"A chicken in every pot and a car in every garage..." – 1928 Campaign Motto, Herbert Hoover (1929–1933). 31st President of the United States of America.
It is the best of times or the worst of times—depending on which economic neighborhood you live in. For politicians it is a good time to be in office. The economy is growing at rates not seen since the 50's and 60's. Everyone who wants to work can find a job. Wages and personal income are rising. Consumer confidence is high. The stock market has risen for 17 straight years. Corporate profits are up. The world is at peace. As the President declared in his "State of the Union" address: "We are fortunate to be alive at this moment in history. Never before has our nation enjoyed, at once, so much prosperity..." (President William Jefferson Clinton, January 27, 2000).
Depending on what you read or what you listen to, there are numerous theories to explain America's current prosperity. Washington takes credit for its disciplined fiscal policies and enlightened political leadership. Wall Street believes it stems from corporate restructuring and a technological paradigm shift from the industrial age to the information age. On Main Street, people are working, wages are rising, portfolios are growing, and there's a lot of consuming going on.
We have a lot to be thankful for. Things look good, and yet, it depends on your neighborhood. Is this as good as it gets or could there be an economic maelstrom ahead? If the times are so good, why is the Fed lamenting about the country's economic prosperity and 17 fat years of continuous rising stock prices? If the times are so good, why is Mr. Greenspan fretting?
"Mr. Fix-It" to the Rescue
From my perspective, there is a reason for all the worrying going on at the Fed. America's continued prosperity stems from easy money and the expansion of credit. The last two decades have seen a series of economic crises that ranging from a plunging US dollar, rising budget deficits, the 87' stock market crash, the S&L bailout, Mexico's devaluation, derivatives and Asia's currency collapse, to the more recent Russian debt default. Since Fed Chairman Alan Greenspan stepped into office, he has developed a reputation as "Mr. Fix-It." He began his reign by almost single-handedly bailing out the worldwide market crashes of 1987. It was his decisive action and wisdom that prevented world leaders from making policy mistakes that could have led to another depression similar to the 1930s.
When the US or the world has a financial crisis, presidents and world leaders call Greenspan's 911. The Fed chairman responds to the crisis in a hero's fashion and solves the problem. The only thing missing is a cape and mask. From Washington to Gotham City, he has become the equivalent of a financial caped crusader. The only trouble with the Fed's response is that it must continuously open up the monetary spigot. With Washington's budget rising to trillions of dollars, the favored solution to most problems is for the Fed to liquefy the markets—whether through lowering interest rates or expanding the nation's money supply. Unfortunately, when the Fed expands the nation's money supply, it creates a lot of dollars it can't completely control.
The Problem With Printing Money a Lesson in Supply & Demand
Those dollars, which the Fed creates through the banking system, can go anywhere. Banks can loan those dollars to businesses, which can help expand the economy. Banks can loan those dollars to Wall Street, which can be used for speculation or to buy government bonds monetizing the national debt. The problem the Fed creates when it prints money is that it causes inflation to rise. Inflation is simply a monetary phenomenon. It results when governments create more money than they are receiving in the form of taxes. The extra dollars created through the printing of money causes demand to increase in the economy. That demand can overwhelm the economy's ability to produce the goods created by that demand. When the Fed prints money, those dollars can create demand in two ways. It can create extra demand for economic goods as we now see in housing or it can create demand for financial assets as evidenced in our rising stock markets.
The Problem With Measurement
The problem with measuring inflation today is that most economists only measure it in terms of rising prices for goods and services within our economy. They don't count rising prices of financial assets such as stocks. It is only the Austrian School of economists who measure inflation in both forms. This failure by economists to recognize the above-trend rising stock prices explains much of the lamenting that is going on at the Fed. We hear much about the stock market's wealth effect and how it is causing consumers to spend more money than normal. The excess demand created by consumers is putting pressure on the economy, thereby causing the economy to grow at above normal levels. The whole process is the result of printing money and thereby increasing the money supply.
