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Boom-And-Bust:
HowCentralBankingHasEvolvedMarketsThroughMonetaryPolicy
WorkingPaper:
May28,2012
Updated:
August29,2012
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NicholasBuchelereswww.NJBDeflator.blogspot.com
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“Itisnotthestrongestofthespeciesthatsurvives,northemostintelligentthatsurvives.Itistheonethatismostadaptabletochange.”--CharlesDarwin
Overthepasttwodecades,theUnitedStateshasseenprosperouslevelsofincomeandassetpricegrowth.WithrealGDPclimbingsteadilyandtheDowJoneshavingmorethantripledsincethemid-90s,mostwouldsaythattheUSmerelyhitaroadbumpin2007.Andthatroadbumpjusthappenedtobeanextremelyover-leveragedfinancialsectorthatwassodesperatetoreapprofitsthattheytradedpeoples’livesonthesketchyasset-backedsecurities(ABS)derivativesmarket.Butyoucan’tblameadogforchewingthroughthesofa,blamethepersonwholetthedoginsidethehouse:theUSFederalReserve.IdonotthinkthattheFederalReserveisamenacingentitywithintheUSfinancialsystem,infact,theFedhasbeenintegralthethiscountry’seconomicsuccessandhassavedusfromruinmanytimessinceitsinceptionin1913.Idon’tevennecessarilyblametheFedfortheloosemonetarypolicyoverthepasttwodecadesthatarguablybroughtusintothecurrentconundruminthefirstplace,butmarketparticipantsmustnotetheFed’sincreasingpresenceinthefinancialmarkets.Inthepastdecade,theFedhasstoodnotasasafeguardagainstruin,butratherithasbeencontrollingtheworldeconomythroughcoordinatedanduncoordinatedmonetarypolicy.Thisisnotatrendthatbeganwithinthepasttwodecades,rather,thisisatrendthathasbeenslowlybuildingoverthelasthalf-century--atrendthathasenteredintoaviciouscycle.Acyclethathascreatedastrongfeedbackloopthatintensifieswithfurtherdebtmonetizationbycentralbanksaroundtheworld.
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TheBeginningofBoom-And-BustFinance
Equityprices(blue),nationalincome(red),andpublicdebt(green)hadbeenrisinghealthilyupuntilthestockmarketcrashof1987.TheFed’sresponsetothecrashwasoneofmonetaryaccommodationthatincludedcuttingthefederalfundsrate(andthusbroaderinterestrates)andinjectingliquidityintothemarkettohelpsupportprices.Theseaccommodativepoliciescarriedoverintothe90s,wherewesawthemostrapidlygrowingstockmarketinAmericanhistory:thedotcom-bubbleofthe90s.TheFederalReserve’sresponsetothe‘87stockmarketcrashhasproventobeaturningpointintheevolutionofmarketsnotonlyinfederalpolicy,butalsoinmarketparticipants’responsetotheFed’sactions:atestamenttohumanfinancialgreedistheparabolicdevelopmentinUSequitypricesthatbeganintheearly90sandcontinuedtoaheadintheearly2000s.Thefactthatmarketspeculatorswereabletodriveequitypricessohigh,soquickly,beforecrashingisevidenceofhowunprecedentedsuchbehaviorwasinmodernUnitedStatesfinance.TheFed’sresponsetothedotcomcrash?Lowerratesandmoreliquidity.Thistimeweseepublicdebtbegintoascendrapidly,butmoneysupplydoesnotincreasebyasmuch.Thepost-dotcomFedslashedratesmoreheavilythanitinjectedliquidity,partlybecauseAmericanswereinstructed(atthebehestofUSleaders)toownhomesinthebeginningofthe21
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century.TheFedkeptrateslowandencouragedhomepurchases(andmortgages)inordertoconvalescetheeconomyfromthe2000crash,andinvestmentbankersweregladtofacilitatethisprocessbybundlingmortgagesandselling-offtherisk.In2005equitypricesbegantoturnparabolicagain,butthistimetheywerefueledbytheexpansionofcreditintroducedbytheavant-gardeasset-backedsecuritiesthatallowedhigherleverage(expansionofcredit).TheunderlyingvulnerabilitiesofthisboomcausedUSequitiestoselloff—acrashofover40%,comparedtothe30%sell-offofthedotcomcrash—bringingUSequityindicesdowntothetroughofthe2000dotcomcrash.
FedLedEvolution
TheFed’sresponsestorecentmarketcalamitieshaveempiricallyproventocatalyzedfuturecrashesthroughaninduced,never-endingboom-and-bustcycleofliquidityprovision,whichhasrenderedmarketsandassetpricesunabletomovewithoutmonetaryeasingbytheFed.Thateasymoney,though,causesparticipantstobecomegreedyandcreatesbubblesinbroad-economyassetprices.Isthecureworsethanthedisease?Maybenot,butpriceengineeringbytheFedisareality.Althoughwemightbeseeinghousingpricesandemploymentbottomout,wearestillfacingseriousrisksthatlienotonlyinEurope,butalsoimportantlyinChina.Untilwehaveastrongrecoveryinthereal