembles an inverted pyramid that rests on legal-tender Federal Reserve notes and credit. These support various forms of bank money such as commercial bank deposits, savings accounts, large time deposits, and other liquid assets. The base of some $672 billion may expand rather moderately, presently at some 6 percent a year or $40 billion; the layered superstructure of $8.333 trillion bank money (M3) may grow at a similar rate or $529 billion (as of 10/23/2002). Commercial banks tend to "securitize" their loans, converting them into marketable securities for sale to investors which enables them to grant new loans in a continuing process of lending, securitizing, selling, and lending again. Massive non-bank credit constitutes the upper layers of the money pyramid; there are Federal Home Loan Banks, thrift institutions, life insurance companies, brokerage firms, mutual funds and other credit grantors. Last but not least, offshore banks in the Bahamas, the Cayman Islands, Panama, Hong Kong, and Singapore, enjoying favorable regulatory and tax treatment, provide the top layer of the multitrillion dollar money pyramid. And high above the American pyramid hovers the international pyramid which builds on the U.S. dollar standard. The Chairman and his fellow governors are expected to balance it all with their high-powered Federal-Reserve-dollar base. They are expected not only to manage this monstrous pyramid of fiat money and fiduciary credit but also to safeguard the stability of the American economy, to maintain asset prices, protect the value of the dollar, and avoid the business cycle. They are supposed to manage a monstrous structure which politicians built for their own use and glory. That's too much to ask of any mortal.

"Money will not manage itself"; that is the very rationale of Federal Reserve existence. Its sponsors and managers usually refer to the days when gold and silver coins were the principal media of exchange. The supply of money, they assure us, depended more on the discovery and exhaustion of gold and silver mines than upon the needs of business. Moreover, many abuses developed, such as debasing the coinage, "clipping" and counterfeiting. Unfortunately, the Fed sponsors and managers hate to admit that the clipping of a few coins in ages past was a negligible abuse when compared with the continuous "clipping" of all forms of money today. Even in moments of "stability" all U.S. dollars in the form of cash or deposits lose at least two to three percent every year. They have lost some 95 percent since the Federal Reserve introduced its dollar in 1914. They probably will lose more in the coming years.

Fed sponsors and managers point to the recurrence of business cycles prior to the inauguration of the Federal Reserve System. They may turn to the crisis of 1873 and the depression that followed, or to the crash of 1893 and the aftermath, or the crisis of 1907 and the "creeping depression" which lasted until the World War brought an unprecedented boom. Unfortunately, the Fed supporters hate to recall the cyclical instability that has characterized the economy ever since. We count at lease eight boom-and-bust cycles since 1914 in addition to the Great Depression which held the country in its grip from 1929 to the outbreak of World War II in 1939. Surely, no one can contend that the Federal Reserve System has brought economic stability or conquered the trade cycle. On the contrary, its critics are convinced that a politically conceived and administered money monopoly, such as the Federal Reserve System, is the worst of all money systems. It will breed business cycles as long as it lives.

Stock market cycles are the most spectacular offsprings of central banking and credit creation. There are several others, less sensational, such as the cycles in precious metals and objects of art and collection. They affect only small groups of affluent clientele who usually suffer in silence. The most ominous of all cycles, which touches millions of people, is the boom-and-bust sequence in real estate. Just as in equity markets, these bubbles are clearly visible in their price-earnings ratios or price-rental ratios that greatly exceed those of healthy markets. Abundant credit at bargain rates of interest causes housing prices to soar, especially in growing communities, which fosters not only feverish construction activity but also enlarges the mountains of debt, even consumer debt. Fannie Mae, the publically owned and government-sponsored Federal National Mortgage Association, reports that soaring housing prices and falling mortgage rates are allowing homeowners to refinance $1.4 trillion of mortgages in 2002, up from $1.1 trillion last year. In both years homeowners are estimated to take out some $100 billion in equity.

The real estate bubble is bound to burst as soon as the distortions become visible to ever greater numbers of participants. Commercial construction already has fallen sharply in 2001 and 2002 with the steepest declines in the industries most afflicted by the September 11 attacks, including hotels and office space. Government-sponsored industries such as public works and health-care facilities are likely to expand further.

Driven by the same forces of easy credit and falling interest rates, all interest-bearing and discounted government securities have developed fever bubbles. The U.S. Treasury bubble, which few economists have as yet discovered, is still growing under the impact of avalanches of investors' money seeking shelter in Treasury safety. Tired of losing any more money in stocks, investors are piling into Treasury notes yielding barely 4 percent. As the federal government will be forced to raise hundreds of billions of dollars in the coming months in order to cover its growing deficits, interest rates are likely to rise. They are bound to increase substantially when the current flood of new money and credit finally aggravates the price inflation. When note rates return to just five percent, the yield of two years ago, the bubble will burst and the market value of all notes and bonds will drop drastically.

The economic maladjustments are numerous and severe, inflicting painful losses on ever more people. The number of job cuts continues to rise, making unemployment a potent economic and political problem. It is compounded by the chronic trade and current-account deficits which are causing many American jobs to move to Asia. The rising rates of unemployment together with the staggering losses of income and wealth cast doubt on the ability of American consumers who are carrying record burdens of debt to support the American economy much further.

Some pessimists hold to the single notion that the length of a readjustment is determined by the length of the bubble which preceded it. Because we experienced the longest and most spectacular financial bubble in history, we are condemned to suffer history's longest recession. Such notions unfortunately spring from robotistic perceptions of human action and reaction. It is the severity of the maladjustment, not its duration, together with the capacity of correction, not its length of time, that will determine the kind and quality of readjustment. An administration walking in the footsteps of Presidents Hoover and Roosevelt who practically closed the national borders to trade and commerce, who doubled the tax burden, and imposed numerous business regulations and restrictions undoubtedly will create another "great depression." An administration that lightens its burdens and releases the energy of the people will facilitate a speedy recovery. A Federal Reserve Board which, obedient to public opinion, keeps its interest rates far below market rates and readily finances growing federal deficits will make matters worse. The popular reduction of its rates on November 6, 2002 was just another popularity ploy which is bound to aggravate the maladjustment and delay the recovery.

Hans F. Sennholz

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