Monetary Stimulus, The Federal Reserve and The Great Recession

I don’t know where the stock market is going, but I will say this, that if it continues higher, this will do more to stimulate the economy than anything we’ve been talking about today or anything anybody else was talking about.

Alan Greenspan (1926- ), former Chairman, Federal Reserve

The difference between fiscal and monetary stimulus is somewhat nuanced, but important. Fiscal stimulus starts with Congress and the President deciding to spend taxpayer money over and above normal levels with the intent of stimulating the economy. The Federal Reserve has no option, but to allow the money supply to grow with the new demand created by government spending. The treasury will then print money well beyond the nation’s GDP. The resulting inflation will supposedly kick-start the multiplier effect and end the economic downturn. Over time, however, long-term inflation simply becomes an expected and normal part of economic life; market adjustments are made; and consequently, even short term stimulus is ineffective at reducing unemployment. A similar phenomenon occurs with protracted periods of artificially low interest rates.

Monetary stimulus is a stimulus plan independent of fiscal policy and driven by the Federal Reserve. As was discussed earlier, an artificial, short term lowering of interest rates will cause a rise in the money supply which temporarily increases economic activity. Unlike fiscal stimulus with its consumer price inflation, the economy experiences “Asset Inflation.” This means that the benefits of monetary stimulus are disproportionately tilted to industries sensitive to interest rates, like banking, finance, the stock market and real estate; meaning, that a disproportionate percentage of the nation’s GDP goes to these industries.

Since the Federal Reserve Board is comprised of bankers, and members of the Federal Reserve System are banks, and between 2002 and 2008 bank assets were heavily tilted toward the stock market and real estate, its pretty easy to see why encouraging asset inflation was the Fed’s primary goal. On the other hand, a booming increase in the general economy would incite wage and price inflation — which would be curtailed by the Fed.

The stock market is affected by low interest rates because low interest rates discourage savers, who look for a better return in the equity markets. The new influx of money from savings accounts and bonds now rushes to the stock market. Therefore, when you increase demand without a corresponding increase in supply, the price goes up. As stock prices rise, a bull market ensues, causing the market version of a feeding frenzy. When the markets stabilize, they settle at elevated prices.

There are three downsides to this policy. First, over time low interest rates become an expected and normal part of economic life, nulling the benefits of stimulus. Second, it creates a bubble in the affected industries that will collapse when interest rates are eventually returned to natural levels, which must eventually happen. Or, the bubble will burst when the markets are stretched to the breaking point, usually coupled with the start of a recession. Third, low interest rates encourage debt and discourage saving. Debt-driven growth creates an exaggerated economic collapse. This is because the leverage used to spur the economy (magnifying corporate profits; and gains in real estate and stocks) will equally exacerbate the recession.

Bretton Woods Agreement

After World War II, the Bretton Woods System was established. Under this international agreement, the United States dollar was to be pegged to the price of gold, and the world’s currencies would then be pegged to the dollar. This system, however, conflicted with a new goal of the Federal Reserve, which was to couple monetary and fiscal policy to stimulate the economy, thus reducing unemployment. This, as we discussed earlier, meant an increase in inflation.

During the 1950’s and 1960’s inflation was low and the economy was booming with low unemployment rates, but just below the surface there was a huge boom in public spending. The Vietnam War was in full swing and President Lyndon Johnson (1908–1973) declared war on poverty in America, calling his new policy “The Great Society.” This created a huge demand for currency at the same time that the private sector, still in its boom, also demanded increases in the money supply, setting the stage for inflation and for a recession in the 1970’s. Being loyal Keynesians, this meant keeping interest rates low and hoping that a policy of continued inflation would end the recession. To that end, Richard Nixon (1913–1994) abandoned the Bretton Woods System in 1971; and suspended the backing of our currency with gold.

The Monetarists

The first hint that the Keynes/Phillips model was flawed came during this period in the 1970’s. Our economy experienced a prolonged period of both high unemployment and high inflation, called “stagflation.” Peaking in 1981, the annual inflation rate soared to 13.5%. In just one decade, the dollar had lost half its value! Economists everywhere were in a panic trying to explain this new phenomenon. If you remember, high inflationary spending was supposed to kick start the multiplier-effect, dramatically increasing aggregate demand and spurring production to higher and higher levels, which would lower the unemployment rate.

Along came Milton Friedman (1912–2006) from the Chicago School of Economics, father of the Monetarist movement. He was the first to criticize the Phillips Curve, and back in the 1960’s correctly predicted the stagflation that occurred a decade later. Friedman, who was a fiscal conservative, believed that inflation was not a stable strategy for reducing unemployment. Instead, he favored a policy of monetary neutrality. The Central Bank’s role would be to match the money supply with the total dollar value of goods and services actually produced in the economy (GDP).

