Even as Greenspan is condemned and blamed for the economic crisis, not just at the Ludwig von Mises Institute but also at the Ayn Rand Institute, the “libertarian” Cato Institute now rushes to his defense (nor is this the first time Cato praises Fed policy )and argues that Greenspan pursued a “tight” (!?!) monetary policy and so can be credited with low inflation and a dampening of the business cycle.
As for low inflation, I guess that’s true if you define low as lower than under Robert Mugabe or even Arthur Burns. But America’s inflation rate under Greenspan was consistently higher than in almost all other major industrial countries and almost all Fed chairman’s before Arthur Burns. What about dampening the business cycle? That is definitely not true, because first of all certain structural factors unrelated to monetary policy have caused business cycle fluctuations to decline and secondly, as I’ve pointed out before, while Greenspan’s radical 2001 rate cuts probably made the 2001 recession milder than it otherwise would have been, the result of this was pnly to postpone and to further aggravate these problems. The extremely deep downturn America is facing now is a direct result of these rate cuts and as this will be a really deep slump, a and so claiming that Greenspan has “dampened” the business cycle is a bizarro world assertion.
In the report, the Cato authors David Henderson and Jeffrey Hummel, note that by 2006, money supply growth had fallen sharply compared to 2001, regardless of whether your preferred measure of money supply is M1, M2 or MZM. That is true, but that certainly does not somehow prove that Greenspan’s interest rate cuts wasn’t responsible for the bubble. The housing bubble by all measures started in 2001. Before that, the level of house prices, construction activity and mortgage debt was reasonable by historical standards. But then during 2001, house prices and mortgage debt started to suddenly rise above 10%-during a recession when they usually decline. And unusually enough for a recession, residential investments increased. Normally residential investment is the most cyclical component of GDP, falling even more than business investments during slumps. But during the 2001 recession, it actually rose even as business investments slumped. This would clearly suggest that the surge in money supply helped kick start the housing boom. That money supply growth had fallen sharply by 2006 is also very consistent with the link to the housing bubble, since residential investments reached its peak during Q4 2005. Other indicators of the housing bubble such as housing prices and mortgage debt continued to increase a bit longer, but given the lags in monetary policy that is still consistent with the monetary explanation.
They then argues that the fact that many parts of broader money supply measures M2 and MZM lack reserve requirements somehow mean that the Fed can’t control them . That is true in the sense that the Fed doesn’t decide on the exact money supply increases in their meetings. As I’ve explained before, money supply is a residual factor of the interest rate that the Fed sets and the various other factors that affect interest rates. Or more correctly, the other factors that would have affected interest rates if the Fed hadn’t fixed it. Now that the Fed has fixed it, these other factors instead affect money supply. But, by fixing interest rates at a certain level the Fed is ultimately responsible for the increases in the money supply and it could have controlled it if it had targeted it instead of interest rates. Furthermore, during the latter part of the housing bubble, money supply increases arguably understated the Fed’s role. The reason for that is that because the low interest rate set by the Fed caused a downward pressure on the U.S. dollar, foreign central banks that wished to avoid seeing their currencies appreciate relative to the dollar started to buy U.S. securities, and so helped keep down U.S. interest rates without any increase in the U.S. money supply.
Henderson & Hummel then asserts that the Fed does control the monetary base. But while it is true that the Fed could potentially control it -like it could with the overall money supply- the fact is that it doesn’t as long as it is interest rates that they target. The monetary base as they note consist of two components: currency in circulation (paper and metal cash) and bank reserves. They themselves immediately note that the quantity of currency in circulation is determined by domestic and foreign demand for it. And they further note that these days (or more correctly, until mid-September) currency in circulation constitutes more than 90% of the monetary base. But they appear to believe that bank reserves by contrast are, or were, directly determined by the Fed.
But that is simply not true, nor has it been true. And I find it astounding that they and many other professional economists don’t seem to understand the dynamics of how the monetary base was determined. The dynamics of bank reserves have recently changed radically for reasons I explained here, but before this recent upheaval bank reserves were for years basically constantly unchanged at roughly $70 billion. Henderson & Hummel takes this as evidence that the Fed’s interest rate moves mimicked fluctuations in the natural interest rate. Just how Greenspan and his associates could have been so remarkably skillful in predicting movements in the natural interest rate is not made clear, but I guess they figure that Greenspan was the great maestro and so was perfect.
But as I pointed out in a response to a article from Robert Murphy (who is usually a lot more insightful than Henderson & Hummel), bank reserves are not determined by the Fed, and this is especially true after the 1994 reforms they themselves mention that allows banks to “sweep” money from demand deposits (with reserve requirements) to savings deposits and money market funds (without reserve requirements). Instead, above the necessary minimum reserves required by the amount of money that they for various reasons must continue to classify as demand deposits, banks have complete discretion to determine how much reserves they want to hold. And before the upheaval that began in September this year, banks had every reason to minimize reserves to the legally required level. The reason was that they could always count on immediate liquidity infusions from the Fed in the case of a liquidity crisis. Meanwhile, as bank reserves yielded zero, they had strong incentives to recycle all cash infusions into the money markets or into loans. Meaning that the quantity of bank reserves was unaffected of how tight or loose monetary policy was, and so was useless as a indicator of that.
To summarize, the report demonstrate a complete lack of understanding of monetary economics dynamics. So here we have leading self-described libertarian think-tank who hires economists who don’t understand the dynamics of monetary economics and who by their own admission in the report can’t come up with any explanation of the current crisis to produce a report with the purpose of defending a government institution from the allegations that it rather than the free market is responsible for the crisis. Am I the only one who think there is something wrong with this picture?
[Cross-posted at my personal blog]