Tuesday, December 2, 2008

When Alan Greenspan was Nearly God

US interest rate graph
WRITING in Slate magazine in 1997, Paul Krugman, an American economist, neatly captured the widespread belief in the omnipotence of the then-chairman of the Federal Reserve. “If you want a simple model for predicting the unemployment rate in the United States over the next few years, here it is: it will be what [Alan] Greenspan wants it to be, plus or minus a random error reflecting the fact that he is not quite God.” [Economist]
Since those heady days of the late 1990s, Alan Greenspan's reputation has nose dived (though Paul Krugman was awarded Nobel Prize for economics this year. (Ostensibly for his work on free trade, though his 8 years of bashing Bush, probably didn't hurt.). Anyway, one important issue which has been raised by the current economic crisis is the seeming impotence of Monetary policy in the current climate.

Paul Krugman was alluding to the fact in 'normal years' changing interest rates would have a powerful effect on influencing the economy - hence the quip it was easy to target a certain inflation or unemployment rate. In the past cutting rates would boost spending and investment, but, now it doesn't seem to be solving the problem.

Firstly it now seems that Monetary Policy in the Boom years was 'Too Effective'

They cut rates in 2001 to boost the economy and kept them low until 2004. This made mortgages very cheap and caused a boom in house prices. Because inflation remained on target, the Federal Reserve felt it was OK to ignore the boom in asset prices. - This was perhaps their great mistake.

Why Has Monetary Policy Become Less Effective? Why is the Federal Reserve increasingly impotent?

Falling Asset Prices.

When house prices are rising, cuts in interest rate make mortgages cheaper and encourage home ownership. With lower rates, people buy more houses causing rising house prices and this causes a positive wealth effect on consumer spending.
But, now house prices have a powerful momentum downwards, cuts in interest rates do little to make buying a house attractive. Mortgages may be cheaper. But:
  1. It's difficult to get a mortgage anyway.
  2. No one wants to buy when house prices are falling
Lower interest rates are helping to reduce the decline spending and investment, but, the interest rate cuts are being outweighed by the dramatic decline in house prices and fall in wealth of consumers.


When people have reasonable confidence, a cut in interest rate encourages people to spend. In the boom years people want to spend, and the rate cut makes it possible. However, in the current climate, confidence has collapsed. It may be cheap to borrow, but, people are asking - Surely borrowing got us into this problem, isn't time to pay off debts and try to save?
  • In a way, people are making rational choices to save more. But, it makes monetary policy difficult. Cut rates by 1.5% and people largely ignore it. It is a classic liquidity trap.
Debt is Very High

Personal debt levels are very high. Therefore, people can't / won't borrow more, whatever the cost.

Cost and Quantity of Credit

In the boom years, credit was freely available. Various money markets meant it was easy for banks to borrow to lend to firms and consumers. Therefore, if demand for credit increased, the supply was there. The problem now is that the credit crunch has caused a shortage of credit. People may want to get a mortgage and banks, but, the banks just don't want to (or can't lend)
In the boom years, banks would try hard to be the most competitive mortgage lender. Now, they try hard to avoid being the cheapest as they get flooded with mortgage requests they can't cope with.

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