Why the Fed is in the dark: The shadow money stock

The shadow money stock: (from the podcast)

It can be argued that the Fed and Ben Bernanke have been engaged in a massive effort to inflate a way out of the current economic contraction. So far, no inflation. Demand Side has not been shy about pointing out the impotence of the Fed's policy. But what are the nuts and bolts?

Two economists from Credit Suisse, James Sweeney and Carl Lantz went on Bloomberg and presented the concept of the shadow money stock. There's a more academic treatment out just this last weekend on the Zero Hedge blog, link on the web site.

http://zerohedge.blogspot.com/2009/05/chasing-shadow-of-money.html

It's a concept which after one hears it seems almost too obvious.

During times of strong demand and liquid asset markets, those assets are held in lieu of money and serve the purpose of money. For example, during the housing boom, housing was extremely liquid as a financial asset. Not only could you sell it almost by accident if you answered the door wrong, you could also tap its market value easily and immediately via a home equity loan.

Let me start again with a straightforward rendition of the premise.

The shadow money stock is money the market itself creates in order to finance a boom. Money in the sense of a medium of exchange. In a boom there is not enough cash to go around, so collateral will be used as near money or shadow money.

Many assets can be converted into cash easily in a boom. Take the example of the house we led off with. Homeowners held less cash in checking accounts and other forms because they knew that virtually overnight they could get low interest money out of their homes.

Similarly, government bonds can be taken to the Repo desk and for a one percent haircut converted to cash. During the boom, private bonds and asset-backed securities of less than perfect ratings could easily be converted to cash, with say a five percent haircut.

People used their cash to buy things and these other assets as the rainy day fund. When the downturn came, the value of the assets went down, yes, but also the terms for borrowing against them, including the haircut became more onerous.

For example, a bank once willing to loan on 90 percent of the value of your house became willing to loan only on 70 percent. The value of trillions of dollars of securities became useless as collateral as their markets became illiquid.

Friedrich Hayek, quoted on Zero Hedge, put it this way. (abbreviated)

"There can be no doubt that besides the regular types of the circulating medium, such as coin, notes and bank deposits, which are generally recognized to be money or currency, and the quantity of which is regulated by some central authority or can at least be imagined to be so regulated, there exist still other forms of media of exchange which occasionally or permanently do the service of money.

...

it is clear that, other things equal, any increase or decrease of these money substitutes will have exactly the same effects as an increase or decrease of the quantity of money proper, and should therefore, for the purposes of theoretical analysis, be counted as money.

In particular, it is necessary to take account of certain forms of credit not connected with banks which help, as is commonly said, to economize money, or to do the work for which, if they did not exist, money in the narrower sense of the word would be required.

...

The characteristic peculiarity of these forms of credit is that they spring up without being subject to any central control, but once they have come into existence their convertibility into other forms of money must be possible if a collapse of credit is to be avoided."

Lantz and Sweeney calculated that at the peak of the boom there was six trillion dollars in the traditionally defined money stock. The private shadow stock accounted for $9.5 trillion, and government-based shadow money a whopping $11 trillion. Thus the shadow money stock dwarfed the traditionally defined M2.

Remember the shadow money stock is a boom time phenomenon, and creates a lower demand for real money than one would expect. It contributes to the experience of stable or even falling interest rates during times of expansion. Not what one would expect.

Lantz reading of recent statistics indicates that today every one dollar increase in the base money increases M2 by one dollar. In more normal times each dollar of base money will increase M2 by 8.5.

The size of the shadow money stock was estimated by multiplying the haircut percentage against the asset base. For example, the value ofthe housing stock times the level of potential borrowing against it. Say during the boom, a homeowner could borrow against 90 percent LTV -- loan to value -- and now it is 80 percent. Plus -- or minus in this case -- the reduction in actual value. Lantz and Sweeney estimate that the total drop was $3.5 trillion.

They also suggest this was offset completely by an increase in the government shadow money stock, following the huge new borrowing needed to finance the deficit as well as the aggressive liquidity measures of the Fed, and presumably including the expansion of the Fed's balance sheet in the conversion of dodgy private securities into full faith and credit. This huge increase in liquidity has been the source of muchhand wringing about potential inflation. Bernanke issued notice that the Fed is "focused like a laser on the exit strategy."

In fact, according to Lantz and Sweeney, this explosion of liquidity was necessary simply to accommodate the demand for cash occasioned by the crisis. Absent this money growth, the collapse of the private shadow money stock would have led to severe, or more severe deflation.

Lantz suggests concern over inflation is ridiculously premature, and predicts much of the unwind of the liquidity measures from the government will occur naturally, as government programs get paid back and rescuemeasures for the banks wind down.

Our observation at Demand Side is that monetarists who can so clearly describe the monsters hiding under the bed will become ever more hysterical as things begin to turn around. We suspect that the adults will choose to calm them, rather than follow the more effective policy measures. The efforts to calm them will be counter-productive to the real economy.

At the risk of dislocating an elbow, we'd like to make the note that we've made a couple of comments that look good from this new perspective. Deleveraging we have said is a process of money contraction. This was an insight that arose from instinct, not instruction. Here is the instruction.

Another self administered pat on the back follows from our observation in early 2008 that credit cards as near money enabled spending from the stimulus to be smoothed, in a downward slope, to reflect the restrictions on this form of money.

In fact, the actions of banks and credit card companies demonstrate clearly the error of the Fed-Treasury plan to allow zombie banks to continue among the living. These insolvent institutions have no choice but to maximize revenues from the spread. That is, they may borrow cheaply, but this will not be passed on to their credit card clients, who will get only the maximum rate laws allow.

This note from the New York Times

From the NY Times: Overhaul Likely for Credit Cards
http://www.nytimes.com/2009/05/19/business/19credit.html

Banks are expected to look at reviving annual fees, curtailing cash-back and other rewards programs and charging interest immediately on a purchase instead of allowing a grace period of weeks, according to bank officials and trade groups.

“It will be a different business,” said Edward L. Yingling, the chief executive of the American Bankers Association, which has been lobbying Congress for more lenient legislation on behalf of the nation’s biggest banks. “Those that manage their credit well will in some degree subsidize those that have credit problems.”

The larger point is that money is a much broader phenomenon than we have been used to thinking. At the same time, the Fed's control of money is much narrower. In a boom, with confidence in asset values, the effective money supply will expand as collateral becomes near-money. In a bust the effective money supply will convulsively contract, as assets become less liquid, banks lend less and keep more in reserve, and all parties hold traditional, not shadow cash against a rainy day.

