My old friends Jeffrey Rogers Hummel and David R. Henderson continue to argue that the Fed had little or nothing to do with fueling the housing bubble during the first five or six years of the present decade. Their latest article along these lines appears in Forbes. This is the third rendition of their argument that I have read, and I am no more persuaded now than I was previously.
Hummel and Henderson base their argument mainly on the claim that the Fed was not an engine of inflation between 2001 and 2006 because the rate of growth of the monetary base and the rate of growth of various monetary aggregates were declining during that period. Indeed, they were declining. Computing the rates of growth for the December value relative to the preceding December value, I find the rates to be as follows for the monetary base: 2001, 8.7%; 2002, 7.5%; 2003, 5.8%; 2004, 5.0%; 2005, 3.6%, and 2006, 2.9%. The rates of growth of M2, computed on the same basis, were as follows: 2001, 10.3%; 2002, 6.3%; 2003, 5.0%; 2004, 5.7%; 2005, 4.0%; and 2006, 5.4%.
It does not follow, however, that simply because these (and other monetary) rates of growth were declining, the Fed bore no responsibility for fueling the housing bubble. If we begin at a high rate of growth, as indeed we did in 2001, then rates may fall and still be “inflationary” in their effect on certain asset markets. Consider, for example, that during the entire period from the fourth quarter of 2000 to the fourth quarter of 2006, real GDP rose by only 14.9%, whereas during the same period (December-to-December monthly figures being used) the monetary base increased by 38.3% and M2 by 42.7%–or, by 2.6 times and 2.9 times as much as real GDP, respectively.
In pondering the Hummel-Henderson thesis, I keep coming back to various analogies, such as this one: I walk onto the street and I’m hit by a car going 50 mph; the next day, I walk out and I’m hit by a car going 45 mph; and, being a slow learner, I walk out during the next three days and I’m hit in daily succession by cars going 40 mph, 35 mph, and 30 mph. After five days, I am pretty nastily banged up, but Hummel and Henderson come along to comfort me by informing me that my being hit repeatedly cannot actually have hurt me because each day the car that hit me was going slower than the one that hit me the day before.
Hummel and Henderson also continue to endorse Alan Greenspan’s story that the real culprit was a surge in foreign savings that was invested in large part in housing-related securities, such as Fannie and Freddie’s bonds. I confess that I have never understood this story. In order to invest in securities of any kind, foreigners need to acquire dollars. And all dollars ultimately come from the Fed, because every dollar consists of either a circulating Federal Reserve note or a dollar deposit account subject to a variety of Fed controls. Was the Fed really powerless to “sterilize” the inflow of foreign savings? Or did it simply not attempt to offset this inflow, which it might have done by, for example, selling securities on the open market or by increasing required bank-reserve ratios?
In raising these questions, I assure my readers that I harbor no ideological or personal animus whatsoever against Jeff Hummel and David Henderson. Indeed, I love each of them as I would love a brother (which, in a sense, each of them is to me). I am puzzled by their persistence in attempting to persuade us with a story seemingly aimed at vindicating the Fed (while insisting, however, that, all things considered, the world would be better off without this central bank). I continue to believe that the Fed deserves a major part of the blame for the housing bubble because, however we tell this whole sorry story, our interpretation must inevitably include a plausible answer to the question: where’d the money (i.e., the dollars) come from?
(posted from Independent blog)
{ 9 comments }
Do agree that the Fed was not the basic cause of our current financial mess. Why? Who established the Fed? Congress (government). Who deficit spends, year after year, causing inflation and devaluation of the dollar? Congress (government). Who told the banks and lending institutions to lower standards? Congress (government). What do you think Congress would do if the Fed said, “we will not fund your overdrawn budget or follow your instructions on other “foolish ideas”? Congress would have dismantled the Fed long ago, in my opinion. And then what? Congress (government) would be in control of money. What a more horrible day that would be. No, the Fed might have had a small role in the cause of our current problem, but Congress set the table and everyone ate too much.
I enjoy Henderson’s blogs at the Library of Econ and Liberty web site, but I would guess that he does not subscribe to the monetary theory of business cycles. He seems to go along with mainstream econ in looking for “shocks,” which they confuse with a real explanation of events. Shocks are nothing more than saying “stuff happens, dude.”
