Gwartney on Greenspan

by Don Boudreaux on January 1, 2009

in Monetary Policy

Jane Shaw asked James Gwartney about the Greenspan Fed’s monetary policy.  Gwartney’s analysis makes good sense.

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{ 20 comments }

mark January 1, 2009 at 1:20 pm

I hope you and Russ had a good vacation and happy new year. Cafe Hayek is part of my morning reading and I was having withdrawal symptoms over the past two weeks.

Alan Watson January 1, 2009 at 2:18 pm

Gwartney's analysis makes sense to me as well, except his statement "Of course, none of this would have happened if the housing regulators had not destroyed sound lending practices". I know there has been considerable political pressure on the banks and GSEs to increase affordable housing, but can you or any of your readers point to any convincing evidence that private-sector lending standards would have resisted this deterioration in the absence of government pressure?

vidyohs January 1, 2009 at 5:24 pm

"but can you or any of your readers point to any convincing evidence that private-sector lending standards would have resisted this deterioration in the absence of government pressure?

Posted by: Alan Watson | Jan 1, 2009 2:18:32 PM"

To this uneducated street smart person it is self evident, Alan.

The fact that, prior to government pressure (and explicit or implied guarantees), lenders scrutinized applicant borrowers carefully and turned down those who did not seem to be satisfactory credit risks all in the name of the profit motive seems convincing evidence to me that had not the government made itself involved in the name of the "takers" that the meltdown would never have happened.

Oh we'd certainly have had a ton more renters in America, just as we always had. But, he who can not repay a loan should never be given a loan.

That is a time honored sound business principle practiced by American businesses until it was subverted by government.

Lee Kelly January 1, 2009 at 6:05 pm

Since the dot-com bubble, the U.S. has had expansionary monetary and fiscal policy. Both are indirect forms of borrowing, that is, a redistribution of income from the future to the present.

Suppose that your income this year is $10k, and your expected income over the next five years is $250k–an average of $50k per annum. Noting that your future self will have a far greater income than your present self, you decide that some income redistribution would be appropriate and borrow $20k (ignore interest rates for simplicity). Your present income then increases to $30k, while your expected income only decreases to $230k–an average of $46k per annum. Thus, by redistributing your income from the future to the present it can be enjoyed earlier and with less variance.

But suppose that you grossly overestimated your future income. Instead of $250k, your future income will actually be $150k. The $30k loan has, therefore, been given on false expectations. You, meanwhile, increase your consumption–not only do you have more money now but also expect to have more in the future. Eventually, however, another year begins and you discover your mistake. Instead of a $50k income you have only a $30k income (150k divided by 5), and furthermore, you still have to pay back your loan! Your income actually declines after the first year from $30k to $26k.

Overestimating your future income by 100k created a personal bubble. It felt great for a while and you enjoyed a high standard of living–your personal GDP increased greatly! But eventually reality imposes itself and you are burdened with debt that cannot be repaid without a significant lowering in your standard of living. However, as painful as this personal recession may be, it is something which has to occur to pay for the mistakes of the past.

It would be incredibly irresponsible for you to borrow more money to maintain your lifestyle and delay a personal recession. Even if this trick succeeds once or twice, it is a cycle that cannot go on forever–lenders are going to wise up, look upon your impoverished future, and decline to loan you any more money. Moreover, by not accepting the recession the first time its eventual impact is magnified.

Your plight in the above scenario is shared by the U.S. as a whole in reality, and moreover, we have already borrowed more money to delay the first recession.

The dot-com bubble saw a massive decrease in wealth. Demand should have plummeted and GDP along with it. People were spending while under the illusory spell of a bubble, that is, with false expectations about their future income. But except three scattered quaters of negative GDP this did not happen. What happened instead was the implementation of more expansionary monetary and fiscal policy.

It became cheaper to borrow money and less rewarding to save (if borrowing is like redistributing money from the future to the present, then saving money is similar but in the opposite direction). In consequence, money that was going to be spent in the future was instead spent immediately, either by way of borrowing or withdrawals from savings. Meanwhile, the government cut taxes and increased spending, further encouraging consumption today at the expense of tomorrow.

