It's Different This Time, I Swear
"There is always something different," former Chairman of the Federal Reserve Alan Greenspan said with regard to market turmoil, "something that does not look like all the previous ones. There is never anything identical, and it is always a puzzlement."1
This time, however, the current Chairman Ben Bernanke has a plan. Bernanke, a long-time student of the Great Depression, believes that the cause of the Depression was that the Fed first overlent and then underlent, whipsawing the economy into catastrophe. The solution to prevent a future crisis is to flood the banking system with liquidity during times of instability, which is what Bernanke has begun to do to contain the fallout from the subprime mess. However, if Greenspan's statement is correct, there is never anything identical, and Bernanke might not have the situation as under control as he'd like to think.
According to Bernanke:
During the Depression years and for many decades afterward, economists disagreed sharply on the sources of the economic and financial collapse of the 1930s. In contrast, during the past twenty years or so economic historians have come to a broad consensus about the causes of the Depression...Deflation, like inflation, tends to be closely linked to changes in the national money supply, defined as the sum of currency and bank deposits outstanding, and such was the case in the Depression. Like real output and prices, the U.S. money supply fell about one-third between 1929 and 1933, rising in subsequent years as output and prices rose...
The Federal Reserve had the power at least to ameliorate the problems of the banks. For example, the Fed could have been more aggressive in lending cash to banks (taking their loans and other investments as collateral), or it could have simply put more cash in circulation. Either action would have made it easier for banks to obtain the cash necessary to pay off depositors, which might have stopped bank runs before they resulted in bank closings and failures... In the end, Fed officials decided not to intervene in the banking crisis, contributing once again to the precipitous fall in the money supply.2
Fast forward to 2007. In the summer of 2007, the beginnings of panic were setting in. Fear was spreading that subprime defaults would lead to a larger scale credit crunch. Banks and investors were selling assets whenever they could and prices were in decline for debt and stocks. Worse, volatility was spiking and liquidity was drying up. In other words, those who were desperate to sell were finding there were no buyers on the other end of the trade.
As a result, the Fed took action, along the lines of what Bernanke had outlined. In an emergency session, the Fed cut the discount rate by 50 basis points and lent lots of cash to banks. In addition, the Fed made several statements indicating they would take certain riskier assets from the banks as collateral. The immediate result was that fears subsided, markets calmed, and liquidity and trading returned to the system. At least for the time being.
Pundits have pointed to the origin of the 2007 panic as subprime defaults and their spread into other financial instruments. However, the cause may in fact be something much broader and in fact much simpler. For nearly the last twenty years, the amount of credit and money supply in the United States of America has grown tremendously. All this excess liquidity has inflated assets prices to a point where they require further injections of liquidity to sustain their high prices.
U.S. Money Supply
In 1960, the amount of M2 Money Supply in the U.S. was $298.2 billion. By 1980, it was $1,482.7. By 2000, $4,671.5. By July of 2007, it was $7,269.3.3 Since 2000, M2 Money Supply has been growing by 5% and 10% each year, much faster than GDP and population growth. Meanwhile, since 1987 (when Greenspan became head of the Fed), Total Credit Market Debt has grown from $13 trillion to $40 trillion and now accounts for over 300% of GDP. According to market analyst Marc Faber, "Non-farm corporate liabilities stood at 44% of National Income in 1946, compared to 101% at the end of 2001, total mortgage debt was 23% compared to 93%, security credit 3% versus 10%, state and local government debt 7% versus 17%, and total credit market debt 192% versus 359%."4
What caused all this excess liquidity? According to U.S. Congressman Ron Paul, the Fed "relentlessly lowered interest rates [in the 1990s and beyond] whenever growth slowed. Interest rates should be set by the free market, with the availability of savings determining the cost of borrowing money. In a healthy market economy, more savings equals lower interest rates. When savings rates are low, capital dries up and the cost of borrowing increases. However, when the Fed sets interest rates artificially low, the cost of borrowing becomes cheap. Individuals incur greater amounts of debt, while businesses overextend themselves and grow without real gains in productivity. The bubble bursts quickly once the credit dries up and the bills cannot be paid."5
Purple Arrows show the lowering of rates to avoid downturns
Yellow Arrow shows the trend towards lower rates over the 1990s and beyond
A recent BusinessWeek article summed up the problem with excess credit as follows: "Back in the fall of 2006, hedge fund manager Nandu Narayanan was thunderstruck by a relatively obscure economic metric, the ratio of credit to a country's gross domestic product. Back during the Asian economic crisis of the late 1990s, Malaysia's ratio was an astonishing 220%, or $2.20 in debt for every dollar of economic output. Yet as 2006 drew to a close, the ratio in the U.S. climbed to an eye-popping 370% to 440%, depending upon how it was measured. 'To say that it was well north of anything ever seen in most countries of the world is a fact,' Narayanan says. 'Any rate rise in the U.S. was likely to cause big problems in the credit space.'"6
The growth in money supply and credit also threatens the value of the U.S. dollar. "The dollar loses value as the direct result of the Federal Reserve and U.S. Treasury increasing the money supply. Inflation, as the late Milton Friedman explained, is always a monetary phenomenon... The result is more dollars, both real and electronic - which means the value of every existing dollar goes down."7
