The Fed is Culpable

Economic bubbles have plagued the American economy ever since the First United States Bank opened its doors in Philadelphia in 1791. They preceded and led to many financial crises, and even depressions…Does it really matter what the Fed does in its attempts to control them?

It is surely more shameful to lose a good reputation than never to have had one.

During the great equity bubble of the 1990s, Alan Greenspan acquired an illustrious reputation as the world’s greatest central banker and the staunch guardian of the U.S. dollar. His admirers in the U.S. Congress never tired of applauding him, and Queen Elizabeth of the United Kingdom joined them by granting him knighthood. But since the collapse of the bubble and the $8 trillion decline in equity wealth since 2000, Greenspan has lost some of his repute. A few critics even hold him and his Fed colleagues responsible for it all.

With his reputation at stake, the Federal Reserve chairman is rejecting all such charges. In a recent speech to money managers around the world, Mr. Greenspan assured them that there was nothing he could have done to prevent the bubble and its collapse. It is beyond the ability of central bankers or anyone else, he asserted, to know with certainty that a bubble actually exists. And even if they knew, neither tough talk nor tight margin requirements would have been effective. Even boosts in interest rates would have worked only if they had produced a recession. Surely no one could expect him to have killed the patient with the cure.

Most Americans probably agree with the Chairman. They believe him because he led and encouraged them in a decade of feverish financial activity and soaring stock prices; they trust him because he always consults the thermometer of public opinion. Most economists probably are in accord with him because they embrace financial theories and doctrines similar to those that guide the Chairman. If called upon, they would gladly follow in his footsteps.

The few critics who hold him and his Fed colleagues responsible for the financial instability disagree with the Chairman on every issue. They are astounded by his inability to know with certainty that a bubble actually exists.

Economic bubbles have plagued the American economy ever since the First United States Bank opened its doors in Philadelphia in 1791. They preceded and led to many financial crises and even depressions, which have been an important object of economic research and voluminous writing ever since.

Searching for the causes of the equity bubble and its painful aftermath, the critics immediately point to the Fed’s mandate "to regulate the national money supply." The mandate obviously elevates Fed regulations over all laws and principles of the market, which, as all economists know, would destabilize and impede the smooth functioning of any and all economic activities. In equity markets, the visible symptoms are extravagant price-to-earnings ratios.

The historic P/E ratio of the DOW stocks hovers around 12; it soared to more than 50 during the 1990s and after a precipitous decline still stands at 20.86 today, November 1, 2002. Surely, when stock prices sell at four times their historic values, the suspicion of a feverish market should arise. Earlier this year Intel was selling at 160.7 times earnings, Disney at 142.6 and Eastman Kodak at 118.1. It is difficult to overlook such ratios or to justify them with prospects of wondrous profits in the future.

The bubble ratios of the National Association of Securities Dealers Automated Quotations system (NASDAQ), which provides price quotations for securities traded Over the Counter, as well as for some securities listed on the New York Stock Exchange, were and continue to be even more extreme. Over-the-Counter securities generally represent high-risk investments in new ventures which command rather low price/earnings ratios. In calm times, they may trade at a ratio of ten or less; during the 1990s, many prices soared to several hundred times their earnings. Yet the Chairman speaks of the inability to know with certainty that a bubble actually exists.

Soaring levels of commercial and industrial indebtedness also pointed to the growth of a financial bubble. Between 1995 and 2000, such loans nearly doubled, rising from some $600 billion to more than $1.1 trillion. The funds were used primarily to repurchase corporate stock in order to create the appearance of improved earnings per share, or to finance mergers and acquisitions which served to cut costs and raise share prices. Many American corporations busily depleted their liquidity and even embarked upon massive borrowing in order to finance the mergers and acquisitions. At the same time, domestic savings sank to an all-time low while consumer indebtedness and foreign trade deficits rose to all-time highs. All such symptoms clearly signaled the growth of a financial bubble and looming danger to the economy. Unfortunately, the Fed Board of Governors persisted in ignoring or misinterpreting the signs.

He who does not recognize a bubble obviously does not search for its causes. While stock prices soared to lofty new heights, the Chairman repeatedly expressed his admiration for the "new economy" and rising productivity which, in his eyes, justified the soaring stock prices. But even if there had been a visible bubble, he assures us, tough talk would have been ineffective.

We readily agree with the Chairman that "tough talk" or even vague threats are rather empty without action. His well-known critical observation of "irrational exuberance" in December 1996 was a timely remark which frightened exuberant investors for a day or two, but, unaccompanied by Federal Reserve action, was soon disregarded. On the other hand, the Chairman’s frequent references to the "new economy" and its admirable productivity said a lot to anyone willing to listen; they made him a cheerleader and backstop of the bubble market.

The Chairman wants us to believe that tighter margin requirements would have been ineffective in deflating the equity bubble. These are minimum amounts of cash which a buyer of stock must deposit in a margin account. Throughout the bubble years, the Fed’s Regulation T had pegged the minimum at $2,000, or fifty percent of the purchase price of eligible securities. The Board obviously did not see fit to raise the required margin because it did not perceive the bubble. But it is rather surprising to be told now that any boost in margin requirements would have had no effect anyway.