The threat of inflation is much lower than widely assumed, since as things pick up, the government shadow money stock will tend to be reduced. Programs end. Loans are paid back. Et cetera.

Another blow to the quantity theory of money.

Fed biased toward obtuseness

There is no greater obstacle to recovery today than the institutional power and economic bias of the Fed.

As we've observed, it was Fed interest rate policy under Alan Greenspan that fueled the housng bubble and the grand increases in leverage and indebtedness across the society -- household, business, government. It was Fed oversight and regulation missing from the field that allowed -- enabled -- the misallocation of capital, mismanagement of risk, and explosion of hidden obligations. It is the inadequacy of the Fed's economic understanding that has kept the current calamity growing long after it could have been dealt with rationally.

The Fed is independent as no other agency of federal government is independent. it reports to Congress. Its chairman and other board members are appointed by the President. It is owned by its member private banks. And since the notorious Treasury Accord of 1951 it has exercised ever more complete control over one-half of economic policy -- monetary policy. The Fed takes direction from nobody. Up until its attention was diverted by an economic collapse of historic proportions, the Fed was obsessed primarily with inflation.

The philosophy under which it operates is shared across the banking community. Today it is a hybrid of Monetarist pap and the aforementioned anti-inflationary bias. This is combined with an ever more aggressively violated trust in the bankers themselves. It is nothing other than the picture of a regulatory agency which has become captive to the industry it was supposed to regulate.

Ben Bernanke himself has made his academic place with the proposition that the Great Depression could have been prevented with radically more expansive monetary policy and a commitment to save the banks. The first -- the monetary policy -- is indeed the primary premise of the Monetarist school led by Milton Friedman. The second, the primacy of the banking institutions, is an unproven hypothesis Mr. Bernanke is testing with trillions of real money.

The size of these megabank zombies is testament to the deregulation which dismantled New Deal protections. Bernanke has turned the Fed's own balance sheet into a replica of those of the zombies in an effort to save them -- transfusing the full faith and credit into basically corrupt institutions.

It is our speculation here at Demand Side that the inability to institute the receivership operation on these zombie banks that is routinely undertaken by the FDIC -- nationalization -- is largely because of opposition by the Fed and Bernanke's interest in keeping them alive. Likely there is sympathy for this position by amigo Larry Summers in the White House and Timothy Geithner at Treasury. But hte central obstacle is the Fed. The Fed is beholden to nobody. And without the Fed no coordinated triage can take place.

No doubt Bernanke will be a one-term chairman, but right now he holds the levers of banking regulation. The good start on fiscal policy made by the Obama administration will be frustrated if there is not some real improvement on this front.

One does not need to accept the Demand Side remedies to admit that the Fed has not provided any relief in the arena of its responsibility. It is our contention that it is the Dark Ages economic philosophy, the institutional decay and the intellectual biases of its chairman that coalesce into the single biggest obstacle to recovery.

Fed Forecasts in the Dark

Demand Side's forecasts have beaten the consensus and the blue chips and would have placed in the top five of the Wall Street Journal's competition. The weight assigned to interest rates and the collapse of inflation with the collapse of the financial sector kept us down.

Fed Forecasts in the Dark

More remarkable, however, than our success is the failure of the Federal Reserve's open market committee. Upon ascending to the post of Chairman of the Federal Reserve Board, one of Ben Bernanke's first initiatives was to institute the publication of forecasts of the Fed's open market committee. It was and still is a thinly disguised inflation targeting exercise. But it has proven to be more an exercise in embarrassment, as the bankers repeatedly and consistently miss and miss widely not only inflation, but GDP and employment numbers. It is as amusing as a chart can be to see the latest quarter's numbers have migrated out entirely from under the dotted lines that mark the previous quarter's estimates.

To be fair this has not occurred in January's GDP for 2009, but only because there are twelve months of 2009 left. A more representative example would be the October figures. With only three months left in 2008, the esteemed economists were still radically downsizing their estimates. It is our observation that the markets are no longer leading indicators of economic events, but coincident. The Fed's estimates of the economy are no longer coincident, but lagging.

FOMC unemployment estimates for 2009 jumped a point and a half in the three months between its October and January meetings, with the minimum expected now at 8.0. Inflation projections are dropping, we suspect, from the evidence of no inflation, rather than from any inference regarding the commodities bubble or financial system crash.

The bottom line is that they have no idea. The Fed expected their monetary policy moves to do something and they have not. At this hour Battling Ben is applying bandages to wounds that need a tournequet and splint. It is a big part of our prediction of a snap back in late 2009 that the situation will get so bad there will be no room for these alternatives to the proper treatments.

On inflation, the Fed has no clue about cost-push inflation and so missed entirely the effects of the commodity bubble on prices. On growth, they have been laggards in realizing the severity of the housing collapse, but most troubling, they have been unable to comprehend the financial sector collapse. This began in August 2007. We arrive in March 2009 with the markets experiencing another jump condition, the financial firms requiring ever more transfusions, and the Fed's and Treasury's remedies having little more effect than waving their arms.

It is not necessary to accept the Demand Side prescriptions to see that the orthodox remedies have not worked, are not working and by extension will not work no matter how many times they are applied. Initially, in the fall of 2007, the markets were confident the Fed could ride to the rescue and were encouraged by every rate cut and new liquidity mechanism. Not only has there been no rescue, there has been no slowing of the train.

Fed Policy a Loser

The monetary policy excursions were defeated time and time again. Bear Stearns, Lehman Brothers, IndyMac, AIG .... you can mark the collapse from any one of these events, but that misses the clearly systemic nature of the collapse. The Fed is responsible for keeping the banking system stable. It has not only failed, it has failed spectacularly. Yet it shows little willingness to alter course. And there is woefully little demand that it do better.

A year ago it was Captain Ben to the rescue. Today it is a tired and defeated Dr. Bernanke who knows nothing more to do than push more borrowed chips into the center of the table and hope for a better hand on the next draw.

Inflation targets are bad economics

When the Full Employment Act of 1946 passed into law it created the President's Council of Economic Advisers and the Joint Economic Committee, the two most influential economic policy offices in the federal government. The president was given broad authority to utilize fiscal and monetary policy to promote, in what is possibly the most famous phrase in economic legislation, "maximum employment production and purchasing power."

The Act ratified activist government, and the phrase set down the order of priority: (1) full employment, (2) maximum growth, and (3) stable prices. Five years after the passage of the Act, in the so-called Treasury Accords, the Fed (with complicity inside the Treasury) arrogated unilateral control of monetary policy for itself.