While it would be misleading to suggest that these policies caused the housing bubble, they did create an environment in which a bubble would inflate more easily. The extra push came from organisations like Fannie Mae, and an implicit guaruntee which eroded sensible decision-making. As the housing bubble grew to replace the dot-com bubble, the recession was delayed. GDP countinued to rise, but it was "growth" at the expense of long term prosperity.

The second bubble has now burst and another even deeper recession is upon us, while the government is busy trying to borrow even more money to delay it once again. However, this time it is going to be more difficult to borrow money, that is, lenders either cannot borrow or will not. The government is trying to prop up GDP by borrowing even more money from an increasingly impoverished future. These are disasterous policies which only benefit politicians who do not think beyond the next election.

But when nobody lends the government money it can only pay for its "economic stimulus" through inflation, and that will only make the long term problems even worse. To use Peter Schiff's analogy, politicias are trying to put out this fire by dousing it in gasoline, because that is all they know to do. When it gets worse they will simply pour on more gasoline and reflect on how much worse it would have been if not for their valiant efforts.

Anyway, that's what I think. I hope that I am wrong too.

Xmas January 1, 2009 at 6:50 pm

Bah…humbug.

The Fed's policies were clearly an attempt to keep the financial markets from freaking out after the tech bubble burst in 2000 and after the attacks on 9/11. If you are going to attack the Fed's policy during those years, you'll have to also provide an alternative solution to those two problems.

Greenspan was also aware of the problems in the housing market. He harped on the problems in the regulation of the GSEs to Congress.

Lee Kelly January 1, 2009 at 10:23 pm

My alternative would be to abolish the Federal Reserve. If you are correct about the Fed's intentions, then today's mess is another example of how unintended consequences can wreak havoc.

Juan C. de Cardenas January 2, 2009 at 7:01 am

Xmas, don't you think that the financial markets should have "freak out" back then instead of freaking out much more now? In other words, have the Fed and the Federal Government let the market corrected itself back then instead of compounding the problems and sweeping them under the carpet we may have had a less traumatic correction back then instead of the present debacle. And the worst is yet to come because they are trying to repeat the trick one more time.

Xmas January 2, 2009 at 9:27 am

Juan,

In hindsight, the Fed kept their foot on the gas too long. I'm not sure about the handling of the tech-bubble bursting. The Feds response to the 9/11 attacks was appropriate though.

So…they shouldn't have dropped interest rates so much when the tech bubble burst, which would have given them more wiggle room to drop and then restore interest rates after September 11th.

I'm torn because Greenspan had only one trick in his bag, lowering interest rates. There are so many other actors in this economic collapse that dropped the ball. Blaming the Fed for lowering interest rates in times of economic trouble feels wrong. It's like blaming the brewery because some teenagers got their hands on a keg.

Michael Smith January 2, 2009 at 10:07 am

Alan Watson asked:

I know there has been considerable political pressure on the banks and GSEs to increase affordable housing, but can you or any of your readers point to any convincing evidence that private-sector lending standards would have resisted this deterioration in the absence of government pressure?

Private-sector lending standards had not deteriorated for decades prior to the unleashing of this political pressure, so why would they have suddenly done so in the absence of said pressure?

The Federal Housing Authority, the Federal National Mortgage Association, the Federal Home Loan Mortgage Corporation, the Community Reinvestment Act — all were created precisely to insure that loans would be extended to less qualified borrowers than the market would otherwise accept.

The Clinton Justice Department launched a “fair lending initiative” in 1992. Here are the words of Janet Reno speaking to the National Community Reinvestment Coalition in 1998:

“You've noted that since the inception of our fair lending initiative in 1992 the Department has filed and settled 13 major fair lending lawsuits. We are going to continue these efforts under the Acting Assistant Attorney General Bill Lann Lee in every way that we possibly can. We will continue to focus on discrimination in underwriting, the process of evaluating the qualifications of credit applicants.”

