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There is an
increasing concern among some commentators that the current, extremely loose
monetary policy of the US central bank could fuel another round of
asset-price bubbles. This in turn, it is held, could pose a serious danger to
the US economy.
Some
commentators, such as John Taylor (the inventor of the Taylor rule), are
urging the US central-bank policy makers to start considering a tighter
stance as soon as possible, in order to prevent a repetition of the Greenspan
Fed's interest-rate policy, which kept rates at very low levels for too long.
(The Fed lowered its policy rate from 6.5% in December 2000 to 1% by June
2003. The Fed kept the rate at 1% until June 2004).
Taylor and others
are of the view that the current financial crisis is the outcome of the
Greenspan Fed's very loose monetary stance, which caused gigantic asset-price
bubbles.
In contrast to
this way of thinking, the former Fed governor and current professor of
economics at Columbia University, Frederic Mishkin, holds that the Fed should
continue with its loose stance. Mishkin is known as a close confidant of Fed
Chairman Ben Bernanke.
In an article in
the Financial Times
on November 9, 2009,[1] Mishkin argues that not every asset-price bubble is dangerous for the
economy. He classifies bubbles into two categories.
The first and dangerous category is one I call
"a credit boom bubble," in which exuberant expectations about
economic prospects or structural changes in financial markets lead to a
credit boom. The resulting increased demand for some assets raises their
price and, in turn, encourages further lending against these assets, increasing
demand, and hence their prices, even more, creating a positive feedback loop.
This feedback loop involves increasing leverage, further easing of credit
standards, then even higher leverage, and the cycle continues.
Eventually,
argues Mishkin,
The bubble bursts and asset prices collapse, leading
to a reversal of the feedback loop. Loans go sour, the deleveraging begins,
demand for the assets declines further and prices drop even more. The
resulting loan losses and declines in asset prices erode the balance sheets
at financial institutions, further diminishing credit and investment across a
broad range of assets. The resulting deleveraging depresses business and
household spending, which weakens economic activity and increases
macroeconomic risk in credit markets. Indeed, this is what the recent crisis
has been all about.
For Mishkin it is
the first category, the credit-boom bubble, that is dangerous to the economy.
The second category of bubbles, which he labels a "pure irrational
exuberance bubble" is
far less dangerous because it does not involve the
cycle of leveraging against higher asset values. Without a credit boom, the
bursting of the bubble does not cause the financial system to seize up and so
does much less damage. For example, the bubble in technology stocks in the
late 1990s was not fuelled by a feedback loop between bank lending and rising
equity values. Indeed, the bursting of the tech-stock bubble was not
accompanied by a marked deterioration in bank balance sheets. This is one of
the key reasons that the bursting of the bubble was followed by a relatively
mild recession. Similarly, the bubble that burst in the stock market in 1987
did not put the financial system under great stress and the economy fared
well in its aftermath.
According to Mishkin,
since banks are currently curbing their lending, there is no danger of the
emergence of a credit-boom bubble in the foreseeable future.
Our problem is not a credit boom, but that the
deleveraging process has not fully ended. Credit markets are still tight and
are presenting a serious drag on the economy.
Hence, even if
the present loose monetary policy were to produce bubbles there is no need to
be concerned, since they belong to the harmless bubble category, argues
Mishkin.
From this it
follows that the Fed should keep its present easy monetary stance as long as
it is required. Mishkin is of the view that a policy aimed at preventing the
second category of bubbles can only damage the economy.
Credit Expansion and Bubbles — What Is the
Link?
According to
popular thinking, an asset bubble is a large, above historical average,
increase in asset prices. A price of a thing is the amount of dollars paid
for it. This means that a bubble is a large, above the historical average,
payment of dollars for various assets.
As a rule, for
this to occur, there must be an increase in the pool of dollars, or the pool
of money. So if one were to accept the popular definition of what a bubble
is, one must also accept that without an expansion in the money pool, bubbles
cannot emerge. (Observe that in his article, Mishkin never mentions money
supply).