Returning to Bernanke's analysis of the Great Depression, Bernanke notes:
speculators turned their attention to the U.S. dollar, which (given the economic difficulties the United States was experiencing in the fall of 1931) looked to many to be the next currency in line for devaluation. Central banks as well as private investors converted a substantial quantity of dollar assets to gold in September and October of 1931, reducing the Federal Reserve's gold reserves. The speculative attack on the dollar also helped to create a panic in the U.S. banking system. Fearing imminent devaluation of the dollar, many foreign and domestic depositors withdrew their funds from U.S. banks in order to convert them into gold or other assets. The worsening economic situation also made depositors increasingly distrustful of banks as a place to keep their savings... Long-established central banking practice required that the Fed respond both to the speculative attack on the dollar and to the domestic banking panics. However, the Fed decided to ignore the plight of the banking system and to focus only on stopping the loss of gold reserves to protect the dollar. To stabilize the dollar, the Fed once again raised interest rates sharply, on the view that currency speculators would be less willing to liquidate dollar assets if they could earn a higher rate of return on them. The Fed's strategy worked, in that the attack on the dollar subsided and the U.S. commitment to the gold standard was successfully defended, at least for the moment. However, once again the Fed had chosen to tighten monetary policy despite the fact that macroeconomic conditions--including an accelerating decline in output, prices, and the money supply--seemed to demand policy ease.8
So what happens now?
My question is simple.
I understand Bernanke's position that crisis should be avoided by flooding the system with liquidity. But what happens if financial markets begin to lose faith in the dollar just as this extra liquidity is needed? Wouldn't the extra liquidity drive the dollar even lower, thereby threatening the economy with inflation? If the panic were severe enough and therefore the extra liquidity required were excessive enough, could not a run on the dollar ensue? The possible scenario is that the Fed would avoid a bank run at the banking level, but it would cause a run at the currency level, which could potentially have results that were as disastrous - if not more so.
I am not forecasting a run on the dollar. I am simply bringing up what I believe to be a crucial policy question.
The Fed historically and today has dual directives that can be diametrically opposed to each other under certain circumstances. In the 1920s and 1930s, as Bernanke pointed out, "Long-established central banking practice required that the Fed respond both to the speculative attack on the dollar and to the domestic banking panics. However, the Fed decided to ignore the plight of the banking system and to focus only on stopping the loss of gold reserves to protect the dollar." Today, the Fed's dual directives are to keep the economy growing and to contain inflation.
Under the scenario I have outlined - a liquidity crunch accompanied by a falling dollar - you have a dilemma that is not easily solved because the Fed's claimed policies would be contradictory to each other. On the one hand, Bernanke would be flooding the markets with liquidity. On the other hand, the Fed would have to ensure against a falling dollar and inflation by reducing liquidity.
According to the New York Fed, "A stable level of prices is most conducive to maximum sustained output and employment. Also, stable prices encourage saving and, indirectly, capital formation because it prevents the erosion of asset values by unanticipated inflation. Inflation causes many distortions in the market... Inflation is sustained by excess money and credit in the economy... The Fed has to maintain an appropriate pace for the growth of money and credit -- one that will produce sustainable economic growth and price stability."9
Thomas Hoenig, President of the Federal Reserve Bank of Kansas City, talked about the lessons the Fed had learned from the massive inflation of the 1970s. "The first lesson is: do not let the inflation process get started. I think it is clear from the U.S. experience and in other countries as well, that once inflation starts to increase, it can easily get out of control. Furthermore, the record clearly shows that inflation is persistent and very difficult and costly to reverse once started. The experience of the past three decades also highlights the costs to the economy of letting inflation get out of hand and the benefits of lower inflation. We experienced major recessions in 1974-75 and 1981-82 as restrictive monetary policy attempted to break the inflationary cycle... The implication of this first lesson is that we can never be complacent about inflation, even in the best of times... The final lesson that I would draw from the inflationary experience of the last thirty years is: never lose sight of the long-run objective of price stability. As members of the FOMC have repeatedly stated, the broad objective of macroeconomic policy is to promote maximum sustainable economic growth. The main contribution of monetary policy to this objective is to achieve and maintain price stability."10
So Dr. Bernanke, if the dollar begins to fall as a credit crunch begins, which Fed directive gets more emphasis? Economic growth or price stability? During the 1930s, the Fed supported the dollar and price stability. That didn't seem to work. Should we try the other method this time? Of course, that would mean throwing out all the hard-learned lessons of the 1970s.
Or may, just maybe, the Fed shouldn't be focused on how to solve the consequences that ensue once overlending has occurred, but rather how to stop overlending from happening in the first place!
If the Fed did that, it would be different, I swear.
Greenspan as quoted in "Maestro" by Bob Woodward
7 Ron Paul: http://www.lewrockwell.com/paul/paul354.html