Greenspan Blows Bubbles Jude Wanniski September 4, 2002

Memo To: Fed reporters
From: Jude Wanniski
Re: Asking the Wrong Questions

I've often wondered if you ladies and gentlemen of the press who cover the Federal Reserve have ever been taught that there are two entirely different ways to "tighten" monetary policy or to "ease" monetary policy. For that reason it really isn't fair to single out Dick Stevenson of the NYTimes for his coverage of Fed Chairman Alan Greenspan's speech last Friday at Jackson Hole, Wyo. "To Greenspan, 90's Bubble Was Beyond Reach of Fed.". Greg Ip's news account of the speech in Tuesday's WSJournal, delayed because the Journal does not publish on weekends, was no different: "Greenspan, at Fed's Conference, Says Bubble Was Beyond Control.". The hell it couldn't, and Maestro Greenspan knows it. But because you folks understand only one way of "tightening" money, his excuses all make sense. And because members of Congress don't know very much about the actual mechanisms available to the Fed – and that includes members of the House and Senate committees on banking and finance – all of official Washington winds up being hornswoggled by the Fed chairman. First read a bit of the Times piece:

JACKSON HOLE, Wyo., Aug. 30 - Alan Greenspan, the chairman of the Federal Reserve, defended the central bank today against criticism that it had mishandled the rise and fall of the stock market and said that the Fed could not have prevented the bubble on Wall Street without damaging the economy.

Mr. Greenspan said the only way to have reined in the stock market would have been to raise interest rates sharply, a step that he said would have put the entire economy in peril. Smaller but more frequent rate increases, he said, would not have done the trick either. "The notion that a well-timed incremental tightening could have been calibrated to prevent the late 1990's bubble is almost surely an illusion," he said.

The other tactic that critics have suggested he could have used, limiting the ability of investors to pay for stock purchases by borrowing against their shareholdings, would also have had little effect, Mr. Greenspan said.

His speech, delivered here to an audience of government officials and economists at a symposium sponsored by the Federal Reserve Bank of Kansas City, was his most extensive and detailed explanation so far of how he viewed the Wall Street boom of the late 1990's and what the Fed did - and did not do - about it....

Though the stock market's course may be far outside even Mr. Greenspan's ability to control, he received some of the credit when the Dow Jones industrial average and the Nasdaq seemed to have no ceiling. And his remarks today suggested that he is sensitive to what the market's downturn, however inevitable, has done to his reputation for successful economic management.

"As events evolved, we recognized that, despite our suspicions, it was very difficult to definitively identify a bubble until after the fact - that is, when its bursting confirmed its existence," he said. "Moreover, it was far from obvious that bubbles, even if identified early, could be pre-empted short of the central bank inducing a substantial contraction in economic activity, the very outcome we would be seeking to avoid."

Mr. Greenspan made no mention of how the Fed was dealing with the bursting of the bubble and the economy's difficulties in recovering from the recession of last year. Neither Mr. Greenspan nor any other Fed official here said anything to counter the growing impression that signs of halting economic improvement and increasing hope on Wall Street that stock prices may have bottomed out will keep official interest rates unchanged in September and perhaps for the rest of the year.

His speech today had the air of a defense of his legacy as, at 76, Mr. Greenspan starts his 16th year as chairman. His main message was that even in retrospect, he could find no way that the central bank could have averted the boom and bust on Wall Street without giving up much of the benefits of the 1990's, from low unemployment to improved international competitiveness. "It seems reasonable to generalize from our recent experience that no low-risk, low-cost, incremental monetary tightening exists that can reliably deflate a bubble," Mr. Greenspan said. "But is there some policy that can at least limit the size of a bubble and, hence, its destructive fallout? From the evidence to date, the answer appears to be no."

Please note all he talks about is lowering the fed funds rate slowly or sharply or calibrating them incrementally. There is no discussion about an alternative operating mechanism available to the Fed, which is to forget about the funds rate entirely and expand or contract the Fed's balance sheet. With this operating mechanism, the Fed need not "hope" that an increase in the funds rate would tighten money, it would do it directly by selling interest-bearing bonds out of its portfolio in exchange for non-interest-bearing dollars. In other words, reducing the supply of liquidity in the banking system.

This is what you do when you are operating on a "rule," or a "standard." If the Fed is operating on a quantity rule, trying to manage the supply of money in the system, it has to buy bonds from the banks when the "M" target is higher than the recorded amount. And it has to sell bonds when the "M" target is being exceeded. Liquidity is drained. This is what the monetarists persuaded the Carter administration and the Volcker Fed to do in the fall of 1979. That was clearly a failed experiment, as interest rates went through the roof when the market correctly saw the excess, unwanted liquidity being pumped into the system was leading to a generalized inflation.

Think back to the fall of 1993, when the Clinton tax increases, encouraged by Greenspan, passed into law. This led to a decline in the demand for liquidity, as less would be needed in a slightly smaller economy. There was no operating mechanism to drain off that surplus, as Greenspan had no "rule" and no "standard." The price of gold began to rise from the $350 level, settling at the $385 level. If we had been on a gold standard, the Fed would have had to "tighten" not by raising interest rates, which was how Greenspan tried to hold back the nascent inflationary pressures. He would have sold bonds from the Fed portfolio to "mop up" the surplus liquidity, in this way keeping gold at the $350 level.

This is not an extraordinary means of managing monetary policy. The Bank of China uses a "dollar rule" in managing its balance sheet, which is how it keeps the yuan at a constant yuan/dollar rate. It doesn't raise or lower an interest rate to ease or tighten. It expands or contracts its balance sheet to keep that exchange rate constant. If Greenspan in 1993 had drained reserves (surplus liquidity) to keep gold from rising to $385, he would also have been in a position to add liquidity when the price of gold began its long, deflationary decline.

There really was no "bubble" in 1999-2000, if by bubble is meant a market irrationality caused by too many silly people buying equities and not enough smart people selling equities. Polyconomics explained back then that in the first stage of a deflation, commodity prices decline, and economies that exist by producing intellectual goods enjoy a sudden very favorable change in the terms of trade. This was the U.S. economy, with the dot.com companies that are pure intellectual enterprises enjoying the greatest gains at the expense of the world's farmers, miners, ranchers and the communities that support them. In the second stage of deflation, as contracts unwind in a generalized fall in the prices of intellectual goods, there is a reversal of these favorable terms of trade. The "bubble" bursts.

Greenspan knows all this, I assure you. I spoke to him directly about it all during the 1990s, until he did not want to hear my criticisms of where his "Greenspan standard" was taking the world economy. If you do not believe me, and Greenspan says he does not remember, ask former Fed Chairman Wayne Angell, who was at the Fed at least for part of the years in question. Angell will tell you, I believe, that he much prefers managing the balance sheet as a method of "tightening" than stabbing at the problem with the overnight interest rate. But please, ladies and gentlemen of the press, don't let Greenspan continue to blow bubbles at you . There is more than one way to skin a cat or to tighten money.