Is Greenspan following in the steps of '27?

By Gerard Jackson
web posted December 11, 2000

It was July 1927 and central bankers had convened a private conference in New York. It was here that Montagu Norman, Governor of the Bank of England, and Benjamin Strong, Governor of the Federal Reserve Bank of New York, tried to persuade the heads of the French and German central banks to inflate their currencies in tandem with that of America and Britain.

They failed and the US and Britain decided to go it alone. It was at this meeting that Strong cheerfully told Charles Rist, head of the French Central Bank, that he was going to give "a little coup de Whiskey to the stock market," which led to the greatest monetary surge of the decade: the period July to December saw stock prices leap by 20 per cent. Rather than relieve the threat of depression it only served to aggravate the tragedy that lay ahead.

Alan GreenspanWhat brings this to mind are reports that Alan Greenspan is planning the same thing. Like Benjamin Strong it seems that Greenspan believes that flooding the market with "easy money" will put a permanent floor under stock market prices, despite the fact that many are grossly overvalued. The mere rumour of this action was enough to cause the Nasdaq to surge by 274 points while the Dow Jones Industrial average jumped by 3.2 per cent.

Greenspan flagged a lowering of rates by saying that "weakening asset values in financial markets could signal or precipitate an excessive softening in household and business spending." As the stock market associates lower rates with rising profits it was no wonder that a sudden leap in share buying was reported.

One of the things said to have worried Greenspan is the reversal of the alleged "wealth effect". According to this notion, as people's wealth accumulates so do their spending. Therefore, reducing the value of assets cuts spending causing the economy to contract.

The "wealth effect" view was supported by a 1999 Federal Reserve research paper which inferred that every dollar increase in consumers' paper wealth, usually through shares or rising property values, increased, after 12 months, consumer spending by about 4 cents.

The question of how increases in paper wealth translate into creased consumer spending is hardly raised by commentators, though some claim that the transmission mechanism is through increased borrowing. That this is the vital key has eluded all the commentators I have come across so far.

It is patently obvious, and Greenspan should know this, that any increase in paper wealth cannot translate into spending unless the assets are sold. Failing that, then increased spending must come through borrowing. Probably because the wealthier people feel the more confident they feel about borrowing. But this does not explain any increase in spending. If the borrowing is real, i.e., it comes out of the income of others, then total spending remains unchanged because increased spending through borrowing must result in decreased spending by lenders.

Real borrowing is the key. What consumers have been borrowing is not the savings of others but newly created bank deposits courtesy of the Fed's credit expansion. This is why consumer spending was booming. However, the process is not quite this straightforward. Now I am perfectly prepared to believe that people have been encouraged to borrow because their paper assets increased in value. But what caused the increase? The same thing that created the credit to fuel the consumer spending boom. And this, I believe, is where the time lag came into play.

Once consumers became accustomed to rising asset prices, which they saw as a continuous increase in their wealth, they then decided to cash in by borrowing, not realising that rising asset values and expanding consumer credit were being fuelled by the Fed's slack monetary policy. Now we have Greenspan, the so-called student of the 1920s boom, preparing to make the same mistake that Benjamin Armstrong made. Will it work?

Circumstances are different in that when Armstrong made his decision manufacturing would not start contracting for about two years. In that light, a rapid monetary boost would be expected to boost profits and delay recession. However, with manufacturing unofficially in recession (the Purchasing Power Management index is now below 50 which is considered a de facto recession) it would take one hell of a monetary boost to offset the profit squeeze, though I must admit I have underestimated in the past the Fed's monetary expansion and hence its stimulatory effects.

If profits are falling and are expected to continue falling then lowering interest rates won't cause these industries to increase their borrowings. If anything, they'll being trying to cash up. This means that production would continue to fall. Any attempt to stave of recession by boosting consumer spending could actually cause the capital goods industries to accelerate the rate at which they are cutting production — and for what? To delay the inevitable recession and thus make it worse than it would otherwise be. And to think many people thought Greenspan was a genuine student of the monetary follies of the 1920s.

In my opinion the real problem is not the stock market or falling output -- it's the Fed.

Gerard Jackson is the editor of the peerless The New Australian. Reprinted with the TNA's kind permission.

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