Sixty years later the order of priority has been reversed. Activist government is a memory. Markets are run without rules in a bad parody of a mob-run city. The Fed stands like a balding policemen on the sidewalk making sure nobody steals the apples, while the crooks in pin-striped suits run their toxic paper and mortgage scams on the shopkeeper inside. Always pleasant, the Fed holds the door for them on their exit.

Employment is viewed with suspicion, as a potential threat to prices. Production is assumed to be enabled by the hands-off enabling of cowboy corporations. Inflation is a bogeyman.

As we wrote yesterday, the claim that the falling dollar will not result in rising prices is absurd. Not only are the dollar prices of commodity imports like oil and metals raised by dollar weakening, but the prices of domestic goods that have export markets will be bid up. Sooner or later the Chinese currency will have to bend to rising energy prices and environmental degradation.

Typical among the patronizing Monetarists is the following exerpt from a blog (Economist's View, February 7, 2007):

To help with the discussion, let the rule for monetary policy be of the standard modified Taylor rule form: ff_t = a + bff_t-1 + c(y_t-y_t*) + d(π_t - π_t*) + u_twhere ff is the federal funds rate target, y is output, π is inflation, and u is the uncontrollable part of policy. A * indicates the target value of a variable and a, b, c, and d are choice parameters for the Fed. The parameters c and d determine how forcefully the Fed responds to deviations from its output and inflation targets.

(In more general models the deviations might be expected future deviations rather than the deviations today, there are issues about whether to use real-time or revised data, the rule can have additional terms, and there are other issues as well such as what target to adopt when market imperfections are present, but this will suffice.) Barney Frank says we must pay "equal attention to unemployment.” If he means that the Fed should respond as forcefully to deviations of output from target as it does deviations of inflation from target, that is at odds with current monetary theory which states that the best way to stabilize output and employment - Barney Franks' concern - is to respond more forcefully to inflation deviations than to output deviations. Thus, the value of d is around three times as large as c in standard formulations. If he means the Fed should take account of deviations of output from target (or employment deviations), they already do that. As to explicit inflation targeting, the issue is whether to announce the value of π_t*, the inflation target.

Barney Frank is worried this will elevate the importance of inflation deviations, but nothing I know of suggests that announcing π_t*changes the values of d or c. Targeting inflation is a means to an end - that of output and employment stability just as Barney Frank wants - and not an end in and of itself. Both theory and evidence tell us that the Fed can stabilize employment and output around their long-run trends, but it cannot change the long-run trends themselves with monetary policy.

Thus, the best the Fed can do is to stabilize the economy around these long-run trends and that, we believe, requires stable and low inflation and an aggressive response to deviations of inflation from target.

Here we have precision rather than accuracy. Two problems:

• Economics has no independent variables, so to try to force inflation to operate in dependence to other variables is simply bad math and bad economics.


• Economics is not a closed system. Leakage is the rule.

The importing of thermodynamic thinking into economics around the turn of the last century was a conceptual error then and has continued to this day as a primary fallacy of the latest Neoclassical economics.

To say that anything is "at odds with current monetary theory" is similar to saying, "We waved at the moon and it went from this side of the sky to the other, so why are you not listening to us?" You will remember the Reagan-Volcker recession of the early 1980s, when "current monetary theory" suggested a simple, painless way of reducing inflation was to reduce the quantity of money, because inflation was simply too much money chasing too few goods. Reducing the quantity of money would bring prices into the comfort zone without pain.

Result, lots of pain. Prices came down after Volcker blinked and oil prices backed off, but not until after millions of unemployed, unwitting inflation fighters, had their lives sometimes permanently damaged.

The idea that price stability in the context of these discussions is intimately associated with anything other than low volatility in prices is not borne out by any evidence, in spite of the neat phrase. The absence of volatility is no indication of stability. Witness the recent financial market collapse after years of non-volatility. In fact, in the case of prices, keeping the lid on will only create pressure that will hurt people and businesses. The falling dollar must be reflected in prices, and translated in an orderly way. Order is stability. Suppression is only building pressure.

We have had hundreds of billions of dollars in trade deficits for decades. Standard economic theory has no explanation for this. The currency is supposed to adjust to keep the trade in real goods and services relatively balanced. The currency is now adjusting. To make the adjustment orderly, we do not ignore it or pretend it is bad. Instead, we should create the conditions for a strong economy which can support its currency by something other than reputation.

All of this would not be so important except for the fact that the Fed has only one tool, or perceives that it has only one tool -- the interest rate. The interest rate is used to hammer down inflation, provide bail-out liquidity for financial sector mistakes, and open demand in the broad economy to counteract downturn.

• As a tool against inflation, it is bad when it is applied to cost-push inflation, because it does not reduce costs, but increases them.


• As bail-out to the financial sector it is bad because the financial sector is not in a liquidity crisis, it is in an information crisis. It is not that there is no liquidity to buy the toxic product, it is that nobody knows what they are worth. (Though it is likely the information is being kept in the closet because the purveyors don't want people to know how badly they've been duped.)


• As a way of opening demand to counteract a downturn, interest rates work after a lag. But of course, the direction is the opposite from that utilized in the inflation fight.
  

One possible silver lining to the financial sector fiasco is that it will prevent the Fed from doing what it wants to do when falling dollar inflation hits their spreadsheets. Of course, the best thing it could do would be to back away from the button and get to work putting some reins on the renegade market.

Is Bernanke's inflation target futile?

Ben Bernanke's end run around Congress and the Humphrey-Hawkins bill last week in setting de facto inflation targets cannot make Barney Frank very happy. Frank is head of the House Financial Committee and a dogged critic of inflation targeting.

Frank sees the determination of the Fed under Bernanke to target inflation as misplaced, and feels the Fed is worrying too much about inflation and not enough about inecome inequality. "We are at the situation where distribution of wealth has become a significant economic issue," he said in July.

In February Frank told the Financial Times that Bernanke "has a statutory mandate for stable prices and low unemployment. If you target one of them and not the other, it seems to me that will be inevitably be favored." Transparency may be a smokescreen. "When you make it more transparent, you enhance its importance.... But when you make it public, you lose flexibility."

The Fed is mandated by statute to pursue two objectives for monetary policy -- low inflation and maximum employment. These two goals have become known as the "dual mandate." Absent an official or implicit employment target, an implicit target for inflation -- such as that issued November 19 by Bernanke -- seems to contradict the Fed's responsibility.

In a July 17 hearing, Frank's House committee heard economists weigh in on the subject.