Irrespective of
their psychological disposition, if the pool of money is not expanding,
people's ability to generate bubbles in various markets is not tenable.
Recall that Mishkin
holds that bubbles in the first category — the dangerous bubbles
— are set in motion by exuberant expectations about economic prospects
or structural changes in financial markets, which trigger a credit boom.
But even if these
factors are capable of triggering increases in credit, why must all this
produce an expansion in the money supply? The increase in the money supply is
the key for the emergence of asset bubbles.
For instance,
when Joe lends his $100 to Bob via his bank, this means that Joe via the
intermediary lends his money to Bob. On the maturity date, Bob transfers the
money to the bank, and the bank in turn (after charging a fee) transfers the
$100 plus interest to Joe.
Observe that here
we don't have any increase in the money supply — the existing $100 was
transferred from Joe to Bob. Also note that the $100 loan by Joe to Bob is
fully backed up by $100.
Things are
however quite different when Joe keeps the $100 in the bank warehouse or
demand deposit. Now, by keeping the money in a demand deposit, Joe is ready
to employ the $100 in an exchange at any time he deems it is necessary.
If the bank lends
Bob $50 by taking it from Joe's deposit, the bank has now created $50 of
unbacked credit, i.e., credit "out of thin air." There is now $150
in demand deposits backed by $100. By lending $50 to Bob, the bank creates
$50 of demand deposit.
In this sense,
the lending here is without a lender as such. The intermediary, i.e., the
bank, has created a mirage transaction without any proper lender. On the maturity
date, once the money is repaid to the bank, this type of money disappears.
The amount of money will revert back to $100.
Hence an increase
in the credit created out of thin air, all other things being equal, gives
rise to the expansion in money supply. A fall in the credit created out of
thin air, all other things being equal, results in the contraction of the
money supply.
What then matters
for asset price bubbles is the expansion in credit out of thin air. It is
this type of credit that boosts the money-supply rate of growth and hence
fuels asset-price bubbles.
Again, an
increase in normal credit (i.e., credit that has an original lender) doesn't
alter the money supply and hence has nothing to do with asset-price bubbles.
(When Bob lends $100
to Joe, what we have here is an increase in lending and a
transfer of an existing $100 from lender to borrower — and no change in
the money supply).
The Fed's Monetary Policies and Asset-Price Bubbles
It must be
realized that without the support from the Fed pumping money, banks will find
it difficult to expand the credit out of thin air.
For instance, a
farmer Joe sells his saved 1kg of seeds for $100. He then deposits this $100
with Bank A. Observe that Joe is exercising his demand for money by holding
his money in the demand deposits of Bank A. (Joe could also have exercised
his demand for money by holding the money at home in a jar, or keeping it
under the mattress).
Whenever a bank
takes a portion of Joe's deposited money and lends it out, it sets in motion
serious trouble. Let us say that Bank A lends $50 to Bob by taking $50 out of
Joe's deposit. Remember that Joe still exercises his demand for $100. What we
have here is $150 that are backed by $100.
"In the extreme case, if there is only one bank it can practice
fractional-reserve banking without any fear of being 'caught'."
Now, Joe demands
money not to hold it as such but to use it as the medium of exchange. So let
us say that Joe decides to use his $100 to buy goods from Sam, who banks with
Bank B. On the following day, Bank B will present the check on $100 to Bank
A. In short, $100 is shifted from Bank A to Bank B. (No more money is now
left at Bank A).
Let us say that
Bob, who borrowed $50 from bank A, also buys goods from Sam (remember that
Sam keeps his money with Bank B). This, however, will pose a problem to Bank
A since it doesn't have the $50 to pay Bank B once the check on $50 written
against Bank A is presented by Bank B. This means that Bank A is
"caught" here, so to speak.
As the number of
banks rises and the number of clients per bank declines, the chances that
clients will spend money on the goods of individuals that are banking with other
banks will increase. This in turn increases the risk of a bank not being able
to clear its checks once this bank practices fractional-reserve banking
— i.e., lends fictitious claims or money out of thin air.
