Auto Focus: The Greenspan Recession – Alan helped get us into this mess. Now he’s trying to get us out.
MiBizWest • November 7, 2001
by Jim Gillette
We haven’t heard much from Nobel laureate Milton Friedman lately. After all, he is 89 and probably enjoying a well-deserved retirement.
We’ll bet, however, that he still pays close attention to the economy and the con duct of monetary policy. While early in his career, Alan Greenspan claimed to have been a follower of the esteemed University of Chicago economist, Dr. Friedman now must be shaking his head and muttering, “Alan, Alan, Alan. If I’ve told you once, I’ve told you a thousand times. Steady as she goes, steady as she goes. Keep monetary policy stable and the markets will take care of the rest.”
It would be easy to blame the current recession on the Sept. 11 attacks. (Yes, it is a recession, although not yet officially labeled as such by the National Bureau of Economic Research.) The truth is, the economy began slipping as early as last fall. After recognizing that over-tightening was slowing the U.S. economy more than was intended, the Fed began to loosen in December.
At that point auto component suppliers had already felt the pinch. Vehicle parts demand began to sink even further late this summer.
We haven’t had a recession since the 1990-91 Gulf War period. The Fed had begun to tighten in mid-1989 and the economic downturn started in July 1990, one month before Iraq’s invasion of Kuwait.
An early warning
Businesses are constantly looking for ways to predict the onset of recessions. One tool long used by Fed watchers is something called the yield curve, which graphically depicts the gap between long-term and short-term interest rates (see the Yield Curve graphic on this page). The Fed conducts monetary policy at the short end of the rate spectrum. Tightening policy results in pushing short term rates upward; loosening pushes them downward. Long term rates move more or less independently, being most affected by investors’ changing expectations of future inflation.
Businesses are most directly and immediately affected by changes in short-term rates as the cost of lines of credit, working capital loans and floating rate debt fluctuates. High short term rates can immediately slow economic activity just as low rates tend to stimulate investment.
Over the past several decades, long-term rates exceeded short-term rates more often than not. An upward sloping yield curve (long-term hates higher than short) is considered to be normal and necessary for economic growth. When short rates exceed (or are approximately equal to) long rates, the yield curve is said to be inverted.
When the yield curve inverts, watch out. Economic activity is about to slow. The yield curve graphic on this page shows that the yield curve inverted just three times in 30 years. Each occurrence was closely followed by a recession.
Three inversions, three recessions
The first was when then Fed Chairman Paul Volker tightened monetary policy beginning in 1979 to squeeze inflation out of our economy. Two quick and deep recessions resulted. (Those of you who have been in the auto industry for a long time will remember how much fun that was.) The next inversion (or near inversion) was in 1989.
This time, short-term rates increased in January 1999 and the yield curve inverted once again.
There is always complexity
In fairness to Greenspan, the current situation has been complicated by three coinciding phenomena that have made reactive monetary policy more complex. First, the stock market was forming a classic bubble, resulting from what Greenspan termed “irrational exuberance.” All else held equal, excess liquidity (loose monetary policy) will cause security prices to rise. Were stock prices rising during the late 1990s because of excess liquidity, or were prices being driven by irrational expectations in the dotcom sector, in particular and other stocks being taken along for the ride? In the latter, liquidity was an enabling factor, not necessarily the cause. Greenspan focused on taking away either the cause or the enabler. Following a policy of fine-tuning monetary policy, it didn’t matter which.
Second, Y2K fears and the resulting cash hoarding prompted an offsetting move by the Fed to increase bank reserves.
The Annual Growth in the Monetary Base graphic on the facing page clearly illustrates the pumping of reserves late in 1999. The monetary base is the sum of depository institution reserves and currency in circulation. This is also what Friedman calls “high powered money.” According to Friedman, the Fed should keep the monetary base growing at a steady pace rather than attempt to actively adjust reserves in order to control economic activity. Frequent adjustment of the monetary base or fine-tuning, according to Friedman, can have unintended consequences.
After the turn of the new year in 2000 (and Y2K was a bust), the Fed began with drawing reserves to offset the pre- Y2K injection. What is interesting is that the annual rate of reserve growth was cut to a much smaller level than the pre- Y2K months. This is further evidence of the tight stance by the Fed.
Banks were already tightening when the Fed stepped in
Third, in 1998 banks and other lending institutions became very concerned about credit quality. After several years of lending with loose underwriting practices and lenient terms that underpinned rampant merger and acquisition activity and fed more debt to already highly leveraged companies, loan defaults began to spike. Independent of action by the Fed, banks began to tighten loan requirements and pull back on credit. This alone would have dampened economic activity without additional action.
While consumer spending has, until recently, been fairly robust, manufacturing and capital goods industries have suffered. Given current low levels of capacity utilization in our factories, the poor outlook for any near-term increase in consumer demand, and banks continuing conservative lending practices, it is easy to see why business investment has ground to a halt.
On a positive note, short-term interest rates are now at their lowest level since 1962. Congress is working on a fiscal stimulus package that may include an investment tax credit for business. We also have a sense of national unity brought on by the events of Sept. 11 directed toward doing whatever it takes to get the economy back on a growth track.
Greenspan’s recent actions are providing a strong push in that direction. Following Sept. 11, the Fed made a large injection of reserves. It is unlikely it will move to pull them back in anytime soon. This will serve to stimulate the economy in the months ahead. The return of the yield curve to its normal upward slope is evidence that the Fed is now doing its part.
Banks have the money to lend. With the poor state of many suppliers’ balance sheets and cash flow, the difficult task will be to convince bankers to re-open their doors to the auto industry.