Keynes and Phillips believed that there was a direct correlation between unemployment and inflation. High unemployment indicated a slack in the economy which could cause disinflation and even deflation (where prices trend downward). Therefore, by injecting inflationary spending into the economy, that slack would be removed and employment would rise. Simply, they believed it impossible for high inflation and high unemployment to coexist. Friedman correctly pointed out that prolonged periods of inflation would become expected and structurally part of the market economy. Thus, as mentioned before, the tool of inflationary stimulus during prolonged periods of inflation would have no impact on reducing unemployment. Economists have since revised their Keynesian models to reflect this newly discovered reality.

The first real test for Monetarism came in the early 1980’s with Paul Volcker, the first monetarist Federal Reserve Chairman. When he took office our nation’s money supply was growing at a much faster rate than GDP due to inflationary government spending. He initially tried, unsuccessfully, to convince Congress to show fiscal restraint. When that didn’t work, he turned U.S. Monetary Policy upside down.

It had previously been the long-term practice of the Federal Reserve Board to maintain the Federal Funds Rate (the rate to which member banks are able to borrow money from the Federal Reserve Bank) within a narrow range consistent with monetary growth objectives set by the Fed. This gave the nation’s money supply ample room to swing with the natural demand for currency. Because inflation was such a huge national problem, Volcker decided to restrict the money supply, not through the control of interest rates, but by managing the volume of bank reserves in the system. This new policy allowed interest rates to fluctuate with the market. According to the simple law of supply and demand when you decrease the supply of a commodity (in this case money) without a corresponding decrease in demand, then the price (in this case interest rates) will go up.

Suddenly, interest rates exploded! Banks were paying 14 to 15% on six-month certificates of deposit. The Federal Funds Rate jumped to 20%. The interest rate that banks were offering to their best business loan customers the “Prime Rate” shot up to a high of 21.5%. And this was at a time when in most parts of the country, under state Usury Laws, the maximum legal interest rate that banks could charge on credit card debt was 18%.

Demise of the Savings & Loan Industry

Let’s compare the economy to a living organism. If you restrict the flow of blood to a certain part of the body, you have what is known as a stroke. A stroke can cause partial paralysis: brain damage, speech impairment, etcetera. Any part of the body that is deprived of blood will soon cease to function. The same is true with money.

The Savings and Loan industry (also known as Thrifts or Building and Loans) began back in 1816 and flourished through the 19th and most of the 20th centuries. By law, they were only allowed to offer savings accounts, including certificates of deposit, and could only make mortgage loans against single-family homes. During the 1970’s these institutions paid passbook savers an interest rate of about 5%. The depositor’s money was then loaned out at 7% or 8%, earning the Savings & Loan an interest spread of about 2% or 3%. Stable interest rates were necessary for the economic viability of the Savings and Loan industry and to a lesser extent, commercial banks. Because of Paul Volcker’s new policy, the cost of funds skyrocketed and with their primary assets fixed at an average yield of around 7%, the entire industry was having a massive stroke!

The business model used by banks and S&L’s relied on stable interest rates especially for their long-term mortgage assets. When it became clear that this was no longer true, the government needed to step in and save the entire financial services sector. Reagan’s solution was to dramatically deregulate the entire banking and Savings & Loan industries. So, with congressional support a number of laws were passed that removed depression-era safeguards. The intent was to give more freedom to the financial services sector, hoping that new avenues of lending and investments would strengthen these sick institutions. They were also now allowed to compete and/or merge with major stock brokerage firms. In addition, reserve requirements for the S&L’s were greatly reduced, allowing thinly capitalized firms to loan many times their net worth, often on risky Loan Participations. Suddenly a new wave of speculative lending and investments flooded both industries at the same time that the economy was headed toward a recession. The result was disastrous!

Dozens of banks failed and hundreds more were in serious trouble. The largest was Continental Illinois National Bank with assets of $45 billion, partly as a result of holding tens of millions of dollars in worthless loan participations from the infamous Penn Square Bank. In 1984 Congress authorized a $4.5 billion bailout, fearing a chain reaction of more bank failures. Several major banks tied to Continental breathed a sigh of relief.

By the late 1980’s Congress authorized The Resolution Trust Corporation, which was charged with managing and liquidating the assets of hundreds of failed Savings and Loans. Between 1989 and mid-1995, the Resolution Trust Corporation closed or otherwise resolved 747 thrifts with total assets of $394 billion.

On a more positive note, Volcker’s policies worked. By the mid-1980’s inflation had been wrung out of the system, and the recession ended just in time for Reagan to win a second term. Subsequent Federal Reserve Chairmen have continued as inflation watchdogs, but that hasn’t stopped them from using their power over interest rates and the money supply to affect, or at least attempt to affect, specific markets. The first example came in 1987, when in response to a 508-point drop in the Dow Jones Industrial Average (DJIA), Alan Greenspan lowered interest rates. He believed that by expanding the money supply, more money would flow back into the stock market, and that industries like banking and real estate (sensitive to changes in interest rates) would boom. The market did recover and continued to expand even when the Fed raised interest rates in the mid-90’s. In fact, from 1995 to 2000 the DJIA was growing at a clip of 15% per year. The NASDAQ index was doing even better, largely driven by technology stocks.