Surely, a boost to seventy or even one hundred percent would have dampened the enthusiasm of most speculators immediately. It would not have removed the driving force of the bubble, the credit expansion, but it probably would have limited or prohibited the use of credits in the stock market, which would in turn have affected stock prices. The credits created by the Fed and the bank credits resting on Fed funds undoubtedly would have found other uses and created other investment bubbles, such as in real estate, precious metals, or objects of art and collection. The stock market, thus circumscribed by Fed Regulation T, might have been spared the sick fever of a bubble.

Aware of a stock bubble, the Chairman and his Board could also have raised the reserve requirements mandating that member banks must keep cash and other reserve assets as a percentage of demand deposits and time deposits. They decide how much money banks can lend, thus setting the pace at which the banks can expand their credits. The higher the reserve requirements, the tighter the limits of expansion.

The very raison d’être of the Federal Reserve System, as perceived by its founders and sponsors, is to promote economic stability by influencing the flow of money relative to the flow of goods and services. The System has no direct control over the flow of money, but it indirectly exerts its influence over commercial bank loans and deposits through the requirement of bank reserves. Its major tools which may be used to determine the cost and availability of reserves are the discount rate, open- market operations, and changes in reserve requirements. They are powerful tools which the Board has used continually, ever since the U.S. Congress created them.

Mr. Greenspan, at the helm of the Fed since 1987, has used them sparingly to restrain bank credit expansion, but frequently to expand its scope and volume. As stock prices were soaring, his Board eased credit because currency crises were wracking Asia in 1997. And again, in the fall of 1998, it chose to expand rapidly when Russia defaulted and Long Term Capital Management ran into difficulties. Between June 1999 and May 2000, at the top of the boom, it finally tightened up six times by raising the discount rate. But as soon as the economy began to stagnate and readjust in the first quarter of 2001, the Fed reacted by lowering its rate no fewer than eleven consecutive times.

The Chairman was always fearful of killing the patient with the cure. He obviously was more averse to any slowdown than to the irrational exuberance he observed. We may understand his feelings and actions – they conformed completely with public opinion. A host of media commentators, market analysts, and vocal politicians never tire of clamoring for ever more money and lower interest rates; they would have instantly vented their wrath against the Chairman if he had raised the discount rate and withheld the credits. It would take great courage of conviction to confront public opinion and its vocal spokesmen. In this age of fanaticism and terrorism, it may even be dangerous to life and limb for a central banker to sanction a recession. But the Chairman was never in danger; he enjoyed the bright light of popularity, laboring to prolong the boom indefinitely.


Hans Sennholtz,
for The Daily Reckoning
November 14, 2002

P.S. Greenspan’s critics are fully aware that the Federal Reserve System, which he and his fellow governors are supposed to manage, is a creature of politics. It sprang from the most revolutionary single piece of legislation in American currency and banking history: the Federal Reserve Act of 1913. It meant to improve the earlier financial system created by the National Banking Act of 1863, which placed the federal government in the very center of American money and banking. Both Acts were designed to reform the market order, which was deemed to be unstable and unresponsive to the needs of the Ffderal government and the national economy.

Actually, these acts constituted the early steps toward a hybrid fiat system, which in time spread to all corners of the world. It is neither a command system in the manner of radical socialism, nor a market order on a gold standard; it is probably the most unstable financial system conceivable which no human being, no matter how brilliant and distinguished, could manage satisfactorily.

Editor’s note: Dr. Hans Sennholz is president emeritus of The Foundation for Economic Education (FEE) in Irvington, NY. His essays and articles have appeared in over thirty- six major German journals and newspapers, and 500 more that reach American audiences. Dr. Sennholz is also the author of 17 books covering the Great Depression, Gold, Central Banking and Monetary Policy. You can write to him by sending an e-mail to this address:

"The United States is presently experiencing something that has no precedent in economic and monetary history," warns Dr. Richebächer.

Our present experience, the good doctor explains, is unique in that the low and declining inflation rates coincide with rampant money and credit growth.

Instead of going up, for example, prices for raw materials are going down, even as the Fed actively tries to inflate them. Both the Goldman Sachs Commodities Index (GSCI) and the Commodity Research Bureau Index (CRB) dropped in the days after the Fed recent rate cut.

"Expanding the money supply usually means inflation, not disinflation or even outright deflation," writes Dan Denning in Strategic Investment. "But when the Fed cuts rates, is it always automatically inflationary? The answer is, quite frankly, is no."

The Fed can’t prevent manufacturers from picking up shop and moving to China, for example.

According to a report in Reuters, China is likely to top $50 billion in foreign investment this year – outpacing the United States for the first time ever. Chinese exports jumped more than 31% in October. At the current pace, Chinese-manufactured goods will flood the world by 2020… increasing four times the current rate to $2.4 trillion. That’s an outright deflationary influence on the world markets.

