A periodic blog dedicated to providing commentary and encouraging debate on topics in Economics and Finance.

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Age: 26 Occupation: Private Equity

Monday, September 24, 2007

My Beef with Greenspan: A Picture is Worth a Thousand Words

Don't you get the feeling that Alan Greenspan, in his last 5 years at the helm of the Federal Reserve, was the financial equivalent of Indiana Jones at the beginning of Raiders of the Lost Ark, with the boulder barreling after him being the over-inflated, debt-riddled Economy that he created. Like Jones, he managed to escape just in time (via retirement in Greenie's case). Boy do I feel badly for Bernanke, who is left to clean up his mess.

I have yet to read his book, but I find it amazing that Easy Al continues to downplay his role in inflating the housing bubble. He credits "low worldwide long-term interest rates" for that. He fails to mention that he set in motion the mechanism that created low long-term interest rates in the first place.

It goes something like this:

1. Fed drops Fed Funds Rate to 1% (practically paying banks to take its money after inflation is accounted for).

2. Foreign central banks drop their target rates to preserve the dollar's value vs. their currencies (so we can keep borrowing to buy their stuff, supporting their economies).

3. Ridiculously low interest rates spur massive increase in the global money supply (money is "created" via lending - e.g...
1. Fed "creates" $10 in Open Market Operations by lending to a bank to defend its 1% Fed Funds target (without the Fed constantly buying, the lending rate would go up as banks would require higher interest rates - at least high enough to cover inflation),

2. The bank lends $7 to someone (person B) who pays person C $7 for an item.

3. Person C deposits $7 in the bank.

4. The bank lends $4 to Person D... and so on and so forth.

Just in these four steps, the Fed's $10 turns into $21 (known as the multiplier effect).

4. U.S. spends a lot of this newly created money on imports (huge trade deficit), making foreign countries RICH!

5. RICH! foreign countries invest their surpluses (paid for by our huge debt splurge) in nice, safe T-Bills, Notes and Bonds, keeping interest rates nice and low so we can continue borrowing to buy foreign goods, making foreigners RICH!

The long and short of it: create a bunch of money, and all of that money chases the same lending opportunities. If you want to lend, you have to offer a good rate (lest the coveted borrower take someone else's monopoly money). As such, massive monetary inflation will keep rates low.

Take away Greenie's step 1., above and you don't get low long-term interest rates, a housing bubble, and most importantly this mortgage mess that Uncle Ben is trying to clean up. Uncle Ben is also trying to do this housekeeping with the politicos on the Hill trying their best to foul things up with short-sighted policy measures in order to win votes for next year's elections.

Greenspan's legacy is pretty much summed up in the following chart (click for a larger image). M3 is the broadest measure of the money supply (which the Fed conveniently stopped reporting after it completely lost control of its growth).

The Fed has aided money creation at a 9% annual rate since about 1995 - massive monetary inflation as stated above - All of that money had to go somewhere, luckily it has been in assets so far (where next?)...

Can you say... slosh - TECH BUBBLE - slosh slosh - HOUSING / CREDIT BUBBLE - slosh slosh slosh - EXPLOSIVE INFLATION? Let's hope not.


__k said...

In the example, how does the bank ever end up with more than the $10 that the Fed created? If it lends $7 from that, then it only has $3 left. When Person C deposits that $7, there is still only 1 instance of that $7 (belonging to Person C, but in the bank's possession).

As for the chart, it looks to me like either a lot of that money needs to "disappear", or the fed rate needs to be raised to a very high level until the global money supply catches up to a reasonable multiple of the U.S. money supply. Aren't the Feds claiming that their primary concern is inflation? It doesn't seem to really be within their 2% or whatever "comfort" zone.

eternitus said...

___k, your comments are always appreciated.

"Money creation" (After the fed "prints" it - print being in quotations because it is created electronically) happens through lending in a fractional reserve banking system (like ours). There are never more than 10 physical dollars in the whole chain. However...

In the U.S., a bank must keep 10% of its deposits in reserve.

Fed deposits: $10

Bank lends $9

Bank's "Cash" Account: $1

Person A's cash paid to person B: $9 - Deposited into bank.

Let's look how things shake out.

Fed Depsoit($10)

Bank Reserves($1) (Not counting as cash because bank can't use it)

Person B Deposit($9)

There are now $19 in bank deposits where there used to be $10.

Step 2.

Bank loans $8.10 (retains $0.90).

Person C pays person D $8.10 with the loan money. Person D deposits $8.10 in the bank.

Let's see how things shake out.

Fed Deposit: $10

Person B Deposit: $9

Person D Deposit $8.10

Total Bank Cash reserves $1.90

There are now $27.10 of cash where there was only $10 before!

This process repeats and repeats until $100 are created.

In this case, money creation is restrained by the reserve requirement.

However... here's the real kicker... that reserve requirement only applies to checking accounts.

There is no reserve requirement for savings accounts, CD's or other types of deposits... meaning a theoretically unlimited amount of money can be created by banks.

SO, MONEY CREATION IS NOW A PRODUCT OF DEMAND FOR MONEY AT PREVAILING RATES (rates determined by willingness to lend and supply of money available to lend).


Unfortunately, this creates a cycle as artificially high money creation leads to more money chasing the same opportunities, which leads to lower rates... rinse and repeat.

In case you were wondering...

Now what happens when all of the depositors want their money back at the same time? The bank only has $1.90 of cash to give out, versus $27.10 in deposits demanded, and it fails.

There's never enough cash int he vault to pay depositors when they run on the bank because most of their money has been lent out.

People used to lose their money when the bank failed... now we have FDIC.

dxm113 said...

Ok, so "back in the day" our (paper) money was created with the intent that it was backed by gold - and there was a limited supply (of the gold and money represented by it). That gave the paper money inherent value. Nowadays our money is backed by "trust" in the U.S. government - and not with any tangible asset.

Does that make you as nervous as it makes me?

Do you ever see our monetary system failing?

eternitus said...

All bets are off if the world stops using the $ as its reserve currency.

An interesting point... No fiat currency has lasted more than 41 years (over the last 800 years).

__k said...

There is $27.10 in deposits, minus the $17.10 in loans to Persons A and C. Then money "creation" is a misnomer. The problem is one of lending -- the same dollar is lent multiple times simultaneously (and thus, in a certain sense, made available to multiple parties simultaneously). If banks were to collect on the loans they gave while not giving out new loans, then the extra money "created" would disappear.

So that money supply chart is more an indication of existing money plus money lent multiple times. It seems to clearly indicate a need to decrease the money "supply" by raising the Fed target rate. I agree completely -- cheap money is what got us into this mess in the first place. They ought to realize that this bubble is backed not by wealth, but by debt.

I just hope that Bernanke is trying only to achieve a slow decline, not trying to prevent a decline at all. That chart makes a great explanation of the current "credit crunch", and why that crunch is necessary.

eternitus said...

___K... All depends on how you define "money." M0 is the actual currency in the system, M3 includes all bank accounts and other "cash" arrangements.

In our example, all of the folks have "cash" accounts that say they own X amount of dollars. However, if people default on their loans, the dollar disappears (bank takes the hit), to your point.

Given no reserve requirements for lending by banks from "time deposits" (savings, CDs, etc) and the proliferation of "non-bank" lending (no reserver requirements), there are about $13 of total money "supply" for every $1 in physical currency (I read somewhere)...