Self-Inflicted Wound


The news was so bad this week; it’s painful to review. Weak retail sales………credit-card delinquencies……..continued credit-market dysfunction…….stricter loan standards. It feels like a bad case of the flu is about to hit, and bed-rest plus medication (the stimulus package) won’t be sufficient to stave it off.

Meanwhile, yesterday’s hero is today’s villain. Consider these book titles:

Bubble Man: Alan Greenspan and the Missing 7 Trillion Dollars” by Peter Hartcher

Who Shot Goldilocks?: How Alan Greenspan Did in Our Jobs, Savings, and Retirement Plans” by William Rutherford

Greenspan’s Fraud: How Two Decades of His Policies Have Undermined the Global Economy” by Ravi Batra

Ouch! Glad I’m not The Maestro.

There’s more to the story, however, than the Fed’s failure to deal with two asset bubbles ( plus real estate) and the Fed’s refusal to support improved regulation and oversight of mortgage-lending practices and the credit markets. (And that’s not just Monday-morning quarterbacking. There were those who raised these issues in a timely fashion, only to have the Fed reject apt advice.)

What about monetary policy itself, the bed-rock foundation of modern counter-cyclical strategy and tactics? It has few opponents and is a feature of all macroeconomic courses and texts. Nobody quibbled when the Fed raised interest rates at the height of the boom or reduced them at the onset of the bust. Most observers applaud the Fed’s easy-money policies today.

But……. Should the wisdom of hindsight goad us into second thoughts regarding the onset of the housing bubble? There’s a case to be made for that. Consider, once again, the shrinking of the bubble from 2000 through 2002. Those years included stock-market bust and recession. The Fed acted promptly to reduce interest rates, eventually driving the federal-funds rate (at which banks lend reserves to one another) down to 1%.

The Fed did precisely what every textbook recommended. As aggregate demand slumped, the Fed did its best to spur bank lending by reducing interest rates: Lower interest rates -> More borrowing -> More spending -> A revived economy.

But the boom and bust was the first classical business cycle in many years, i.e. centered in business investment. Household spending had driven earlier cycles. In a nutshell: The economy had boomed when households splurged on homes and autos, only to collapse as rising inflation and interest rates choked off spending. Then the Fed would ride to the rescue and rekindle the economy by reducing rates, permitting housing and autos to surge once more.

Since the dot,com boom was a technological phenomenon rather than a response to reduced interest rates, falling rates would not rekindle it. But the Fed could not say “Reduced interest rates are not appropriate now because hi-tech will not respond to reduced rates. All that reduced rates will do is stimulate the residential-real-estate sector, which requires no assistance now. Since rate-cutting would be inappropriate and misplaced, better to do nothing and let things work themselves out.”

You can imagine the uproar if the Fed had said and done nothing. Alan Greenspan would have been lynched. No way would the Fed let that happen. So the Fed did what everyone wanted it to do: The Fed reduced rates and unintentionally set off a residential-real-estate tsunami of historical magnitude.

Worse yet…….. Since the residential-real-estate tsunami, like the boom before it, generated an asset inflation that was not reflected in the conventional (e.g. CPI) statistics, few cared. Having a boom without inflation was like draining the punchbowl without a hangover.

Well, a different sort of hangover is upon us now and, like every hangover, it was a self-inflicted wound. Yet no one sounded the alarm in 2000 – 2002 when the Fed instituted its easy-money policy. No one told the Fed in 2000 – 2002, “New-home sales are already robust. Sending interest rates into the cellar will ignite a fire under this sector.” No one told the Fed, “This is a cyclical industry. Your actions will generate a secular boom that extends far beyond the scope of any earlier cycle.” No one said, ”Leave interest rates alone.”

And that, of course, raises the specter of future consequences. What happens now? An article in today’s New York Times ( discusses just that. It includes an interesting quote, “Compared with the boom-bust cycle in Japan, the American housing market looks positively sedate.” Yet the charts included with the article (be sure your pop-ups are enabled) seem to portray similar asset-inflation outcomes for both the residential-real-estate and stock markets in Japan and the United States. Why can’t we repeat the Japanese experience once more by suffering a long, deflationary slide following an asset-inflation bubble?

The New York Times article points out that our banks and central bank won’t make the same mistakes made by the Japanese banks and central bank. But suppose we make different mistakes that have the same unhappy outcome? After all, who got us into this mess? Didn’t our guys have the Japanese experience to help them avoid a destructive asset inflation? Why didn’t they learn that lesson? Perhaps a new self-inflicted wound will follow upon the heels of an earlier one.

As Mark Twain said, “Giving up smoking is easy. I’ve done it many times.”

© 2008 Michael B. Lehmann