"It’s possible that the bulk of the world’s capital will now being going to a place where goods are produced… rather than consumed," says Denning.

Meanwhile, "faced with fewer quality borrowers, banks in the U.S. are ignoring the Fed’s rate cut and simply choosing not to lend."

The same phenomenon has been alive as well for some time in Japan, where rates have been perilously close to 0% since 1995…yet, bank lending in the land of the "rising sun" has fallen for 57 consecutive months.

What are we expecting will happen here? Mr. Fry updates us on Mr. Greenspan’s opinions as of yesterday evening…



Eric Fry reports from New York…

– The stock market slumped lower shortly after the opening bell yesterday, but that was before Dr. Greenspan rolled into town with a fresh supply of "Feel-Good" elixir. Investors tossed it back and faster than you can say, "Buy me 100 Cisco," the stock market erased its losses and dashed a bit higher. By the end of the session, The Dow was 12 points higher at 8,398, while the Nasdaq had gained nearly 1% percent to 1,361.

– The bond market also inched higher, pushing the yield on the 10-year Treasury down to 3.83%. Even the struggling dollar managed to gain some ground, as it added about half a percent against the euro to 100.5 cents per euro.

– During his appearance before Congress yesterday, the Fed chief droned on and on – in his usual style – about the various economic difficulties plaguing our economy. But the REAL message was nevertheless clear: "I’ve got it all under control." Investors felt better immediately.

– So potent is Dr. Greenspan’s elixir that it induces a kind of delirium deadening one’s critical faculties. Some folks were so affected that they actually believed the news out of Iraq that Saddam Hussein would permit "unconditional" weapons inspections inside his country.

– Those of us not under the influence of any narcotics recognize this ploy as simply another of Saddam’s endless diversionary tactics. Nevertheless, the news from Iraq simultaneously boosted the stock market and knocked the wind out of the gold market. The safe-haven metal tumbled $5.80 to $318.90 an ounce. Score this round for the stock market, but this boxing match is far from over.

– Yesterday, a couple of the top executives from Countrywide Credit, the mortgage lender, rang the opening bell on Wall Street. The NYSE often accords this honor to heroes, celebrities or dignitaries of some sort. What heroic, celebratory or dignified act – you may be wondering – did Countrywide commit to warrant ringing the opening bell? Only this: it changed its name and its ticker symbol.

– What’s next? A company that changed its phone number? How about a change of address? I’m about to relocate my office from 30 Wall Street to 80 Broad Street. These are the very same streets that bracket the stock exchange! Surely my relocation deserves at least one bell-ringing.

– The NYSE might want to consider hiring a new talent agent to book its bell-wringing ceremonies. Couldn’t SOMEBODY over at the NYSE have called up a couple of the cast members from "Friends" on short notice and asked them to come downtown to ring the opening bell?

– The only thing more absurd than the raison d’être for yesterday’s bell-ringing was the portrayal of the event by Countrywide’s PR department. A company press release, faxed to me by my good friend Michael Martin at R.F. Lafferty, described the name change as a "milestone" that reflects the terrific "growth and development that has transformed Countrywide Credit Industries into a provider of diversified financial services," now to be called Countrywide Financial Corporation.

– Once upon a time, corporate milestones were measured in terms of weighty financial stuff like sales or profits. But no longer…In the age of political correctness, EVERYTHING can be a milestone if it wants to be.

– Even so, referring to a name change as a "milestone" seems a bit mock-heroic – much like referring to Alan Greenspan as a "hero." Alan Greenspan isn’t a hero, he’s just a guy in a business suit trying to hold down a government job. Likewise, Countrywide’s spiffy new name change isn’t a milestone, except for the printer who received the order to produce millions of sheets of new corporate letterhead and business cards.

– For Countrywide itself, the name change is probably more millstone then milestone. Events like these always seem too enshrine the sort of corporate hubris that precedes a spectacular collapse.

– I hadn’t considered selling short Countrywide, but I think I’ll take a peak at this one.


Back in Paris…

*** The phone on my desk rang just a moment ago. I picked it up. The voice on the other end sounded familiar, but distant. "Addison?!…Is that you? This has never happened to me before."

It was Bill. Yesterday, Bill returned to New Orleans to attend an International Living Retire Overseas conference.

"I went out with Kathie and the crew…" He explained, referring to International Living publisher Kathie Peddicord.

"After dinner, I was walking down Bourbon Street with a Hurricane in my hand…have you heard about these drinks?"

"Yes, in fact, I have."

"And on Bourbon Street… do you know what they do there with the beads? Have you heard about this tradition?"

"Yes, in fact, I have."

"Well, that’s the last thing I remember. I tell you… this has never happened to me before." Apparently, the town had worked a bit of delirium of its own.

It was about 7:30AM New Orleans time. He said he’d made plans to have breakfast and wouldn’t be able to contribute this morning. But he’ll be back in Paris tomorrow…and on the job as usual.

Until then, ‘Laissez les bon temps rouler!’, eh?

Addison Wiggin,
The Daily Reckoning

The Daily Reckoning