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US economy: why the recession stumped Alan Greenspan
Gerard Jackson
On 20 January 1999 Alan Greenspan said that we need “to seek a deeper understanding of the forces that have produced” eight years of economic expansion. This was quite a statement from the chairman of US Federal Reserve. With all its resources, highly trained manpower, mathematical models and computers the Fed felt forced to publicly admit that it did not know what was happening to the economy — or even what would happen to it.
As I have said more than once, give me sound economic reasoning any day of the week to several hundred simultaneous equations purporting to show how an economy works. Of course, Greenspan and his modellers knew that the party was coming to an end and that there was going to be a lot of hangovers. But when and why? Two questions in one that had the Fed baffled. “Holy Riddler!!!” as Wonderboy would have exclaimed. Only this ‘riddle’ had serious consequences for us all.
There were a number of explanations, none of which seemed to impress Greenspan, who had his own explanation, and one that did not impress this tired old “rightwing hack”.* A favourite at the time was that the stock market was driving the economy. But what then was driving the stock market? The answer that was usually given, when one was given at all, was higher productivity and capital gains.
This, incidentally, was also Greenspan’s view and one he expressed at length. Unfortunately, it had as much substance as a Clinton oath. Now the productivity and capital gains explanations are really two sides of the same coin. Productivity raises output and reduces costs which generate profits which are exactly what capital gains are.
But was it really so? That America is superior to other advanced countries in its allocation of capital goods is easily confirmed by statistical studies. But this has been the case for decades and the reason is not hard to discern: The less government intervention in the allocation of capital goods the greater the efficiency in their allocation. So it simply did not do to argue that capital efficiency was driving the stock market.
However, taking the argument further, the capital gains generated by a more efficient allocation of capital raised asset values which in turn supported rising consumption. This is called the ‘wealth effect’ and it is at this point that the analysis broke down.
For starters, there is no way that then returns on investment could justify earning ratios of 30 plus which were translated into inflated asset values. In other words, future profit streams were greatly exaggerated, something Greenspan recognised and something sagging corporate profits and increasing layoffs in certain industries brought home to more astute economic observers.
So the stock market was rising while a good slice of the economy began to sink. Moreover, only realised capital gains and asset values can be consumed. This strongly suggests that the simultaneous increase in consumption expenditure and asset values was fuelled by credit expansion.
If so, then credit expansion generated the market boom. Put another way, rather than rising asset values boosting consumption through the ‘wealth effect’ we find that booming liquidity has been boosting both. Therefore rising asset values and rising consumption have the same cause — credit expansion.
This view is born out by the Fed’s own monetary figures. From January 1991 to December 1998 M1, of which credit is an important component, grew by about 35 per cent. (Since January 2001 and M1 has expanded by over 30 per cent. Although M1 does not strictly in accord with the Austrian definition of the money supply it is close enough to serve our purpose).
As the Austrian school of economics has explained, monetary booms eventually let loose real economic forces that create the apparent paradox of a booming stock market and buoyant consumption even as profits begin to sink and unemployment in manufacturing begins to rise, as was the case under Clinton. Once manufacturing starts contracting it is only a matter of time before the bubble finally bursts.
Unfortunately this chain of economic reasoning is still alien to most of the economics profession and nearly every economics commentator. That is why media pundits can seriously tell their readers that falling equity prices reduce spending and consumption which then sends the economy into depression. (It is never explained how falling share prices reduces the money supply, which is what they are really saying).
That this sequence has, to my knowledge, never occurred totally escaped them. Why? Because they do not do their homework. The 1929 crash is a graphic example of their intellectual indolence and textbook mentality. Time and time again economic commentators keep repeating the story that the 1929 October stock market crash sparked off the Great Depression.
It did not. The economy had visibly slid into depression as early as July when manufacturing output was seen to be clearly falling. The statistics are there for anyone who cares to look. We saw the same thing under Clinton and we shall see it again.
Gerard Jackson is Brookes’ economics editor
BrookesNews.Com
Monday 11 April 2005