Current Economic Effects of the Federal Reserve

Having given the institutional composition and powers of the Federal Reserve, and having given our opinion on what it should be doing and why, we will now look at what it has been doing since the start of the Alan Greenspan chairmanship. The Greenspan chairmanship stretched from August 11, 1987 to January 31, 2006. Therefore he was the head of the Fed from the start of the housing bubble’s inflation to almost the time it burst in 2007. If you recall from our discussion of Japan’s “Lost Decades”, caused by the bursting of twin stock market and real estate bubbles, whenever bubbles like these cause significant financial crises, the central bank must bear a significant amount of the blame for causing the bubble. If the central bank (in our case the Federal Reserve) did not provide the fuel for the fire that inflates the hot air balloon of the bubble, the bubble could not exist. The fuel the Fed provided was easy money.   

One significant change in the influence of monetary theory from the times of Milton Friedman’s greatest sway was the capture of monetarism by Keynesians. As we saw in the post The Evolution of Modern Economic Theory, the Keynesians developed their own monetary theory that justified using monetary policy to stimulate economic demand. In addition, after Friedman and Schwarz explained that a Fed monetary policy was the primary cause of the Great Depression , even most neoclassical economists did not favor a restrictive monetary policy during recessions. The views of Keynesians and neoclassical economists began to interact together during Alan Greenspan’s Federal Reserve Chairmanship to create the monetary policies of the Fed today.

Following Greenspan’s confirmation to the Fed Chairmanship on June 2, 1987 came a stock market crash two months later (the so-called “dot-com bubble” or “internet bubble”). Simultaneously, the savings and loan crisis was playing out. It started in the late 1970s, peaked during the 1980s, and was finally resolved in the 1990s, and it occupied much of the Federal Reserve’s attention. To calm the financial markets, Greenspan said that the Federal Reserve “affirmed today its readiness to serve as a source of liquidity to support the economic and financial system”. He then lowered short-term interest rates to as low as 1% to assure market liquidity. Clearly, Greenspan and his fellow governors and presidents of the Fed had learned their lessons well from Milton Friedman and the Great Depression. This “cheap money” allowed banks and investment firms to borrow the money necessary to fuel the real estate bubble that culminated in the “Great Recession”. With the federal government mandating subprime mortgages, the future disaster became unstoppable. As a result of all this “irrational exuberance”, Greenspan and his colleagues raised interest rates several times. These interest rate hikes almost certainly helped to deflate the real estate bubble.

By the year 2005, the developing real estate market bubble was becoming obvious. This caused experts such as Robert J. Schiller to give early warning that the real estate market was greatly overvalued. Succeeding Greenspan as the Chairman of the Federal Reserve, Ben Bernanke inherited the mess the Fed and the federal government had jointly caused. Although his economic policy persuasions were initially obscure, his subsequent actions have shown him to be a New Keynesian. As the country fell into the abyss of deep recession during the 2007-2008 recession, “Helicopter Ben” made sure that money stayed cheap with low interest rates. This despite the fact that it was low interest rates in conjunction with federal government policy that caused the crisis in the first place.

Yet keeping interest rates low did not create a significant increase of aggregate economic demand, as the economy recovered extremely slowly from the recession. Attempting to find yet another way to “goose” the American economy, Bernanke’s Fed came up with the idea of “sterilized” Quantitative Easing (QE). Quantitative Easing (see here and here) was a Fed program, beginning in 2008 and ended in October 2014, where the Fed would create new money by buying federal treasury bills and mortgage backed securities from member banks. These banks in turn redeposited most of this new money as excess reserves in the Fed. In return, the Fed paid a small interest rate to the member banks, making their excess reserves an absolutely risk free investment. The return of the QE money to the Fed as excess reserves effectively removed it from the economy so that it could not create inflation. It is in this sense that QE was “sterilized”. What remained of the QE money (approximately 20%) that stayed in the the economic system was lent primarily to the banks’ most credit-worthy customers, investment firms and large corporations, who used the money to buy real-estate and stock market assets. With the stocks being currently over-valued, one could be permitted the suspicion that the Fed is helping to inflate yet another asset bubble.

Despite all these heroic attempts to stimulate the American economy with Keynesian monetary policies, GDP growth since the end of the “Great Recession” has remained dreadfully low, averaging about 2% per year. In the process of making these “investments”, the national debt financed by the Federal Reserve with these QE transactions has increased from $10.6 trillion on Obama’s inauguration day to $18 trillion on January 1, 2015, an increase of 70%. Over and beyond that we may be on the verge of seeing the deflation of the current stock market bubble, which may be as bad as or worse than the “Great Recession”.

It is apparent that the Federal Reserve System has great responsibility, along with the executive and legislative branches of government, for our present dreadful economic condition. If in fact the stimulation of the economy can not be achieved by Keynesian monetary policy, how should the Fed craft monetary policy, and how could it be bound to a method of making policy that does not do actual harm? We know from the history of the Great Depression that monetary policy should not be unduly constrictive during times of recession, but the history of the last two decades should have also taught us we can not use monetary policy to stimulate our way out of recession.  We will discuss this when we look at monetary rules.

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