What would you do if you were running the central bank for the world’s biggest economy and you saw “irrational exuberance” in the financial markets?
Your answer is right at hand. You have read Milton Friedman and you would worry that the exuberance might be evidence of too much money which is bad for inflation and for economic stability. So you would tighten the screws so the exuberant irrationalists could do less damage.
Alan Greenspan, head of the United States’ central bank, forgot his Friedman and found a “new paradigm”. He added hubris to the exuberance he found in 1996.
He reasoned that prices were rising moderately. So he kept interest rates low.
That green-lighted firms, consumers and investors to borrow and spend. That generated a gaping deficit in the United States’ transactions with the rest of the world and ran up huge household and country debt. It all seemed OK because prices of shares and houses kept going up so everyone felt safe to borrow and spend still more and banks felt free to forget risk and lend against those rising “asset” “values”.
The government borrowed and spent, too, having cut taxes but not spending. That created a gaping budget deficit and a huge government debt. (John Key and Bill English might take careful note.)
Hence a bizarre spectacle: the world’s richest economy borrowing from much less well-off economies — the opposite of what economic textbooks tell us should happen.
Greenspan got it wrong, on three counts.
First, China’s rapid expansion as a manufacturing economy in the 1990s was cutting world goods prices and computerisation and outsourcing through the internet (to, for example, India) were cutting prices of many services. So logically prices overall should have been falling, not rising, as when manufacturing mechanised and rail integrated national economies in the nineteenth century. (I suggested this in 2001 to a former high official in our Reserve Bank, who gave me an anonymously encouraging response.)
In short, Greenspan, charged with constraining inflation, was stoking inflation by keeping interest rates low.
Second, he took his eye off the credit (money) blowout. Household debt soared to dizzying heights (as it did here). There was a huge inflation of, first, share prices, then house prices far beyond their underlying value.
Third, Greenspan was allergic to recession. As in turn the late 1990s dot-com share and the 2000s house bubbles swelled, Greenspan said asset bubbles were not central banks’ business. The market would fix them.
Well, the market has been at work. Huge banks, investment banks and mortgage lenders are collapsing in “developed” economies, badly squeezing smaller banks and financial institutions and in turn businesses that make and do things (the real economy) — and infecting other economies.
On Friday here interbank lending seized up. The Reserve Bank pumped in money to get it moving.
The problem with leaving the cleanup of a big asset bubble to the market is that the real economy, where most people work and earn their living, gets badly damaged. So governments (read taxpayers) and central banks have no real choice but to step in. You might be forgiven for recalling the old quip that capitalists like to privatise profits and socialise losses. The small people pay to clean up the mess the big people make.
Part of the problem is that where once so-called Keynesian governments tried to banish the downside of the economic cycle (including recession), a practice discredited in the 1980s-90s worldwide economic reforms, in recent decades central banks have been keen to avert recession.
This is a hangover from Great Depression which followed the 1929 sharemarket crash.
But, as Gareth Morgan has noted, recession is not depression. It is part of the economic cycle. Evoking “depression” as a reason for averting recession at all costs all the time is the wrong lesson to draw from 1929 — especially when prices (of goods and services or of “assets”) are far above underlying value. You may actually invite depression if you try to abolish the economic cycle because in the end the market does rule.
Look closer to home. Our two post-1989 Reserve Bank governors have breached the top end of their inflation targets with impunity but rarely threatened the bottom end.
This is understandable on two counts.
One is that as a tiny, open economy, our monetary conditions are heavily influenced by external events (including, recently, scarcity of resources, as the Greens noted in the parliamentary monetary policy report). So when foreigners shovelled money in here, that loosened monetary conditions enough to fuel a house bubble and now as foreigners retreat and as international banks do it hard money is tight.
The second count is that we — and the politicians on our behalf — don’t want an economic slowdown, ever. We want, as Charlie Brown once said, ups, ups and more ups.
Well, sometimes there are downs. And the higher the up the deeper the down.