Then the bubble burst! First, in 1998, the enormous hedge fund Long Term Capital Management (LTCM) collapsed. Of the $1 trillion held in derivatives, $125 billion was borrowed from major New York banks. In the end, the Fed arranged for a $3.5 billion-dollar bailout, rescuing Lehman Brothers and other banks. This led Wall Street to believe that the federal government would continue to be a safety net for the big banks, encouraging highly leveraged and risky investments. The LTCM collapse preceded another big stock market crash. Between 2000 and 2002, the total market value of New York Stock Exchange (NYSE) and NASDAQ companies combined went from $18.3 trillion to $9 trillion. The Fed responded again by lowering interest rates. Only this time, Greenspan kept them artificially low, even as the economy heated up; which it continued to do until the “Great Recession” hit in 2008.

Between 2003 and 2008 the economy seemed to be doing just fine. Stock prices, real estate values and GDP were all rising and unemployment rates were trending down. But, just below the surface there were serious dysfunctions. First, job growth in the private sector was non-existent. Second, wealth in the United States was moving from a manufacturing-based economy to financial services. Even big traditional manufacturers Like General Electric and General Motors had set up huge finance divisions; and not just to finance commercial equipment and automobiles, but to get in on the now lucrative mortgage business. Third, low interest rates were causing a refinance boom. People were taking out second, even third mortgages, and spending the money. This created a debt-fueled expansion:

According to US Federal Reserve estimates, in 2005 homeowners extracted $750 billion of equity from their homes, up from $106 billion in 1996; spending two thirds of it on personal consumption, home improvements, and credit card debt.

Fourth, deregulation of the banking industry, easy money, and rising real estate prices (rising collateral values provided a cushion to banks in the case of mortgage defaults), set the stage for a booming derivatives market to insure the mortgage-backed bonds. Further, there evolved a view among bankers that the federal government would bail them out of any difficulties. These were the major factors that encouraged banks to over-leverage themselves and take on increasing risky investments, which in turn led to the Great Recession.

When the Great Recession ended, there was such weak demand for currency that the Fed implemented a program called “Quantitative Easing,” which was a policy of purchasing massive amounts of mostly long-term government bonds, artificially lowering mortgage rates. They also lowered the Fed Funds rate to zero, buoying the money supply. The goal was to once again, stimulate the sick banking and real estate industries. Remember Albert Einstein’s famous quote: “The definition of insanity is doing the same thing over and over again but expecting different results.”

Let’s step back for a minute. From 1990 to 2008, nearly all job growth came from service based businesses and government. Health care was the biggest jobs creator, followed by government (and education accounted for nearly 70% of government jobs).

Economist Michael Mandel has shown that, between February of 2001 and February 2011 employment in the U.S. economy in health care, education and government increased by 16%. This was not simply a function of a growing population and economy. During the same period, employment outside of those sectors decreased by 8%.

While there is plenty of blame to go around, actions taken by the Federal Reserve contributed not only to the mortgage crises but also to changes in the economy that lowered employment in the private sector, particularly manufacturing.

A Difficult Balancing Act

The Federal Reserve has no control over government spending and very little control over health care spending (partly due to Medicaid and Medicare, and partly due to the power of the various health lobbies). It, does however, have significant control over the rest of the private sector. In other words, government and health care spending will continue to rise regardless of interest rates. The private sector will not. Therefore, the balancing act is to allow enough money into circulation to keep the economy from falling into recession; but fearing inflation, they will not allow enough money to fuel what we all really want — a true economic expansion.

As you remember, it was the long-term policy of the United States to maintain stable interest rates. The money supply was allowed to fluctuate with market demand. This policy worked fine until inflationary government spending (at the time it was the result of the Vietnam War and President Johnson’s Great Society programs) increased the money supply well beyond the true growth of the economy (GDP). The dollars were consequently worth less and therefore prices were driven up. Federal Reserve under Chairman Volcker stopped this cycle by dramatically allowing interest rates to rise. And since that time the Fed has maintained a low inflation policy for the past thirty years and for the past thirty years the private sector economy has sputtered along while the growth in health care and federal government spending has skyrocketed. So, until the federal government is brought under control we will never see a true private sector boom because the Fed, fearing that an increased upward pressure on wages and prices (caused by an increased demand for products, services and labor) will create high private-sector demand for currency at the same time the public-sector demand for currency is already high. Therefore, fearing inflation, the Fed will respond, as it did under Volker, by raising interest rates to artificially high levels. This will reduce the money supply, squashing the boom. Meanwhile, the Fed is repeating the asset inflation that led to the crash in 2008. Since 2013, the 4% difference between the growth in our money supply (M2) and growth in goods and services (GDP) would normally be inflationary — but the extra currency has only modestly driven-up consumer prices; the remainder has inflated stocks and real estate.

(From the Book Greed, Power and Politics, the Dismal History of Economics and the Forgotten Path To Prosperity, by Daniel Cameron)

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