Harvard University's Bejamin Friedman told the committee:

"The idea that economic policy should pursue price stability as a means of promoting more fundamental economic well-being, either currently or in the future, is not ground for pursuing price stability at the expense, much less the exclusion, of ... more fundamental economic well-being.

"It would be a mistake for the Federal Reserve to organize its monetary policy within an inflation-targeting rubric."

According to a Market Watch report by Greg Robb, "Friedman disputed the Fed's suggestion that an inflation target would improve transparency. He added that many of the world's central banks that have inflation targets "avoid any reference to the possibility of tension, even in the short run, between their inflation objective and any real outcome."

In the same July hearing, according to MarketWatch:

Prof. James Galbraith of the University of Texas said that inflation was killed by globalization in the early 1980s and would only come back if there was a collapse in the value of the dollar.

He said Bernanke should assure Congress "that interest rates will not be raised solely on the evidence of low or falling unemployment."

In fact, Bernanke's de facto inflation target is not only usurping Congressional power, but is inevitably flawed. As we will blog tomorrow, any effort to keep the falling dollar from appearing in higher inflation can only suppress the economy. The prices of imported manufactures from countries with flexible exchange rates must rise with the falling dollar, but more importantly, so will commodity imports like oil and metals. The strengthening of exports is good news for manufacturing companies and their employees, but it is no respite from higher prices. The prices of those goods with export markets will be bid up, and will rise for domestic consumers.

Keeping the lid on prices can be done only by suppressing wage rates. We've written the past two days that this is the Fed's preferred method, but its effect in the upcoming climate will only be to exacerbate the downturn.

Inflation: Cost push, demand pull, Fed pratfall

Yesterday we looked at what is in the inflation basket, both in core inflation and headline inflation. We saw that the depression of wages over the past 30 years has been the chief inflation-fighting strategy by the Fed.

Today we follow that up with a look at the two dynamics of inflation, cost-push and demand-pull. We’ll give you our conclusion and forecast up front. The Fed will apply the interest rate brakes in error because it does not distinguish between the two dynamics, or if it does, it finds no problem in continuing to call on the middle class to shoulder the inflation-fighting burden for everyone.

First let’s listen to some of the conceptual context. Here’s Fed Chair Ben Bernanke responding to a question from Joint Economic Committee vice-chair Carolyn Maloney on November 8.

“... In all but the shortest of terms the Federal Reserve’s policy determines how much inflation there is, and we’re going to make sure that the inflationary impact that may come from the weakening dollar is not passed into broader prices and become part of the underlying inflation rate.”

Chairman Bernanke is adamant that the Fed not only can control, but can determine inflation in all but the shortest of terms.

Bernanke is not encumbered by concern for the real world. A practicing economist who spoke to the point was Carl Weinberg, chief economist at High Frequency Economics (November 20, Bloomberg’s “On the Economy with Tom Keene).

“... The Fed is out to control the things it can control. When it comes to goods and services, things that are controlled by labor costs, the Fed is in there keeping an eye on it. It doesn’t mean headline inflation isn’t important, but it means that in terms of the Fed monitoring things in terms of what it can do, I think core inflation is probably the place to look.

“Something else to think about is when you see food prices go up, or you see energy prices go up, that’s not inflation. That’s a relative price change. And in fact, the analysis is very different when you see the price of food go up relative to the price of everything else, because it squeezes out consumption of other things and is actually a depressing impact on the economy as long as we don’t have wage increases to offset those food price increases. So generally speaking a rise in food prices brakes the economy by itself. A rise in energy prices brakes the economy as long as other prices are under control.”

To round it off, here is Marvin Goodfriend, former Fed staffer, now a professor at Carnegie Mellon University and a Bernanke disciple (November 15, Bloomberg):

“...Insofar as inflation forecasts go, as you lengthen the horizon the Fed ought to be able to manage inflation. That is, you can target inflation over the long run. That’s the nature of what Monetary Economics teaches us, that Central Banks determine the rate of inflation over the longer run. So the longer the horizons are, the more these forecasts turn into targets for the Federal Reserve to aim at.

“On the other hand, the longer the forecast horizons are, the more difficult it is to forecast the real GDP numbers and the unemployment, over which the Federal Reserve has less control over the longer run.”

So the clear message is that the Fed under Bernanke feels it has an iron lock on inflation in all but the shortest of terms, and the only part it can really affect is wage growth by sponsoring ongoing slack in the labor economy. (Parenthetically, this is a big reason for the support of free trade in many financial quartes – it ships out wage growth).

But back to cost push vs. demand pull.

There are two reasons prices might go up. One is the price of inputs goes up – commodities like oil, metal, grain, etc. The second is that the supply of the product is insufficient for the demand, and the price is bid up. This second is the market’s very effective means of rationing scarce products.

The last event of demand-pull inflation in the US economy was in the 1960s under Lyndon Johnson, with the Great Society competing with the Vietnam War for labor and capital. It was called “Guns and Butter” inflation. American consumers, flush with cash, pulled prices up. Johnson responded with an income tax surcharge of 10 percent to cool off demand. He was the last president to make a tax increase the central point of economic policy. Since that time taxes have been equated with the vilest of sins, the US has run immense budget deficits, and the economy has generally performed at one-third the Johnson era level.

Also since that time – even in the “New Economy” Dot.Com boom of the 1990s, we have not had demand pull inflation (noting that inflation is a generalized rise in prices).

But we have had cost-push inflation. Beginning under Nixon with the first OPEC oil crisis: Oil supplies were reduced by the OPEC oil cartel for the precise purpose of pushing up the price. The market began to ration the supplies by way of the price mechanism. “Stagflation” began, and plagued the 1970s.

Yes, I said “ration.” Here, too, the supplies are insufficient for the demand, but because the supply is constrained. One is too many dollars chasing goods. The other is too few goods being chased. It’s all the same, you say? Upon reflection, you will see there is the possibility of balance without inflation that lies between the two extremes. But more importantly the events on the ground look different.

In demand-pull inflation, there is a boom. Producers are motivated to generate product in the earlier, lower cost years, further stimulating demand. In cost-push inflation, there is not a boom, because the costs of the commodities are already, as Weinberg says, braking the economy.

In terms of economic policy, stagflation was an important turning point. It was here that the country, under Richard Nixon and Ronald Reagan, took a hard right away from the Keynesian Demand Side policies that had accompanied the great growth of America after the Second World War. The proposition that supposedly refuted the Keynesian conceptual framework was the supposed contention by Keynesians that unemployment and inflation could not co-exist. This connection between inflation and employment began with the so-called Phillips curve, an invention outside Keynesian theory. But that made little difference to ideologues looking for a return to Supply Side dominance.

