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December 2002, Volume 20, Number 12

Monetary Mendacity

Christopher Westley

There are many characteristics that Alan Greenspan shares with Benjamin Strong, the New York Fed president during the 1920s. Both decided US monetary policies during eras of massive, unsustainable growth in the business cycle. Both played major roles in creating asset bubbles that eventually resulted in stock market crashes and recessions. Both misused their offices for personal ends—the anglophile Strong to shore up deluded British efforts to resume the prewar pound-gold link, Greenspan to bail out multi-billion-dollar losses of his friends’ hedge funds.  

It seems that the major and important difference between Strong and Greenspan is that the former was lucky enough to die a year before Black Thursday 1929, with a legacy rarely questioned by economic historians. Greenspan, on the other hand, still lives and must defend the consequences of his actions in places such as Jackson Hole, Wyoming.   

Indeed, Greenspan recently defended himself and his legacy as Fed chairman at this exclusive resort community to criticisms that he didn’t respond correctly to the late-1990s bubble that resulted in our current recession. His comments that monetary policy is impotent to deal with a sector-specific bubble without harm to the macroeconomy made for front-page news and should concern anyone who continues to believe that fiduciary Viagra is the solution to economic weakness.

“It seems reasonable to generalize from our recent experience that no low-risk, low-cost, incremental monetary tightening exists that can reliably deflate a bubble,” the former master of the universe said. “But is there some policy that can at least limit the size of a bubble and, hence, its destructive fallout? From the evidence to date, the answer appears to be no.”

The answer also appears that Alan Greenspan is trying to dodge responsibility for modern monetary management of the business cycle by invoking the Keynesian argument that bubbles are some mysterious occurrence, the existence of which we cannot explain, but which are simply another aspect of the market system’s inherent propensity for instability and failure. This is an old argument, but one that is kept alive by the myriad of “public servants” who believe that their sole vocation in life is to protect the market from itself. This market failure excuse has become the great alibi of interventionists when the consequences of their policies are made obvious. 

The answer is also a big lie. Greenspan knows the effect of monetary manipulation on sector prices perhaps better than any previous Federal Reserve chairman. So for him to talk about bubbles as if they were akin to the common cold, the cause of which is a mystery, is true duplicity in action.  

So it might help to review how bubbles occur. Bubbles are speculation-fed price increases that occur in sector-specific markets resulting from greater-than-average demand for a resource that is in fixed supply. Under normal circumstances, bubbles are not a cause of concern for the economy at large, due to the self-correcting mechanisms found in the price system. Rising relative prices would signal consumers to switch their demand for substitute goods, while simultaneously revealing consumer characteristics to entrepreneurs, signaling to them to provide substitute goods.  

This is why, under normal conditions, it is possible to observe bubble-like price surges due to short-run speculation. In the long run, however, the bubble recedes when entrepreneurs, in response to the change in market conditions, reallocate capital and labor resources.  

Unfortunately, bubbles can pose problems for the larger economy when—you guessed it—extra-market forces intervene in this process. In fact, bubbles grow to dangerous sizes when the state (1) encourages new waves of buyers to enter the market (demand management), and (2) provides a fiat currency (or weakens an existing currency’s tie to gold). Such policy interventions sow the seeds for an eventual bursting of the bubble because they promote overvaluation that is recognized by more astute investors. The result can be severely damaging to investors with portfolios highly concentrated in a bubble-plagued sector. 

This is clearly what happened in asset markets, during both the Strong ‘20s and the Greenspan ‘90s. During the Strong years, the money supply was allowed to expand significantly beyond its hard money base. From 1921 to 1929, a broad measure of the money supply increased by more than 60 percent—a much faster rate than the creation of real goods. (This measure was tabulated by Murray Rothbard for his book, America’s Great Depression, which today remains the definitive account of the monetary and fiscal policies of the 1920s that culminated in the 1929 crash.)  

Asset prices soared. The Dow would grow from a low of 62.57 in August 1921 to a high of 381.17 in September 1929—a six-fold increase. In any sector-specific bubble, astute investors recognize it for what it is and try to exit the market just before the speculative frenzy recedes. For instance, both Bernard Baruch—the 1920s’ version of Warren Buffet—and Joe Kennedy exchanged stock for bonds and gold more than a year prior to the stock market crash. (Kennedy is known for his comment, “only a fool holds out for the top dollar.”)   

The story is the same for the 1990s. Although the Dow grew throughout the 1990s, it grew in bubble-like proportions in the latter half of the decade, growing from a low of 6391.69 in April 1997 to a high of 11722.98 in January 2000—an 87-percent increase. During this time period, every primary monetary aggregate increased on an annualized basis, and significantly, all but the narrowest aggregate, M1, began increasing at least two years prior to 1997. (M2 and MZM increased steadily from at least the beginning of 1995, while M3’s increase can be dated to 1993.) Greenspan’s complicity is underscored when we recall that he identified an asset bubble as early as 1996 during his now-famous December 5, 1996, “Irrational Exuberance” speech. Again, investors who, either by shrewdness or luck, were able to get out of stocks prior to the bursting of the bubble fared extremely well.

During both periods, the general price level seemed to remain steady, and mainstream monetary economists credit both the Strong and Greenspan regimes with maintaining low levels of inflation. Austrian economists, on the other hand, define inflation as increases in the money supply, and the experience of both decades underscores why this definition is superior. Increases in general price indices and asset bubbles are possible effects of inflation as defined by the Austrians. A steady CPI is irrelevant in a bubble-plagued economy, a situation which suggests that increases in the money supply can and often do affect specific sectors while not showing themselves in government price indices. All that Fed-created liquidity, after all, has to go somewhere.

What are we to conclude?

First, Fed policies that oppose the economy’s natural tendency toward lower prices over time can result in steady general price levels while simultaneously fueling damaging bubbles in equity markets. This is the lesson of US economic history in the 1920s and in the 1990s.  

Second, if the monetary aggregates increase whether or not an explicit expansionary or contractionary policy is announced by the Federal Open Market Committee—both policies were pursued between 1997 and 2001—then Fed weaknesses are greater than Greenspan is letting on. Thinking people may ask to be reminded why was it that we needed a Federal Reserve in the first place.  

And third, if Alan Greenspan truly is an economic maestro, a master of the universe, or something in between, then he surely knows what causes bubbles and the role played by Fed policies in the creation of the stock market bubble that occurred under his watch. It is mendacious, therefore, in the midst of a prolonged recession, to claim an alibi of impotence problems in terms of policy to deflate a bubble when his very own policies fed them in the first place. His lack of candor when asset values were inflated suggests that at that time, he was more concerned with concealing that he never was a glorious wizard after all.


Christopher Westley is an assistant professor of economics at Jacksonville State University ( 


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