The Financial Bubble Was Created by Central Bank Policy

Charts & Tables
Graph 1. US Monetary Aggregates
Graph 2. Selected US Real Interest Rates

With a collapsing housing market, a falling stock market, and a serious economic recession on the immediate horizon, the blame game about who or what has been behind the financial nightmare is in full swing.

In recent testimony before a congressional committee former Federal Reserve Board Chairman, Alan Greenspan, pointed his finger at various financial insurance schemes and the inescapable uncertainty of the future. “We’re not smart enough as people,” he said. “We just cannot see events that far in advance.”

The one thing he did not admit was that it was his own monetary policy when he was at the helm of America’s central bank that created the boom that has now resulted in a crash.

The ballooning housing market and the rising stock market of the past decade would have been impossible if not for the easy money policy of the Federal Reserve. Monetary expansion through the banking system and resulting low rates of interest fed the housing and stock market frenzy, indeed it made them possible.

Graph 1 shows the growth in the U.S. money supply by several measurements.

Two of these measurements, MZM and M-2, (which measure currency in circulation and various types of checking deposits, time deposits and money market mutual fund accounts) have exploded over the last 10 years. They have increased between 72 percent (M-2) and over 100 percent (MZM). Even if we only look at the period, 1999- 2007, before the Federal Reserve turned on the monetary spigot even more to try to counteract the emerging financial crisis, the rates of expansion were still huge: 60 percent (M-2), and 83 percent (MZM).

Over the last 10 years, real Gross Domestic Product has grown 32.4 percent. By any standard, the rate of monetary increase has been far in excess of any amount required to facilitate the transactions of an expanding economy.

At the same time, the monetary expansion dramatically pushed down market interest rates, especially when adjusted for inflation. The graph below traces out the pattern of real interest rates in the U.S. during the last 10 years.

The Federal Funds rate, the rate of interest at which banks lend money to each other, is targeted by the Federal Reserve as an important policy tool. It is influenced by the amount of money the Fed makes available to the banks through Open Market Operations. Between 2001 and 2005, the Federal Funds rate was either negative or well below 2 percent in real terms.

In other words, the Federal Reserve supplied so much money to the banking sector that banks were lending money to each other for free for a good part of this time. No wonder related market interest rates were also pushed way down.

The yield on 1-year Treasury securities, as seen in the graph, was also near zero or negative in real terms for the middle years of the last decade. Conventional mortgage rates for home buyers--again, in real inflation-adjusted terms--fell dramatically, from barely 4 percent in 2001 to less than 2.5 percent in 2005. It was still well below 3.5 percent at the end of 2007.

If there was any “irrational exuberance” in the market place, as Greenspan called it during the boom years that have now ended, the responsibility lies with Federal Reserve System over which he was the chairman until the end of January 2006.

With the financial markets awash in Fed-created money, credit-worthy standards were lowered, “inventive” financing was introduced to make it possible for the credit-unworthy to obtain home loans, and for others to have access to large sums of money for speculative buying at low margins.

Greenspan was certainly right that an uncertain future makes it difficult to predict when speculative bubbles will burst. But it was not unpredictable to know that years of easy monetary policy and accompanying near zero or negative real interest rates were creating an unsustainable boom that was setting the stage for an inevitable great crash.

[Graph 1 Source: Federal Reserve Bank of St. Louis, Monetary Trends. M-1: Currency in circulation, demand deposits and other checkable deposits, and traveler's checks; M-2: M-1 plus savings deposits (including money market deposit accounts and money market mutual funds, $50,000 or under) and small time deposits ($50,000 or under); MZM: M-2 minus small time deposits, plus larger money market mutual funds ($50,000 or more).

Graph 2 Source: U.S. Department of the Treasury, Federal Reserve Bank, D.C. Real Interest Rates equal nominal interest rates minus the year-over year Consumer Price Index rate of inflation.]

Charts & Tables
Graph 1. US Monetary Aggregates
Graph 2. Selected US Real Interest Rates