The lag between a change in monetary policy and its maximum effect as inflation about 4 years, but that doesn’t mean it has no effect sooner or later. The effect begins immediately and grows in strength until the middle of the 4th year when it peaks, then rapidly declines. This is based on pretty good statistical analysis. However, inflation is the last effect of a change in monetary policy. Other effects, such as that on interest rates, investment, profits and allocation of resources, will happen sooner, though at different rates depending on the total economic environment at the time.
If you look at the cas-schiller housing index, the housing bubble began in the last decade of the 20th century. To discover the monetary causes, you would have to look at the monetary policy of the 1990′s.
PS, if the new money from the Feds went to Asia through purchases of imports and then back to the US as investments, the lag would be even longer, but the results will still be the same.
The Fed obviously played a major role in allowing the credit/money markets explode uncontrollably. By setting short term rates below inflation and holding them there for too long, and attempting to micro manage the rates (silly), they sent the money creation signals and laid the foundation upon which the large commercial banks and other lenders could create vast amounts of credit. Of course, the ability and willingness of these large lenders to issue loans was only exceeded by the extraordinary optimism which borrowers displayed in taking on ever greater amounts of debt. So the key point is that the Fed gave the lenders the nod and refused to properly “regulate”; however, esentially all of that credit creation was in fact done by the lenders and not the Fed. Banks were lucky to have been in an environment where asset values started rising and unemployment stabilized quickly after the last “recession” in late 2001. Most importantly, the banks found a never ending stream of borrowers and would be borrowers (thanks to reduced underwriting standards industry wide) who were more than “able” (used very lightly) and willing to take on the gigantic amount of debt the banks were able and willing to lend out.
The the key point is, yes the Fed is a major culprit, but in fact the biggest contributors to this are the banks, borrowers and the explicit approval of Congress to not only permit the fraudulent fractional reserve system to exist, but enhance it by removing caps on the leverage lenders could take on.
The Fed is actually an impotent entity. The disastrous result of their policies are yet to be seen – but if they had real power, they could have prevented the deflationary catastrophe we now find ourselves in. They will only make matters worse.
JO
Trying to analyze the rate fiat money creation and pronounce one amount of money creation “acceptable” and another (presumably higher) rate of fiat money creation “unacceptable” really kind of misses the point. Unfortunately, Austrians often get pulled into discussions like this where we aren’t even arguing about the right subject. The whole discussion, by implication if not said outright, is that there is an acceptable level of fiat money creation, but the Greenspan either exceeded it or did not. This misses the point.
The problem of fiat money creation is not that it causes general price inflation or uneven price inflation in certain “bubble” assets or commodities. These are symbtoms not root causes or ends in an of themselves.
The fundamental problem is one of mal-investment, of which Greenspan is no doubt guilty as sin of creating, in abundance. The malinvestments ARE the bubble, and their liquidation IS the bust.
The bubble could not have occurred without some kind of institution promoting easy credit, like the Fed. In a free market, in order for you to buy something worth $100,000 someone (usually multiple people) have to save (aka not consume) $100,000. That’s $100,000 worth of material that is saved so another can use it. This prevents a bubble from occurring at all, since prices remain low. Moreover, if people decided to borrow more and more to buy more houses, interest rates would necessarily rise, killing off any bubble before it formed.
All other government interventions in the market via the Community Reinvestment Act of 1977 and its various revisions up to 2005; Fannie Mae, Freddie Mac, and Ginnie Mae; mark to market accounting; and other regulations cannot create a bubble. They can simply create market inefficiencies. For example, lower lending standards would have meant higher interest rates for creditworthy borrowers. It could not have caused a bubble to begin with.
I’ve been reading up on Steve Keen’s post-Keynesian theories, and he presents an interesting take on the money creation process here:
(http://www.debtdeflation.com/blogs/2009/01/31/therovingcavaliersofcredit/).
He has 2 main conclusions:
1. The money multiplier is not limited by reserve ratios and the amount of money created by the fed..
2. Fed money creation lags the inflation rather than leading it
I think this is how it works:
Bank “A” exists with $100 in reserve, and is free to loan at fractional reserve, let’s say with a 10% reserve ratio. This means that it can have up to $900 loaned out once the multiplier has had its effect. This is where the classical money multiplier ends.