The Fed keeps talking about inflation and Wall Street keeps telling us there isn't any. This disparity can be explained by a set of circumstances that originated in the crises of the 1990s. We began the decade with a banking crisis and a recession. In order to liquefy a nearly bankrupt banking system and revive a sinking economy, the Fed bailed us out with its tool of lowering interest rates. Greenspan's Fed moved aggressively to cut interest rates at the beginning of the '90s, thus allowing banks to borrow money cheaply from the Fed as it moved aggressively to lower interest rates from the double-digit range to as low as three percent. Banks could borrow from the Fed at low rates and invest in treasuries paying higher interest rates. This helped banks to return to profitability, while greatly improving their balance sheets. It also explains why the economic recovery that began in 1991 got off to a slow start. After the disastrous real estate loans of the '80s, banks weren't about to start making generous loans to Main Street.
Our economic recovery began at the financial level and this is why the economy got off to such a slow start. Banks were investing in treasuries. Corporations were restructuring. Main Street was downsizing. As the Fed began its aggressive interest rate cuts, lower rates forced investors to follow banks in search of higher yields. As CD rates came down even further, investors followed banks into the bond market chasing higher yields.
The Rate Reversals of '94
As the Fed created money through the banking system, the economy, the financial markets and inflation began to pick up. Inflation was rising by 1994 and the Fed began a series of rate hikes that year which created havoc with financial institutions who were invested in derivatives and with foreign countries who were borrowing dollars and doing their own bit of inflating. The rate hikes of 1994 also created problems for Wall Street, Mexico, Asia, and city governments invested in derivatives. It was one of the worst years for the bond market and stock prices struggled to remain above water.
Things weren't looking too good for the country. Our dollar was plunging overseas, our trade deficit was expanding and our economic recovery was fragile at best. Although the recovery was taking place in the financial realm, corporate restructuring meant more layoffs. Although lower interest rates helped companies refinance debt at lower rates boosting profits, people were still losing their jobs. To make matters worse, President Clinton and a Democrat-controlled Congress enacted the largest tax increase in the nation's history.
Once again, help came from an unexpected quarter. Foreign central banks began to liquefy the financial markets by heavy buying of US treasury debt. The plunging US dollar was hurting exports to America because a lower dollar meant higher prices for foreign goods. This time the Fed was given a reprieve from money pumping. Greenspan had help from his peers in foreign countries. Heavy buying of US treasuries by foreign central bankers helped to push up the dollar and lower interest rates in the US.
However, the crisis that began at the beginning of the decade set in place a series of crises that demanded Fed pump-priming to move into higher gear. The implosion of derivatives, the devaluation of the peso, rising taxes, and Washington's budget deficits all required easy money to offset growing financial problems. From 1994 forward, the money spigot at the Fed remained permanently opened. The money supply grew at above-average rates and found its way into the financial markets and the economy.
At long last, the economy began to recover, the financial markets began to accelerate at above-average rates and prosperity was spilling over to Main Street. As the Fed money spigot began to flow, interest rates began their decline and the economy and the financial markets prospered. Even so, crises were erupting around the globe. China's devaluation in 1994 set the stage for the Asian crisis of 1997 while political corruption in Russia would eventually lead to a debt default in 1998. Throughout this period, overseas money began to flow into our financial markets. This double faucet of Fed money and overseas money funded the largest credit expansion in our nation's history. Banks were lending, businesses were borrowing, and investors were speculating. It all gave the impression of a new paradigm and a false sense of prosperity.
Investors in search of higher returns turned to the stock market after the bond market debacle of 1994. Bonds suffered disastrous returns that year; while stocks managed to squeak by with minor returns. As interest rates declined, money came out of bank CDs and bonds and moved into stocks in search of higher returns. The Fed's money expansion worked its way through the banking system and the stock market. Banks had plenty of money to lend, the stock market was producing great returns and consumers began to open up their checkbooks. The myth of the "new economic paradigm" had been created. Fiscal responsibility in Washington had been restored. The restructuring of corporate America was producing higher profits. Technological advances were engineering a new economic landscape.
