Academic journal article The Cato Journal

U.S. Decapitalization, Easy Money, and Asset Price Cycles

Academic journal article The Cato Journal

U.S. Decapitalization, Easy Money, and Asset Price Cycles

Article excerpt

In Matthew 25: 14-30, Jesus recounts the Parable of the Talents, the story of how the master goes away and leaves each of three servants with sums of money to look after in his absence, He then returns and holds them to account. The first two have invested wisely and give the master a good return, and he rewards them. The third, however, is a wicked servant who couldn't be bothered even to put the money in the bank where it could earn interest. Instead, he simply buried the money and gave his master a zero return. He is punished and thrown into the darkness where there is weeping and wailing and gnashing of teeth.

In the modern American version of the parable, the eternal truth of the original remains: Good stewardship is as important as it always was and there is still one master the American public (albeit in name only) who entrusts capital to the stewardship of his supposed servants. Instead of three, however, there are now only two: the Federal Reserve and the federal government. They are not especially wicked, but they certainly are incompetent. They run amok and manage to squander so much of their master's capital that he is ultimately ruined, and it is he rather than they who goes on to suffer an eternity of wailing and teeth-gnashing, not to mention impoverishment. For their part, the two incompetent servants deny all responsibility, as politicians always do, and since there is no accountability (let alone Biblical justice) in the modern version, ride off into the sunset insisting that none of this was their fault.

U.S. Asset Bubbles: Past and Present

The story starts with the Federal Reserve. Since October 1979, under Paul Volcker's chairmanship, the Fed's primary monetary policy goal had been the fight against inflation, a fight he went on to win though at great cost. Given this background, many monetarists were alarmed by Fed Chairman Alan Greenspan's formal abandonment of monetarism in July 1993, but a subsequent tightening of policy in 1994-95 had caused satisfactory amounts of distress on Wall Street and seemed to indicate that the overall thrust of policy had not in fact changed.

The great change in U.S. monetary policy, so far as it can be dated, came early in 1995. In his biannual Humphrey-Hawkins testimony to Congress on February 22-23, Greenspan indicated that his program of rate rises, the last to a 6 percent Fed funds rate on February 1st that year, had ended. Elliptical as ever, Greenspan's hint of easing was veiled: "There may come a time when we hold our policy stance unchanged, or even ease, despite adverse price data, should we see that underlying forces are acting ultimately to reduce price pressures" (Greenspan 1995: 17). The Dow Jones Index rose above 4,000 the following day, and was off to the races.

By December 5, 1996, the Dow was already at 6,400, and Greenspan famously expressed his doubts about the market's "irrational exuberance." Nonetheless, he did nothing tangible to reinforce his skepticism and pushed interest rates generally downward over the next three years. In July 1997, he then came up with an explanation of why the high stock market might not be so excessive after all. In his usual Delphic manner, he remarked that "important pieces of information, while just suggestive at this point, could be read as indicating basic improvements in the longer-term efficiency of our economy" (Greenspan 1997: 2). The press seized on these utterances as confirming a "productivity miracle" that turned out later (like its predecessors the Philips curve and the Loch Ness monster) to be a myth, but not before it gave a nice boost to tech stocks in particular, which positively boomed. Only in 1999 did Greenspan begin to take action, pushing Fed funds rate upward to an eventual peak of 6.5 percent in 2000, by which time tech stock prices had reached stratospheric levels and then soon crashed.

The cycle then repeated. In January 2001, Greenspan began a series of interest rate cuts that saw the Fed funds rate fall to 1 percent in 2003, its lowest since 1961. …

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