The inflation-employment connection continues today at the Fed (hardly a Keynesian institution) in the form of NAIRU – the non-accelerating inflation rate of unemployment. NAIRU as a proposition was blown up by Nobelist Robert Eisner, but adhered to anyway by the Fed, who may have realized that tighter employment markets might not accelerate inflation, but slack markets certainly dampened it.

And since the 1960s, in spite of the confusion of pundits, all recessions have been accompanied by inflation.

The Why of this is not difficult to see. Weinberg put his finger on it. If the product of an economy is composed of labor and commodity inputs, and the price of commodities goes up, in order to keep the overall price level constant, the price of labor must go down.

Now as we approach an inflation fueled by higher oil prices, higher commodity prices of all kinds – including food, metals and energy, and higher input prices from a falling dollar, we basically have two options. We can allow inflation; that is allow these pressures to be reflected in the overall price level. Or we can attempt to reduce demand further, put a lid on prices, by raising the interest rate. No matter that demand, as Weinberg says, is already dampened.

The risk is that the Fed will choose the low volatility in the short run, by increasing the downward pressure on the middle class, rather than allow the short-term price volatility that will release the pressure. Complicating the problem is that the asset investor bubble that moved from the Dot.Com boom to Housing has now migrated into commodities. This source of inflation pressure ought to be addressed by an increase in margin requirements.

The Fed has already released its inflation targets, although it refers to them as “forecasts.” And as you heard, the Fed considers itself duty bound to address only inflation, never mind regulating the Wild West of mortgage originators or the Wild West of unregulated securities and investment trusts. Never mind the collapsing dollar or incipient recession. The Fed will raise rates when prices begin to rise. Why raise rates instead of, say, increasing reserve requirements or some other demand-dampening tactic? Because as we’ve seen the Fed knows only one tool – the easy button of interest rates.

Two additional points.

One: Attempts to keep oil prices out of even core inflation are hopeless. Oil leads all energy prices – including coal, electricity and natural gas – as a component or as a substitute. These energy prices must contribute to transportation, power and heating components of other goods and services. A simple example, air travel.

Two: Raising interest rates to fight cost push inflation is similar to the medical practice of bleeding the patient practiced in the pre-scientific era. Higher interest rates contribute to higher costs, not what you want to do with cost-push inflation.

In the end, I suppose, the patient either recovers in spite of the treatment or dies. In either case, the disease is resolved and the Fed can point with pride at its interest rate remedy.

Fed target on inflation is painted on the backs of the middle class

Ben Bernanke told the Senator Chuck Schumer and the Joint Economic Committee on November 8, quote.

“... In all but the shortest of terms the Federal Reserve’s policy determines how much inflation there is, and we’re going to make sure that the inflationary impact that may come from the weakening dollar is not passed into broader prices and become part of the underlying inflation rate.”

The hubris is chilling.

What is inflation? It is a generalized rise in prices. A basket of consumer goods is priced from one period to the next and the rise in the sum of its prices is the rise in inflation.

Sometimes food and fuel are taken out of the basket purportedly to remove volatility, because their prices bounce around. The slightly emptier basket is called core inflation.

Bernanke is not encumbered by concern for the real world. A practicing economist who spoke to the point was Carl Weinberg, chief economist at High Frequency Economics (November 20, Bloomberg’s “On the Economy with Tom Keene).

“... The Fed is out to control the things it can control. When it comes to goods and services, things that are controlled by labor costs, the Fed is in there keeping an eye on it. It doesn’t mean headline inflation isn’t important, but it means that in terms of the Fed monitoring things in terms of what it can do, I think core inflation is probably the place to look.

“Something else to think about is when you see food prices go up, or you see energy prices go up, that’s not inflation. That’s a relative price change. And in fact, the analysis is very different when you see the price of food go up relative to the price of everything else, because it squeezes out consumption of other things and is actually a depressing impact on the economy as long as we don’t have wage increases to offset those food price increases. So generally speaking a rise in food prices brakes the economy by itself. A rise in energy prices brakes the economy as long as other prices are under control.”

We'll take up food and energy below, but the key point here is a primary component of prices -- up, down, or sideways -- is the wage rate, or remuneration to workers. Not, of course, as a separate item in the basket, but as an element of all the items, all the goods and services. This is particularly true of the core inflation basket. And this is the secret the Fed has found to keeping inflation down, keeping enough slack in the labor market.

Real wage rates have stagnated since the 1970s. “Real” means adjusted for inflation. Productivity has gone up by 50 percent. Wage rates could have adjusted upward by 50 percent. Imagine the economic dynamo. This is particularly true since the turn of the century (see chart). Productivity gains have not been realized by workers, but have been transferred to the upper classes (the rentiers, as Keynes called them) and to the producers of commodities and services, notably health care.

If we look at “core” inflation as a proxy for the price of labor, we begin to get a different take on inflation. The evil of rising labor prices is not so easy to fathom. If labor prices rise, demand rises, and presuming there is capacity in business, all boats rise. Labor prices can rise at the rate of productivity improvement without increasing inflation. Instead, labor prices have risen only at the lethargic rate of core inflation, thus real incomes have stagnated, as mentioned.

Combine this with the fact that food and fuel consume a great deal of the American budget, so removing them removes much of what is important to lower and middle class Americans. This "headline" inflation affects different economic levels differently. Food, fuel and health care make up a larger portion of the costs at the lower end. The rate of inflation has been greater for the bottom ranks of the population than for the top. In fact, the inflation rate goes up as you go down the income scale. This means the balance is made up at the upper end with lower inflation.

So when the Fed chairman insists he has the answer to the inflation problem, that the Fed controls inflation, the middle class of America should watch out. The interest rate button, the Fed’s tool of choice, is connected to a trap door under their jobs.

Stagcession and Inflation, Bernanke's not on board, but he's on the tarmac with his suitcase

Now I'm worried. Ben Bernanke seems to agree with me. Inflation AND recession. (Blog or better, check out the two podcasts on the subject via the link to the right). Not that he would speak so clearly, particularly when he has lots of covering of his backside to attend to, but the tone changed in testimony before the Joint Economic Committee and Chuck Schumer today.

Particularly note that further rate cuts are not indicated by either his long-term imagination that economic fundamentals will eventually come around, nor by his concerns for short- and long-term inflation. In spite of this, you don't need to be a Fed watcher to know that further interest rate cuts are coming to benefit the financial sector and credit markets.