The Problem With Cheap Money
As the graph below indicates, the Fed money expansion was the main impetus to this new economic miracle heralded by Washington and Wall Street pundits. In reality, our prosperity was a monetary phenomenon. Lower interest rates helped to restore bank balance sheets. It also meant banks now had money to lend. Lower rates helped to temporarily boost corporate profits through debt refinancing. Higher profits spawned higher stock prices. Higher stock prices helped to create more wealth for consumers. Money began to feed on itself. More money meant lower interest rates. Lower interest rates allowed companies and consumers to refinance their debt. Lower debt payments put money into the hands of companies and into the pockets of consumers. This cycle of money began a life of its own.
M3 = Measure of money supply which includes currency, demand deposits, saving and time deposits at commercial banks, institutional money funds, short-term repurchase agreements, and other large liquid assets. MZM = Money with zero maturity; includes mutual fund money market funds.
A Decade of Debt Expansion
Initially, that money began to work its way through the economy, but by 1996, the bulk of it was going into the stock market. Consumers were now able to borrow more money at lower rates to offset the burden of higher taxes. Take-home pay shrunk with Clinton's giant tax increase. Tax rates rose each year from an increase of the social security tax base. The tax rate base expanded. But money was cheap. Consumers borrowed more money to finance consumption, while savings by consumers came to a standstill. Why save when the stock market was going up over 20 percent a year? Those who did save through corporate pension plans such as 401(k) plans, offset those savings with additional borrowing.
It seemed to be a win-win situation. Consumer spending made the economy grow. Stock market gains expanded the consumer's net worth. Expanding consumer balance sheets through rising stock and housing prices further fueled consumer borrowing and spending. It all added up to accelerating stock prices, rising home values, and above-average economic growth. It began to look like permanent prosperity. Something different was happening in America and the rest of the world wanted a part of it. Other nations began to import capital and expand their money supply. If it worked in the US, why not elsewhere? The American brand of capitalism was being exported.
Good for U.S.—Not So Good for Others
The trouble was it didn't work elsewhere. The advantage America enjoyed was that the dollar was the world's international currency. When we inflated, other governments were forced to buy our dollars through our rising trade deficits or through currency intervention. The expansion of money in other countries led to currency devaluations which occurred in China and Mexico in 1994. Those devaluations would set the stage for Asia's currency and market crises in 1997, the emerging market crisis, and Russia's debt default in 1998. Each new crisis required more central bank intervention either by the Fed, the IMF, the World Bank or other central banks. The world was awash with money and each new crisis seemed to require more of it.
Fuel for Stock Market Mania
By 1999 the Fed's money spigot was opening the floodgates to an ocean of money. A new crisis in the form of a computer bug called "Y2K" required even more money. Fears that consumers would pull money out of the banking system caused the Fed to expand the nation's money supply. As the graph below indicates, the rate of money expansion became parabolic. In an effort to calm financial institution worries of possible outflow of cash due to Y2K, a tsunami of dollars was created. Much of those dollars found its way into the stock market, creating a stock market bubble in the process. Greenspan lamented over the bubble-like quality of the stock market back in December 1996 in his famous "irrational exuberance" speech. At that time, the market was at 6500. It has nearly doubled since that speech was given. Each new crisis from Asia, to Russia, to hedge fund leverage required more doses of money to solve the problems. As more money found its way into the system with each new crisis, that money became the fuel for a stock market mania.
A Year of Monumental Debt
Greenspan could only caution investors. Each new crisis required an opening of the money spigot. More money found its way into the market, as speculation now became rampant. During the tulip mania of the 17th century, tulip bulb prices rose 700% in one year. The tulip mania of that century looks minuscule compared to today's Dot Com Mania where prices for new issues rise as much as 700% in one day! Greenspan could only warn investors by talking tough and raising interest rates, while at the same time flooding the banking system with money. Remember—it is the availability of money that is important and not the cost of money. Interest rates were rising but money was plentiful. Consumers and corporations continued to borrow money and margin debt in the stock market was at record levels. When the Fed pumps money into the banking system, banks do what they are supposed to do, which is to lend money. They were doing so in spades.