Bank “B” is created, and borrows $100 from A (as part of A’s $900). B can then loan out $900 as long as they can repay A with the interest. B only has to pay interest on $100, but collects interest on $900. That’s a pretty good spread, although the interest collected may be at a lower interest rate due to the already increased supply of credit.
So with $100, a 10% reserve ratio, and 2 banks, there is now a $1900 money supply, for a multiplier of 19:1, much more than the 10:1 allowed by the classical model. Each new bank can do the same thing B has done, adding another $900 for each $100 they borrow. Bank “C” borrows $400 as part of B’s $900, then loans out $3600. Etc. etc. B could even loan an additional $100 to A and vice versa to continually refuel the fire. This is all done on bank balance sheets with no new physical cash and no central bank action.
This sets up a nice ponzi scheme with the borrowers footing the bill. The interest revenue comes from real production revenues (on increasingly speculative and risky ventures due to the increasingly low interest rates from excessive credit supply), and can provide additional reserves for more lending. Of course, when no more borrowers are available or people start defaulting or withdrawing deposits en masse, the whole thing comes crashing down for a massive deflation. Banks fail, depositors lose their money, cats and dogs living together, mass hysteria, socialists take to the streets chanting slogans. Austrians buy more gold and ammo.
However, in order for it to happen as easily as I have laid it out, the banks would have to trust each other to the point of collusion. This is where the central bank comes in. Rather than allow these banks to fail, they issue bailouts, safety nets, etc. to fill all of the holes. This happens after the money has been created within the banking system, a phenomenon which Keen says has been empirically confirmed. So the Fed is more like a scapegoat in all of this – their actions are noticed by the public, but the banks get off scot free (unless they are stupid enough to ask for cash bailouts rather than more subtle FDIC-style guarantees).
The Fed is not innocent, and this is why the Austrians are still right. By preventing bank failures, they create a moral hazard and allow the next cycle of “endogenous” money creation to begin. The money the fed prints does not directly fuel the next inflation, but it entrenches the previous one. So fed money printing isn’t a leading indicator for inflation, it just reduces the deflation from all of the deleveraging. There is causation from the fed printing money to inflation that follows, but the new inflation is not necessarily proportionate to the amount of new money printed. The money multiplier exists, but it is not a linear relation to Fed money printing and reserve ratios.
Keen discusses some of his thoughts on the Austrian school in the comments. He’s a big fan of Schumpeter. He says that at some point he will write a post explaining his thoughts on the Austrian School.
Here’s an Austrian rebuttal to the post-Keynesian theory by Frank Shostak: http://mises.org/daily/2504
I think that Keen’s conclusions are not in opposition to the Austrian position. He shows that fractional reserve lending is the primary cause of inflation, and relies on the Fed to sustain it indefinitely.
I intend to keep an eye on Keen, he has some interesting analysis, and has so far provided the most cogent and plausible alternative to the Austrian explanation that I’ve seen.
I personally don’t agree with all of his arguments and question the methodology of his Minsky FIH model. I especially don’t like his proposed solutions – tax the boom and print your way out of the bust to reduce the amplitude of business cycles. I think a 100% reserve ratio would have the same dampening effect with less opportunities for corruption and fewer unintended consequences. I would like to see this model with 100% reserves.
The main challenge then is whether a free banking system could actually achieve 100% reserves, or whether this would require government intervention.
Bob.
While I am not trying to justify our terrible government I want to encourage you to do a little math research. Comparing the amount of liquidity the Fed has introduced into the market in comparison to the estimated amount of inflation our government has caused by means you mentioned. Which by the way is usually financed by a special relationship with the fed….
700 billion dollar bailout plans are dwarfed by the amount of money dumped into the market by the fed.
Also if you look at the Feds inception you will see it seemed more il-legitimate then otherwise known. Not trying to take any responsibility off of our GOV but I think the Fed definitely shares a vast majority of the responsibility.
This is a good example of what happens when you define economic events in econometric terms such as inflation/deflation defined by the level of the money supply. Inflation/deflation are not defined by the money supply but by the quality of the currency. If demand increases but the money supply increases but at a lower rate than demand there will be deflation yet the econometricians, many here at this site, will cry inflation.
Mises makes it clear that it is the supply and demand of money that determines the value and he also makes it clear that the best determination of the value of the currency is its price relative to gold, not an absolute money supply.
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