Bernanke's testimony, in part:

"[The FOMC does} not see the recent growth performance as likely to be sustained in the near term .... the contraction in housing-related activity seem[s] likely to intensify. Indicators of overall consumer sentiment suggested that household spending [will] grow more slowly, a reading consistent with the expected effects of higher energy prices, tighter credit, and continuing weakness in housing.

....

" [H]eightened uncertainty about economic prospects could lead business spending to
decelerate as well. Overall, the Committee expect[s] that the growth of economic activity [will] slow noticeably in the fourth quarter from its third-quarter rate.

"Growth [is] seen as remaining sluggish during the first part of next year, then strengthening as the effects of tighter credit and the housing correction began to wane.

....

"The Committee also [sees] downside risks to this projection: One such risk was that
financial market conditions would fail to improve or even worsen, causing credit conditions to become even more restrictive than expected. Another risk [is] that, in light of the problems in mortgage markets and the large inventories of unsold homes, house prices might weaken more than expected, which could further reduce consumers’ willingness to spend and increase investors’ concerns about mortgage credit.

....

"[The] inflation outlook was also seen as subject to important upside risks. In particular, prices of crude oil and other commodities had increased sharply in recent weeks, and the foreign exchange value of the dollar had weakened. These factors were likely to increase overall inflation in the short run and, should inflation expectations become unmoored, had the potential to boost inflation in the longer run as well."

His recommendations for policy changes and his belated oversight efforts come long after the horse is out of the barn. His analysis of the problems comes fully two years after they would have been useful.

The economy? No. Fed action is to benefit the financial sector

If Fed action is supposed to forestall a downturn in the economy, there is a small problem. Interest rate cuts work into economic results only after a lag of about 18 months.

The Fed action is really about bailing out the financial sector. Banks are in big trouble, with their off-balance sheet vehicles threatening to come onto the balance sheet when more CDOs turn bad. The so-called Super Conduit, or whatever its current name is, will only push the problem out six months. When the borrow short, lend long SIVs come back home to live, the sheet will hit the fan.

At least $400 billion is likely tied up in this mess.

And to be fair, the Fed didn't pretend that this was an attempt to improve things on Main Street. Their statement began:

The Federal Open Market Committee decided today to lower its target for the federal funds rate 25 basis points to 4-1/2 percent.

Economic growth was solid in the third quarter, and strains in financial markets have eased somewhat on balance. However, the pace of economic expansion will likely slow in the near term, partly reflecting the intensification of the housing correction. Today’s action, combined with the policy action taken in September, should help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets and promote moderate growth over time.

(emphasis added)

There is panic in the big banks.

The problem is too big for the only tool the Fed ever uses, the interest rate, to solve. Rate cuts are no doubt the wish of everybody on the FOMC's cocktail circuit and these banks and bankers will call the tune for the Fed, but this is not a moral hazard we're driving a golf ball into. This moral hazard is a sinkhole swallowing the dollar.

5 Lessons and 7 Remedies for the Mortgage Meltdown and Credit Crunch

The meltdown in mortgages, overbuilding of housing stock and infestation of the world's financial markets by bogus instruments is a failure of the entire financial system: Banks, hedge funds, investment institutions of all types, rating agencies, the Federal Reserve Board and its chairman, local mortgage brokers and loan originators, state regulatory agencies, and individual home buyers. Ultimate responsibility for the order of the market lies with the Federal Reserve.

What are the lessons from the housing debacle that is now unwinding? That is, What are the lessons that should inform policy?

Too much congratulation and not enough corporal punishment is being dealt the Fed.


The need for financial markets to be regulated has been exposed by one crisis after another. The S&L bailout, the Long Term Capital Management fiasco, Enron and World Com and many more in between. Rather than set standards and hold to them, under Greenspan and Bernanke, there has been cheap money at the end. This in spite of a direct mandate from Congress.

• The Fed is not going to regulate, or indeed, set any standard at all, nor use any tool other than short-term interest rates, no matter what problem confronts it.


• The Fed is going to bail out the financial sector whenever things go bad for them. This insurance makes a mockery of the "risk" for which they compensate themselves so well. So mortgage holders should stop looking.


• No other sector will be bailed out, because the Fed is in thrall to the financial sector. When banks moved to broad services over the past four decades, they took their control of the Fed with them.


• Neither inflation nor recession is as important to the Fed as padding the financial sector. The need for "confidence" in the financial markets, which turns out to be a "confidence game," trumps both inflation and recession in the mind of the Fed. Prediction: As soon as financial firms and hedge funds signal their solvency, the Fed's practice will be to support the value of the dollar for as long as possible. This will be done for the benefit of its financial sector constituents. The announced reason will be to stem inflation pressure, but the inflation will be cost-push from higher commodities and imports, rather than demand-pull, and so higher interest will not touch it.


• The financial sector controls monetary policy and monetary policy is out of control (see inverted yield curve).

The absence of action by the Fed is the big problem. The policy response MUST do what the Fed has not done and -- of equal importance -- institute a clear civilian control of the financial sector, both in fact and in the minds of the public.

Seven Policy Remedies

1. Financial transaction tax, a .0025 tax on the value of each financial transaction. This one-quarter of one percent. This will be incidental to most transactions. 25 cents on every one hundred dollars, or 25 dollars on every ten thousand dollars. For transactions with high leverage, this tax is relatively more for the hedge fund, since they will incur the tax on the total no matter that their total is small. That is, if using a million dollars, they leverage another nine million for the transaction, the effective tax on them is 2.5 percent. If money is being moved higgley piggley to take advantage of short-term arbitrage, over a year's time it will be subject to the tax several times. The yield of such a tax would be immense. The cost to the real economy would be negligible. (This is similar to the Tobin Tax, proposed to slow down the mad rush of currency speculation around the globe.)


2. New top marginal rates on personal income tax, no income source excluded, of 50% on $1 million or more and 90% on $10 million or more. Take the reward out of high risk. Return sobriety to corporate governance. The companies of Europe are winning with executive salaries one-third of those in the U.S. Top hedge fund managers make $1 billion per year.


3. Reestablish the SEC. William Donaldson, former head of the SEC, whose appointment actually brought confidence in Wall Street back from the grave after the Enron and World Com fiascos, abandoned the post after three years. Partisan hacks returned to the posts. Donaldson has called for "getting tough" on conflict of interests, increasing oversight and closing the loophole that lets hedge funds play in the market without disclosure of their practices.


4. Windfall profits tax. There are obscene rewards to those who take a company private, do financial slicing and dicing, and sell it back to the public. These and other financial gymnastics are today's replacement for productive work. They do not have to be encouraged in the tax code.


