In mid to late 2007, I had a couple of beers with a very impressive individual who had just returned from a rather important US Federal Reserve conference. Apparently, the conference had been abuzz with discussion and dark rumour of an ensuing economic accident. My drinking partner told me that there was a distinct possibility that the US would lose a major bank and that the Federal Reserve was ready to stand firm in the face of the trouble to come and not cut interest rates.
I said at the time that I agreed with the first half but on the second suggested that my compatriot had perhaps had too much to drink.
To understand why the Federal Reserve may have at least been thinking this way in late 2007, let’s turn to some history. I wrote the following passage in The Great Crash of 2008, co-authored with Ross Garnaut:
The story of the great Anglosphere asset bubble begins with an atypical period of economic calm. Western economists and officials began to note in the late 1990s that volatility in their economies was in decline. By this they meant that the frequency and depth of swings between periods of growth and recession had diminished. Inflation was under control and there was less need to raise interest rates to high levels. This phenomenon was called The Great Moderation by the economist James Stock of the Kennedy School of Government, Harvard University.
The term caught on.
Central banks around the world claimed that The Great Moderation was the result of their increasingly competent use of interest rate policy. However, Stock attributed the decline in volatility as much to the good luck of living through a period with limited external shocks, such as commodity price spikes induced by supply disruptions. Other explanations for The Great Moderation have included the mitigating effects of information technology on the inventory cycle; the anxieties and competitive pressures of globalisation deterring labour unions’ pursuit of higher wages; the increased role of services in the economy and the corresponding reduction in the potency of the ‘stock cycle’; and the disinflationary effects of expanding exports from China and other developing countries with low labour costs.
Whatever the mix of forces that produced subdued consumer price inflation through the early 1990s, the calm enabled a new set of central bank practices to emerge. Liberated by the apparent defeat of inflation, the United States Federal Reserve under Alan Greenspan adopted a ‘risk management’ approach to monetary policy during crises. Greenspan, who had been appointed chairman of the Board of Governors in 1987 and held the post for a record period of almost twenty years, repeatedly shifted US interest rates lower in response to financial and other shocks. He did so following the 1987 stock market crash, the first Gulf War, the Mexican debt crisis, the Asian Financial Crisis, the Long Term Capital Management crisis, Y2K, the ‘tech wreck’ stock market crash and the September 11 terrorist attacks. No matter what the crisis, Alan Greenspan, his sagging, impish face supporting oversized spectacles, emerged to announce remedial interest rate cuts.
The markets loved him for it. The phrase ‘Greenspan put’ was coined to describe traders’ confidence that Greenspan, who became known as ‘The Maestro’, would always boost liquidity to prevent falls in asset prices following a shock. Over time, this lifted asset valuations, narrowed interest rate premiums on riskier loans, and led to lower pricing of risk generally. If a multitude of forces worked together to subdue economic volatility in the early 1990s, the ‘Greenspan put’ continued the calm throughout the latter 1990s and into the new millennium as asset prices rose and rose.
John Taylor, a Stanford University economist, makes the point that by keeping their interest rates low, US authorities caused interest rates in other countries to be lower than they would have been. This played a role in the swelling of the technology stock market bubble, as well as in the expansion of the housing bubble that began at the same time and continued well after the former had ended.
In short, through two decades of easy money, Greenspan transformed US central banking from the practice of taking away the punchbowl when the economic party got too crazy, to the practice of spiking the punchbowl whenever the folks tried to leave the party. In 2007, according to my drinking buddy, the Fed under Bernanke was determined to restore some of its former sobriety.
To describe this as too little, too late seems the understatement of the century.
Fast forward to today and the US Federal Reserve faces a similar test. As we approach the end of QE2, the US economy is sputtering once more. The causes are myriad: the ongoing housing collapse, subdued credit, high unemployment, a structural shift away from labour’s share of national profits and a steady but slowing revival in US manufacturing. The question is, what will the Fed now do about it?
On the one hand, with unemployment now rising again, Bernanke could justifiably argue that there is little chance of inflation or inflation expectations rising sustainably. And, with further fiscal stimulus under a cloud, the US economy could very easily stall as the rest of the world slows, notwithstanding some recovery in Japan. This is an argument for more stimulus.
On the other, it is surely self-evident that the effects of the ‘Bernanke Put’ are now far more pervasive even than those of his predecessor, with risk premia flattened across most of the global economy, mass correlations across asset classes and real asset prices very inflated following QE2. Here’s the CRB Index:
The choice of the Federal Reserve is clear to my mind. They can continue two decades of spiking the punch bowl when financial markets get a bit tired and, in doing so, bring on a blowoff round of commodity inflation. That may stoke foreign demand in the short term but will quickly prove self-defeating as nations exposed to the commodities complex, on the demand and supply side, stamp on the monetary brakes all at once (Australia included). It’ll be a spectacular boom and bust.
Or, the Feds can do what they are supposed to do. They can take way the punch bowl (though at this point, it’s more like insisting party goers drink from a glass than stay face down in the Wedgewood).
The result may well be slow global growth, but that’s the better alternative.
Will it happen? It’ll take real cojones. Perhaps Bernanke can brace himself with a bit of Dutch courage.