Conversely, as
the number of competitive banks diminishes, that is, as the number of clients
per bank rises, the likelihood of being "caught" practicing
fractional-reserve banking diminishes.
In the extreme
case, if there is only one bank it can practice fractional-reserve banking
without any fear of being "caught" since it will always clear its
own checks. Thus Sam, who sold goods to Bob, will deposit the check with bank
A. All that will happen now is that the ownership of the deposit will be
transferred from Bob to Sam. If Joe decides to spend his $100 on goods from
Tom, then again we will have here a transfer of the ownership of the deposit.
We can thus
conclude that in a free banking environment with many competitive banks, if a
particular bank tries to expand credit by practicing fractional-reserve
banking, it runs the risk of being "caught." So it is quite likely
that in a free-market economy the threat of bankruptcy will bring to a
minimum the practice of fractional-reserve banking.
From what was
said so far, we can suggest that in a free-market economy the practice of
fractional-reserve banking would tend to be minimal. This is, however, not so
in the case of the existence of a central bank. By means of monetary policy,
which is also termed the reserve management of the banking system, the
central bank permits the existence of fractional-reserve banking and thus the
creation of money out of thin air.
If bank A is
short $50, it can sell some of its assets to the central bank for cash,
thereby preventing being "caught." Bank A can also secure the $50
by borrowing it from the central bank. Where does the central bank get the
money? It actually generates it out of thin air.
The modern
banking system can be seen as one huge monopoly bank, which is guided and
coordinated by the central bank. Banks in this framework can be regarded as
the branches of the central bank. As we have seen, one monopoly bank can
practice fractional-reserve banking without running the risk of being
"caught."
Through ongoing
monetary management, i.e., monetary pumping, the central bank makes sure that
all the banks engage jointly in the expansion of credit out of thin air.
The joint
expansion in turn guarantees that checks presented for redemption by banks to
each other are netted out. By means of monetary injections, the central bank
makes sure that the banking system is "liquid enough" so banks will
not bankrupt each other.
"So it is quite likely that in a free-market economy the threat
of bankruptcy will bring to a minimum the practice of fractional-reserve
banking."
Hence without the
support from the Fed's pumping, the commercial banks' creation of money out
of thin air would be barely noticeable. Pay attention that without the Fed's
pumping, the so-called exuberant expectations or mysterious structural
changes in financial markets couldn't produce an expansion of the money
supply and thus set in motion asset bubbles as Mishkin suggests.
Once it is
realized that the key source for asset bubbles is the monetary pumping of the
Fed (i.e., central bank) it becomes clear that there is no need to categorize
various bubbles.
What matters is
the fact that the Fed's loose monetary policy gives rise to various
nonproductive (bubble) activities that undermine the process of real-wealth
formation, thereby impoverishing the economy.
The reversal of
the Fed's pace of money pumping sets in motion the bursting of bubble
activities.
Bubbles and the Fed's Policies — Historical
Evidence
Both the plunge
in technology stocks from February 2000 to September 2002 and the October
1987 stock market crash were set in motion by the boom–bust policies of
the Fed.
By the end of
September 2002, the NASDAQ composite stock-price index closed at 1,172.06
— a fall of 75% from the high of 4,696.69 reached at the end of
February 2000.
What set this
collapse in motion was a sharp fall in the growth momentum of the Fed's
monetary pumping. Year-on-year, the rate of growth of the Fed's balance sheet
fell from 16.9% in December 1999 (Y2K pumping) to −3% by December 2000.
In response to
this, the yearly rate of growth of our monetary measure AMS[2] fell from 6.7% in January 2000 to −1% by
December 2000.
Also note that
the yearly rate of growth of commercial-bank lending fell from 13.1% in
September 2000 to 1.5% by December 2001. (Given the sharp decline in the
growth momentum of commercial-bank lending, it is quite likely that the
growth momentum of commercial-bank lending out of thin air had also fallen).
The yearly rate
of growth of our measure of monetary liquidity fell from −1.1% in
January 2000 to −5.3% by December 2000.