5. No free lunch on bailouts. Companies and funds who are bailed out with cheap money from the Fed need to be identified individually and dealt with individually. Rather than this upper class welfare, there needs to be a price for liquidity, a share of the firm or specific repayment conditions, that benefit the government and the people who are footing the bill. Stiglitz seconds this suggestion in his piece:

Those in financial markets who believe in free markets have temporarily abandoned their faith. For the greater good of all (of course, it is never for their own selfish interests), they argued a bailout was necessary. While the US Treasury and the IMF warned East Asian countries facing financial crises ten years ago against the risks of bail-outs and told them not to raise their interest rates, the US ignored its own lectures about moral hazard effects, bought up billions in mortgages, and lowered interest rates.

....

It may make sense for central banks (or Fannie Mae, America's major government-sponsored mortgage company) to buy mortgage-backed securities in order to help provide market liquidity. But those from whom they buy them should provide a guarantee, so the public does not have to pay the price for their bad investment decisions. Equity owners in banks should not get a free ride.


6. Mortgage loan disclosure. Surveys, investigations and anecdotal evidence by the boxcar load have shown that many home loan purchasers do not understand the terms of their loans. This is not confined to unsophisticated subprime borrowers. A simple one-page disclosure summary is available that sets things down in black and white. It needs to be mandated for every mortgage.


7. Strict limits on the type of mortgage instruments. The ARMs promoted by Alan Greenspan are not appropriate. They are speculative instruments. Prepayment penalties are loan shark stuff. Congress must set a strict limit on the types of loan that are eligible for income tax interest deduction.

These are what could be done. The collapse in pother nations' economies undergoing similar stress in the housing sector did not happen. These countries have at least minimal standards for financial institutions and instruments. The rest of the world does not let financial markets regulate themselves.

The housing debacle

What are the lessons from the housing debacle that is now unwinding?

First and most important, we were right. We predicted the housing collapse. We'll dig up the links and enter them on the web site treatment on Friday.

We predicted that the low interest policy of the Fed would produce the bubble. Others have talked about how the leverage and corruption of the mortgage brokers was key, but the cycle begins at the beginning -- turning housing into an investment. Speculation fever follows as prices rise. Then the leverage and the corruption.

Too much congratulations and not enough corporal punishment are being dealt the Fed. Under Greenspan and Bernanke, there was low interest at the beginning and bailing out at the end, with absolutely no oversight in the middle (or anywhere, really).

Second, others predicted it as well. Dean Baker is foremost among these. Baker of CEPR and now the American Prospect used a simple historical trend analysis comparing housing rents to home prices over time. It worked. He should be on every talk show in the nation.

Third, the people who didn't see it coming are still the "experts." (Much like in another key blunder, when Thomas Friedman and even the Neocons blew the Iraq analysis, yet are still showing up as experts. Compare this to others -- George McGovern, Joseph Stiglitz -- who offered accurate analysis and peaceful, productive resolutions. They are still on the outside.)

So, fourth, the people who say, "Nobody saw it coming" were and still are listening only to each other.

This debacle continues the ballooning of the financial sector. Henry Kaufman, formerly of Salomon Brothers and now of Henry Kaufman & Co. and hardly a communist, reported that the Finance Sector is now bigger than Health Care and Energy combined. Why not? Too bad some homeowners can't get hold of that "liquidity" and out from under their ARMS. Now is the time to buy stocks in the financial sector, before everybody realizes that -- just like in 1987 and 1998 -- the Fed is bailing them out. They get a hundreds of billions of "too big to fail" insurance for free.

Upcoming we'll look closely at tool the world class analysis at the Fed is linked too. It looks a lot like a catapult. The Fed's single blunt instrument is its control over short-term interest rates. It doesn't matter how smart you are, the interest rate is (1) ineffective against inflation, (2) operates with a lag in producing growth and is wildly inferior to fiscal policy for jobs, but (3) is great at bailing out a financial sector.

Outlook for the economy as housing deflates? Which economy?

• The financial sector will likely bounce back with great new investment opportunities.


• The wealthiest 20 percent will no doubt wonder what everybody is complaining about.


• The middle class will watch their home values receding in front of them as they approach retirement.


• The multiplier will bring down wages.


• The collapse of housing could create more hysteria in the immigration discussion, as migrants move out of their niche in relatively low-skill residential construction and residential support and compete for other jobs.


• A huge burden of private debt has been created, for the purpose of building an immense stock of passive housing vs. productive assets. And very little of this building was green. Both the debt and the character of the housing stock will weigh us down.

What a mess.

Prediction: Strong Stock Market, Weak Economy

The economy slips toward recession and stocks ignore it. Why? Courage from the average investor perhaps? Confidence in the underlying strength of the economy? Hardly.

Investors are in full flight, trampling each other to get out from under the collapse of the housing industry, just as they rushed out of stocks and into housing after the so-called dot.com bust. Now they are fleeing housing after creating a similar fiasco in that market. But the money has nowhere to go.

The Fed’s solution to every crisis since 1987 has been to pump low-cost money into the financial markets. That’s one reason Wall Street thinks strength over the past four decades while Main Street has turned into a row of double-wides.

The money pump rattled into action again on September 18, when Bernanke and the Fed cut rates by half a point. There was only one excuse: To give the financial markets "confidence" so they can “run smoothly.” Bailing out financial institutions is a central bank theme.

So we have plenty of money sloshing around at the top. But where to put it? Housing is deflating. (Pity the poor homeowner who was counting on that to finance his retirement.) Stocks? It IS rumored some companies have foreign presence. Bonds? Sure, but you’re going to lose real value if inflation kicks up.
The smart money is buying foreign securities. Even if they don’t appreciate in value, you can ride up with the underlying currency. Or at least avoid sliding down with the dollar.

Upside Down at the Fed

Sunday, December 25, 2005

I despised Alan Greenspan long before it was fashionable. Most recently it was for his disingenuous explanation of why the Bush tax cuts for the rich were okay. We might run out of safe investments, he said, if we paid off the debt too fast. Horrors! The government would be forced to purchase equities. Imagine the temptation to corruption. Well, the retirement of the federal debt has been pushed off for another millennium, anyway. Problem solved, thanks to Greenspan and the Bush economic blunder machine.

Before that was his hiking of interest rates in the late 1990s at the same time energy prices were spiking. This caused the economy to stall as much as the bursting of the stock market bubble, and far more than 9-11.

It was back in the 1980s, though, when I first learned to distrust him. Greenspan chaired a Social Security Salvation Committee (not its true title) which pompously proposed hiking payroll taxes to protect social security from the coming demographic aging of America. Simultaneously fellow Republican Ronald Reagan was cutting income taxes. The result was a shift of the tax burden down onto working people. (And as we now see Social Security is no safer.)

