Greenspan’s Bubbles

This article appeared in the June 2008 issue of Finance Asia.

Military history is written by the victors.Economic history is written, to a large extent, bycentral bankers. In both cases you haveto take official accounts with a largedose of salt.

Just consider the bubble-blowing chargesleveled at the former chairman of the FederalReserve, Alan Greenspan. The former chairmanhas proclaimed his innocence. Let's look at theevidence.

What is a bubble? A bubble is created whenthe Fed's laxity allows aggregate demand to growtoo rapidly. Specifically, a demand bubble occurswhen nominal final sales to US purchasers (GDPminus exports, plus imports, minus change ininventories) exceeds its trend rate of growth by asignificant amount.

During Greenspan's 18-year tenure as Fedchairman, nominal final sales grew at a 5.4%annual trend rate. This reflects a combination ofreal sales growth of 3% and inflation of 2.4%. (see chart)

Final Sales To Domestic Purchasers

Click on chart for larger view

The first deviation from the trend began shortly afterGreenspan became chairman. In response to the October 1987stock market crash, the Fed turned on its money pump and createda bubble: during the next year final sales shot up at a 7.5% rate, wellabove the trend line. Having gone too far, the Fed then lurchedback in the other direction. The ensuing Fed tightening produceda mild recession in 1991.

From 1992 through 1997 growth in the nominal value of finalsales was quite stable. But successive collapses in certain Asiancurrencies, the Russian ruble, the Long Term CapitalManagement hedge fund and finally the Brazilian realtriggered another excessive Fed liquidity injection. Thisresulted in a boom in nominal final sales and a bubblein 1999-2000. This was followed by another round ofFed tightening, which coincided with the bursting ofthe equity bubble and a slump in 2001.

The last big jump in nominal final saleswas set off by the Fed's liquidity injectionto fend off the false deflation scare in2002. As Greenspan put it, "We face newchallenges in maintaining price stability,specifically to prevent inflation from fallingtoo low." By July 2003, the Fed funds ratewas at a record low of 1%, where it stayed for ayear. This set off the mother of all liquidity cycles andyet another massive demand bubble.

During the Greenspan years, and contrary to his claims, the Fedoverreacted to real or perceived crises and created three demandbubbles. The last represents one bubble too many – and one that isimpacting us today.

Steve H. Hanke

Steve H. Hanke is a Professor of Applied Economics at The Johns Hopkins University in Baltimore and a Senior Fellow at the Cato Institute.