 
As a result of
the plunge in the pace of monetary pumping, the yearly rate of growth of
industrial production fell from 5.5% in June 2000 to −5.7% by November
2001.
Also, in the
October 1987 stock-market crash, the Fed's monetary policy played a key role.
By the end of October 1987 the S&P500 closed at 251.79 — a fall of
23.7% from the end of August 1987.
What set in
motion this plunge was the sharp fall in the yearly rate of growth of Fed's
balance sheet from 17% in April 1987 to 7.5% by September of that year.
In response to
this, the yearly rate of growth of our monetary measure AMS fell from 17.2%
in January 1987 to 10.5% by September. (Our measure of liquidity plunged from
15.1% in January to −0.3% in September).
As a result of
the decline in the Fed's monetary pumping, the yearly rate of growth of
industrial production fell from 7.7% in November 1987 to −0.3% by
October 1989.
At present we are
observing a repetition of the past boom–bust policies of the Fed. Thus the
yearly rate of growth of the Fed's balance sheet jumped from 1.5% in February
2008 to almost 153% by December of last year.
Afterwards, the
yearly rate of growth has been in steep decline, closing at 0.3% by
mid-November this year. It seems that notwithstanding pronouncements by
various Fed officials that the US central bank will keep its easy stance
intact, the Fed in fact has already drastically reduced the pace of monetary
pumping.
As a result of
the wild fluctuations in the pace of money pumping by the Fed, the yearly
rate of growth of AMS jumped from 0.8% in January last year to 33.1% by November
of 2008. In early November 2009 the yearly rate of growth of AMS stood at −9.1%
against −6.2% in October. In short, the Fed has already set in motion
another economic bust.
Now after
settling at 2.5% in January 2006 the yearly rate of growth of industrial
production fell to −13.3% in June 2009. We have seen that in the
2000–2001 recession the yearly rate of growth of production fell from
5.5% in June 2000 to −5.7% in November 2001. Furthermore, from November
1987 to October 1989, the slump in industrial production was even less
severe. Recall that Mishkin is of the view that the much more severe, current
economic slump is a result of the collapse in bank lending.
We suggest that
the main reason for the present, more-severe slump is not a fall in lending
but the damage inflicted to the pool of real savings by past and current
monetary and fiscal policies. A fall in bank lending only reflects the
precarious state of the pool of real savings. This fall, however, is not
responsible for the economic slump. As a result of the past and present loose
monetary and fiscal policies, the process of real-wealth formation has likely
been severely damaged. (Note that loose monetary and fiscal policies provide
support for nonproductive activities by diverting real savings from
wealth-generating activities).
Conclusion
In his Financial Times
article, the former Fed governor Mishkin argues that the possible emergence
of asset-price bubbles on account of loose Fed policies shouldn't be feared. He
argues that only bubbles that originate from credit expansion pose a danger
to the economy. Since banks are currently curbing the expansion of credit,
bubbles that emanate from loose monetary policy by itself are not harmful,
argues Mishkin.
On the contrary,
maintains Mishkin, in the present, still-subdued economic climate, the Fed
must keep its loose-money stance in place for a prolonged time. According to
Mishkin, a policy that will try to counter the emergence of bubbles whilst
banks are cutting their lending can only damage the economy.
We suggest that
what matters here are the Fed's boom–bust policies and not bubbles that
emanate from credit expansion. It is the Fed's loose monetary policy that
gives rise to various nonproductive bubble activities, while the reversal of
the Fed's policy undermines these activities and sets in motion an economic
bust. This means that it is not bubbles as such that pose a threat to the
economy but the boom–bust monetary policies of the central bank. Note
that bubbles are just the manifestation of loose monetary policies.
So we are in
perfect agreement with Mishkin, although for radically different reasons,
when he says, rather unwittingly in our view,
Monetary
policymakers, just like doctors, need to take a Hippocratic Oath to "do
no harm."
Frank Shostak
Frank
Shostak is a former professor of economics and M. F. Global's chief economist.
Also
by Frank Shostak
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