You can read the whole speech at: http://www.usdoj.gov/archive/ag/speeches/1998/0320_agcom.htm

What’s more, when the Gramm-Leach-Bliley Act, which repealed the Glass-Steagall Act and allowed commercial and investment banks to merge, when that law was passed Clinton insisted it contain a specific clause giving regulators the power to reject any mergers if any of the entities had a “less than satisfactory score” under the CRA.

So, yes, there was considerable “pressure” to reduce lending standards.

But as to the topic of this post — namely, to what extent is the Fed to blame — I offer this point. Regardless of the lowering of standards, the housing bubble could not have formed without people who were willing to accept the loans and purchase the house. Obviously, low interest rates were a factor in inducing people to cease being renters and become owners. Who created those low interest rates? The Fed.

What’s more, the decision to purchase a home is no doubt influenced by the near-universal belief by Americans that a house is “a good investment”, i.e. the belief that housing prices will rise indefinitely. This belief exists for one reason only: the Fed’s long-term, relentless inflating of the money supply in an attempt to “stimulate economic growth”.

Michael Smith January 2, 2009 at 10:26 am

Xmas wrote:

In hindsight, the Fed kept their foot on the gas too long. I'm not sure about the handling of the tech-bubble bursting. The Feds response to the 9/11 attacks was appropriate though.

So…they shouldn't have dropped interest rates so much when the tech bubble burst, which would have given them more wiggle room to drop and then restore interest rates after September 11th.

The flaw in your thinking is that you’ve accepted the premise that we should have a fiat money supply under the control of a centralized planning agency — the Fed — who manipulates the money supply to achieve economic growth.

In the first place, centralized planning doesn’t work. See the history of the U.S.S.R. In the case of the Fed, there is no way for a single individual, or a group of individuals, to determine the ideal interest rate for an economy comprising millions of individual decision makers.

In the second place, the whole Keynesian notion that consumption — “consumer demand” — drives economic activity, and that economic growth can thus be insured by expanding credit to stimulate consumption, is false. See Say’s law for an explanation of why demand can only come from production.

Centralized planning based on false economic ideas is a double dose of economic poison bound to sicken us sooner or later. And it has.

Lee Kelly January 2, 2009 at 12:58 pm

Interest rates should be rising. Because of recent monetary and fiscal policy, future income has declined, and like anything else, as future income becomes scarcer, its price (i.e. interest rates) should increase. This would induce more saving, that is, redistribution of income from the present to the future, and correct the imbalance which politicians are clamouring to maintain.

If the market set interest rates alone, then one function would be to redistribute money from the present to the future when the future is poor, and vice versa when it is wealthy.

But for politicians it almost always pays to increase income in the short term. It seems to me that the Fed's role in the economy is to prop up short-term GDP at the expense of long term prosperity, or at least that has been its primary function for the last twenty years or more. A fiat currency under the control of politicians is a recipe for disaster. It is a wonder that it didn't come sooner.

Keyensianism has simply provided intellectual credibility for policies which politicians have always had an incentive to impose. Hopefully the current debacle will destroy that credibility once and for all, though I rather more expect that the free market will get the blame.

Anonymous January 2, 2009 at 1:19 pm

In the second place, the whole Keynesian notion that consumption — “consumer demand” — drives economic activity, and that economic growth can thus be insured by expanding credit to stimulate consumption, is false. See Say’s law for an explanation of why demand can only come from production. – Micheal Smith

Excellent point. It has become accepted wisdom over the last couple of decades that the U.S. has a 'consumption driven economy'. But that is nonsense. Consumption does not drive an economy, production does. Production has simply shifted overseas to places like China while Americans bought it using debt. What is more, much of the debt will never be paid back, and so countries like China will be sending the U.S. fewer goods.

Americans may demand more consumption, but without an ability to pay there will be less. People in China do not benefit by sending products to the U.S. which Americans cannot afford to pay for any longer.

Consumption is not driving anything. For politicians, however, all these problems can be solved by increasing demand and consumption. For them, the problem is that Americans have stopped buying cars, televisions, homes, etc., and the solution is to get people consuming again.