But the thing that really gives me a rash every time he does it is Greenspan's use of the interest rate to fight inflation. This practice is likely to continue under the next chairman, unfortunately. It's like treating a hangnail with doses of radiation.

There are two basic kinds of inflation, cost-push inflation and demand-pull inflation. Cost-push is where producer costs go up and suppliers are forced to pass these costs along to their customers. The classic case is with energy prices. Transportation and production costs are directly tied to energy prices. These costs get embedded in everything from airline fares to the price of bread. (Only direct purchases of fuel are excluded from the so-called "core inflation" calculations.) Not surprisingly, cost-push inflation is associated with stagnation. Stagflation.

The second type, demand-pull inflation, occurs when there are too many dollars chasing too few goods. This occurred after World War II when pent-up demand rushed into a private marketplace that was not geared up for it. It occurred again during Viet Nam, when Lyndon Johnson ran his Great Society projects at the same time as the war. ("Guns and butter," it was called then.) Demand-pull is where buyers essentially bid up the price of goods. Not surprisingly, demand-pull is associated with booms in the economy.

Raising interest rates is useful only in the case of demand-pull inflation, since it increases costs and suppresses demand. Yet the Fed uses it for both. This was a great tragedy in the massive recession of the early 1980s. The Fed's hike in interest costs combined with the OPEC spike in oil prices to send the country into the deepest recession since the Great One. But increasing interest in cost-push situations only increases costs, and thus adds to, rather than subtracting from, the inflation phenomenon. [Before you start yelling, yes, I know the mechanism the Fed used was restricting the money supply, but the effect was felt in interest rates.]

At the end of that day in the 1980s, inflation did fall, but only after oil prices had fallen. Left on the battlefield were millions of unwilling inflation fighters, an army of jobless men and women whose lives would never be the same. The period of high interest and expensive dollars that began then led directly to the de-industrialization of America and the loss of millions of manufacturing jobs. In Washington, generals Reagan and Paul Volcker (Fed Chairman) congratulated themselves on their sacrifice. Of course, neither had been out of a job for a single day.

Alan Greenspan took the reins of the Fed from Volcker in the mid-1980s, and since then (insofar as he has been consistent) Greenspan has continued the tradition and raised interest rates whenever his tea leaves tell him inflation is coming. For many years this was when unemployment got too low. Yes, this was the explicit official position, that low unemployment would create demand that would drive up prices. The theoretical formula was NAIRU -- the "non-accelerating inflation rate of unemployment," a rate which if crossed would somehow loose the demons not only of inflation, but of accelerating inflation. Once upon the land these demons would create grisly outcomes, which never quite clearly identified.

The concept of NAIRU was thoroughly debunked by Nobelist Robert Eisner in the early 1990s and subsequently exposed by the experience of the late Clinton years, when unemployment tickled its historic lows and yet inflation stayed dormant. Yet this period also corresponded with the height of Greenspan's popularity, when he was touted as Maestro. Periodically he messed with the rate and when no inflation occurred he pronounced himself pleased, and the public congratulated him for the result. It was not unlike the man who wore cabbage leaves in his hat and when asked why, replied "To repel elephants." "There are no elephants around here," he was told. "Works pretty good, eh?"

In the end we were to discover, however, that Maestro Magoo relies only on the politically expedient theory and his obtuse remarks are often no more than camouflage, or more aptly, smoke. Over time, the exercise has worked well for Greenspan personally, resulting in a record term in office. Unfortunately, in combination with the Bush evisceration of common sense, it has not been such a happy result for the economy as a whole. The current system is dangerously imbalanced, domestically and globally. Like the retirement of the federal debt, the prospect of economic stability and a society that relies on earning, not borrowing, lies far, far in the future.

Maestro Magoo, you’ve done it again!

Alan Greenspan, Fed chairman and master of scatterspeak, addressed again this week the dangers of the huge debt overhang and the federal deficits.

He spoke to the Group of 7 finance ministers Friday, yesterday, saying among other things, the current course of trade deficits is “a pernicious drift toward fiscal instability.” He wants a return to the “procedural restrains on the budget making process” that have been “violated with increasing frequency.”

"Federal operating deficits have cooked us good. The president and Congress did the wrong thing when they got rid of Clinton era tools, pay-go, for one. And Bush and his compliant Congress have thrown away not only fiscal responsibility, but moral responsibility."

[Oops, not quite his words. Forget the quotes.]


What Greenspan doesn’t say and never says is that he’s the one who is driving the bus. As the most powerful non-elected government official in any democracy anywhere, this Fed chairman has set the policies that have allowed us to get to this sorry state.

Emblematic of the Maestro’s competence, and perhaps comforting for those who now worry that he has some forecasting ability, is a speech of mid-2001:

“While the magnitudes of future federal unified budget surpluses are uncertain, they are highly likely to remain sizable for some time.” [emphasis added]

He went on in this speech to worry about what the government will do with its bountiful surplus, and he concluded it would be okay if Dubya’s tax cuts went through. This was support Bush needed.

We can’t even see that day in 2001 from here, the pile of federal debt has grown so big. If you think I'm taking him out of context, here's the speech.

Recently Greenspan worried about the financial health of Fannie Mae, the nation’s mortgage lender. Too much debt. The next day he cautioned about the huge burden we have left future generations: we’ve promised the baby boomers more than the economy can produce.

Where was he when this was going on? Pedal to the metal on interest rates. No restriction on the off-the-wall financing instruments like interest-only mortgages. This massive debt, both public and private, is his creation as much as anyone's. The economy can produce much more efficiently and at a higher level if the driver can see where he's going.

The surplus-debt whiplash is very similar to the historic high-historic low interest rate phenomenon. In the late 1990s Greenspan had promoted rates of interest to their highest levels in post-war history. By 2003 they were at their lowest. Four years.

The interest rate is his only tool. It’s amazing. He uses it to motivate the economy, to discourage stock speculation, to combat inflation, whatever. In the post-war period, the economy has always done best when interest rates were stable and the cost of money was predictable. Poeple can plan. Businesses can know what their costs are going to be. Since he’s been in office, Greenspan has ridden the interest rate like a pogo stick and done nothing with any other tool.

After he is replaced at the Fed next year by Ben Bernanke, Greenspan and his wife Andrea Mitchell may no longer be on the A-list in Washington society, but I’m sure he’ll show up in cap and gown from time to time to receive the plaudits of the children of Wall Street.

“Ah, Magoo, you’ve done it again!”