As we can see from these graphs, all sectors were on a borrowing binge. Corporations were borrowing money to buy back stock and finance acquisitions. Consumers were borrowing money to finance consumption. Americans were financing purchases of new homes or trading-up to even bigger homes. Meanwhile, investors were trying to leverage their returns by borrowing from brokerage firms through increasing margin debt.
As far as Wall Street and Washington were concerned, times have never been better. Clinton praised his economic programs for the country's prosperity. Wall Street proclaimed the new economic paradigm of technological transformation of the economy. In reality, Wall Street was getting rich on commissions and underwriting fees. In Washington, the taxes from capital gains and social security taxes were making politicians gleeful with new spending possibilities. An election year was ahead and there were plenty of promises being made. The President's address last week sounded more like The State of Largesse than The State of the Union. There seemed to be something in the speech for everyone as the President delivered a laundry list of new spending programs.
A Chicken in Every Pot... A Dot Com in Every Portfolio
While Clinton gave his "A Chicken in Every Pot" speech, Wall Street was getting ready to bring a bevy of new dot coms public. Just as the President was promising a chicken in every pot, Wall Street was advocating a dot com in every portfolio. Lest both parties forget the wellspring of such prosperity, Greenspan was on Capitol Hill warning Congress that trouble might be on the horizon. The Fed may have to take away some of the punch out of the punch bowl. In fact since the beginning of the year, the Fed has already begun to drain the banking system of some of its punch. The Fed has removed over billion of money from the system. Greenspan might have been speaking softly to lawmakers, but the Fed was acting toughly by draining liquidity from the banking system.
Just as money helped to fuel the stock market's meteoric rise last year, the removal of those dollars was creating some of this year's market problems. The stock market ended up in negative territory at the end of January. Wall Street is taking a second look at the possibility of difficulties ahead for the stock market. The new "paradigm crowd" is getting worried too. Historically, easy money and its credit expansion always end in a bust. Roman emperors, Spanish Kings, Prime Ministers and American Presidents have learned the hard way that whenever the supply of money is artificially created for a period of time, it creates a false sense of prosperity. The boom that is created by the expansion of the supply of money has always produced a bust. History books are full of numerous examples throughout history. In this century it has been America's roaring 1920s, the Florida land boom, the 70's precious metals boom, Japan's stock market and numerous other bubbles. They have all come to an end.
In the words of the philosopher George Santayana, "Those who cannot remember the past are condemned to repeat it." Perhaps this is what occupies Greenspan's mind as his thoughts focus on the bubble he has helped to create. A former predecessor of his at the Fed, Benjamin Strong, chairman during the 1920s, created a similar problem in the US. The rampant growth of money created by the Fed during his reign led to a fast growing economy and booming US stock market. Strong began to address the problem by raising interest rates in 1928. Unfortunately, Strong fell ill and died in the fall of 1928. His successor continued to raise interest rates right up to the stock market's crash in October the following year. Japan's central bank faced a similar problem at the end of the 1980's with an invincible economy and meteoric rise in its stock market. Japan tried to deflate its bubble market and economy without much success. A decade later, Japan is still trying to recover. Today it portrays an anemic economic growth and a stock market that is still 50% below its peak in 1989.
So perhaps all of Greenspan's ramblings about "irrational exuberance" should not be dismissed so cavalierly. He is probably the most able Fed chairman to occupy the post. To his credit, he has bailed the US and the world out of many financial crises. But with each new financial crisis solved, he has created another. The monetary tool of opening and closing the money spigot has gotten us through them. However, as we've seen, those crises have become more numerous and require even more money. Greenspan has acquired a reputation as Mr. Fix-It, inspiring awe in his Wall Street and Washington peers. Yet, in the process of fixing each new problem, the solution has created the largest expansion of money and credit in the twentieth century. Its side effects have been the biggest stock market bubble in history. To deflate the bubble will require more than a miracle. It will require financial alchemy. If Mr. Greenspan can accomplish that, then he will have earned a place in the history books occupied by no other mortal.