Politicians want to reinflate the bubble, because politicians benefit from creaing bubbles. They endevour to create an illusion of prosperity, and one way to do that is to create a bubble whether by design or not. Many years pass before it bursts, and by that time its instigator has left office and his replacement takes the fall.

Lee Kelly January 2, 2009 at 1:19 pm

The above comment was mine.

John Dewey January 2, 2009 at 2:52 pm

Lee Kelly: "Production has simply shifted overseas to places like China while Americans bought it using debt."

Let's be a little more clear. Production of some labor-intensive goods has moved to other nations which have lower labor costs. But the U.S. is still the world's largest goods producer, accounting for 25% of the world's output of goods.

Until 2008, U.S. production of goods – the real value added by U.S. goods-producing operations – had continued to rise, and successively reached all time highs in 2005, in 2006, and in 2007. The reduction of that production in 2008 was due not to offshoring but to the global economic recession.

Cheers January 2, 2009 at 3:28 pm

Lee, I have to say, I have so thoroughly enjoyed reading the posts on this page, especially the personal-lending analogy.

Though I totally agree that a huge portion of the problems we're facing are the result of self-interested elements of the political machine, I'm tempted to also blame the fragmented nature of decision making for rendering impotent whatever competent and well-meaning people were at play. If you've gotta hang a picture and all you've got is a screwdriver, I'd bet you'd at least try to hit the nail with the screwdriver. Then, if it works well enough the first few hits, I guarantee you're going to end up with a bent nail.

Lee Kelly January 2, 2009 at 5:38 pm

John,

Thank you for the correction. My statement was too strong. The United States is still a massive producer. I meant only that a higher proportion of goods sold in the U.S. have been imported from places like China in recent years, and much of it using borrowed money that cannot be easily paid back.

As the purchasing power of U.S. consumers declines and rises in other nations, many consumer products will increase and price. It seems to me that many such products will again be produced within the U.S. in the coming years.

Politicians will triumphantly declare that they're bringing jobs back from overseas. But in reality it will only reflect a lower standard of living brought about by irresponsible monetary and fiscal policy.

Lee Kelly January 2, 2009 at 5:40 pm

As the purchasing power of U.S. consumers declines and rises in other nations, many consumer products will increase and price.

The above was meant to read:

As the purchasing power of U.S. consumers declines and rises in other nations, many consumer products be redirected away from American shores.

Lee Kelly January 3, 2009 at 11:11 pm

Interest rates are the price of borrowing money and behave little different to ordinary prices.

Price controls which make the price of a good or service artificially low create a shortage–at the controlled price, more is demanded than is supplied. In consequence, either a good or service is depleted too quickly or some people go without. Price ceilings create the illusion of abundant supply, and so resources are not rationed efficiently

The Federal Reserve manipulates interest rates and has been artificially suppressing them, that is, it has been lowering the cost of borrowing from the future. Like other price ceilings this creates an illusion of abundant supply; in this case, it induces people to overestimate their future wealth. Thus, future wealth is not rationed efficiently.

Such policies create overconsumption of the controlled resource, in this case credit, and consequently, it is depleted is too quickly or some people go without. We are now at that final stage. A shortage of credit has been engineered by government policy.

The only way to increase the supply of credit (future wealth) is to start saving and investing again.

Does any of this make sense to anyone? I am making this up as I go along, but it makes crystal clear sense to me. And does anyone here know where else I can find ideas like these? My only course in macroeconomics was thoroughly bewildering and partly responsible for my attempts at disentangling the mess above.

Thanks!

Tim Smith January 5, 2009 at 4:10 pm

Lee Kelly, the answers to your questions can be found in the work of business cycle theorist Roger Garrison, available here: http://www.auburn.edu/~garriro/

Dr. Garrison also addresses Fed performance in this recent article: http://www.auburn.edu/~garriro/fedmess.pdf

Tim Smith January 5, 2009 at 4:35 pm

Lee Kelley, you can also listen to some of Roger Garrison's lectures here: http://www.mises.org/media.aspx?action=author&ID=390

I found the one titled "The Great Depression" to be a very illuminating introduction to the dynamics of credit-induced booms and the busts that follow.

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