“Greenspan’s global-savings-glut theory of the housing boom leaves unexplained why the boom ended when the Fed finally restored short-term rates to sanity. China and other savings suppliers to the US did not, after all, repatriate their savings.

John Taylor’s critique of Fed policy is basically right and Greenspan is basically wrong.”

http://divisionoflabour.com/archives/005715.php

See:
http://www.federalreserve.gov/boarddocs/speeches/2004/200404012/default.htm

First, Greenspan did oversee a more than 300% increase in the monetary base during his tenure. Although banks can\\\’t multiply checking account money on the cash portion of the base, they still managed to buoy narrowly defined money substantially through the near elimination of reserve requirements. For this reason, comparatively small growth in bank reserves accomplished substantial growth in new money.

Second, the creation of new money is destructive of wealth, whether originated from growth in bank reserves or loosened reserve requirements. When banks multiply checking accounts through fractional reserves, the supply of loanable funds on the market increases. This sets in motion the wealth consuming process of mis-allocating capital in projects that, given the reality of scarcity, the borrowers could not afford. Mal-invested capital is largely wasted. This fact stands, even when part of the newly created money that depressed interest rates flows abroad, where it circulates as money.

Third, the creation of new money–regardless of its ultimate source–inspires widespread capital consumption through the wealth effect. With the Fed and foreign central banks joined in their pursuit of easy money, asset prices rise unrealistically. Businesses and households act as though they can afford expenditures that they would otherwise avoid. Those ill-conceived expenditures consume capital and reduce saving.

Fourth, all the fancy calculus relating to M2 and M2 velocity is a waste of time. M2 contains mostly non-money components that may wax or wane depending on the action in the stock market or elsewhere. But those non-monetary components–CDs, for example–are simply an alternative form of investment. When the supply of CDs grows, this doesn\\\’t cause prices to be bid higher than would be the case in the absence of the CD increase. CDs tend to rise in quantity over time, just like stock prices rise, in response to growth in the money supply.

Fifth, the authors could write a more interesting analysis of Easy Al\\\’s tenure if they knew of what money consisted. I suggest they go study Frank Shostak\\\’s articles that discuss the distinction between claim deposits (checking account money) and credit deposits (CDs, savings, etc., which when included in the money stock constitutes double counting.)

Sixth, the authors\\\’ claim that Monday Morning Quarterbacks have no business criticizing Easy Al\\\’s inflationary reign is, to put this with polite restraint, amusing and ridiculous. It was obvious for a couple of years before the crash ensued that we were sailing into the falls. Any fool could see that real estate prices had risen far beyond the realm of realism, and that the rate of debt creation of all kinds had stampeded out of control. Consumer prices were held down in the United States, not by M2 velocity hocus pocus, but rather by the flood of imports from Asia. The new money funded rising asset prices and new generations of financial derivatives (that exist to facilitate new forms of highly leveraged speculation, and that are mostly another new variant of mal-investment.) I won\\\’t belabor this point further; I made excellent money shorting stocks and buying yen. Thank you, Easy Al!

Finally, if the authors think this recession is another garden variety downturn, then I suggest they stay tuned a little longer. The capital destruction imposed on Americans by several generations of Big Government inflating and spending, taxing and regulating, has passed the tipping point. There won\\\’t be a glorious recovery from this recession that brings renewed prosperity to the masses of Americans. This is because our capital base is rapidly eroding. At best we\\\’ll see a cosmetic upturn at some point, and most likely raging inflation later. Meanwhile, all sorts of indicators–such as the earnings deficit for the S&P 500 in the last quarter–the first deficit in recorded history.

First, Greenspan did oversee a more than 300% increase in the monetary base during his tenure. Although banks can\’t multiply checking account money on the cash portion of the base, they still managed to buoy narrowly defined money substantially through the near elimination of reserve requirements. For this reason, comparatively small growth in bank reserves accomplished substantial growth in new money.

Second, the creation of new money is destructive of wealth, whether originated from growth in bank reserves or loosened reserve requirements. When banks multiply checking accounts through fractional reserves, the supply of loanable funds on the market increases. This sets in motion the wealth consuming process of mis-allocating capital in projects that, given the reality of scarcity, the borrowers could not afford. Mal-invested capital is largely wasted. This fact stands, even when part of the newly created money that depressed interest rates flows abroad, where it circulates as money.

Third, the creation of new money–regardless of its ultimate source–inspires widespread capital consumption through the wealth effect. With the Fed and foreign central banks joined in their pursuit of easy money, asset prices rise unrealistically. Businesses and households act as though they can afford expenditures that they would otherwise avoid. Those ill-conceived expenditures consume capital and reduce saving.

Fourth, all the fancy calculus relating to M2 and M2 velocity is a waste of time. M2 contains mostly non-money components that may wax or wane depending on the action in the stock market or elsewhere. But those non-monetary components–CDs, for example–are simply an alternative form of investment. When the supply of CDs grows, this doesn\’t cause prices to be bid higher than would be the case in the absence of the CD increase. CDs tend to rise in quantity over time, just like stock prices rise, in response to growth in the money supply.

Fifth, the authors could write a more interesting analysis of Easy Al’s tenure if they knew of what money consisted. I suggest they go study Frank Shostak\’s articles that discuss the distinction between claim deposits (checking account money) and credit deposits (CDs, savings, etc., which when included in the money stock constitutes double counting.)

Sixth, the authors’ claim that Monday Morning Quarterbacks have no business criticizing Easy Al\’s inflationary reign is, to put this with polite restraint, amusing and ridiculous. It was obvious for a couple of years before the crash ensued that we were sailing into the falls. Any fool could see that real estate prices had risen far beyond the realm of realism, and that the rate of debt creation of all kinds had stampeded out of control. Consumer prices were held down in the United States, not by M2 velocity hocus pocus, but rather by the flood of imports from Asia. The new money funded rising asset prices and new generations of financial derivatives (that exist to facilitate new forms of highly leveraged speculation, and that are mostly another new variant of mal-investment.) I won\’t belabor this point further; I made excellent money shorting stocks and buying yen. Thank you, Easy Al!

Finally, if the authors think this recession is another garden variety downturn, then I suggest they stay tuned a little longer. The capital destruction imposed on Americans by several generations of Big Government inflating and spending, taxing and regulating, has passed the tipping point. There won’t be a glorious recovery from this recession that brings renewed prosperity to the masses of Americans. This is because our capital base is rapidly eroding. At best we’ll see a cosmetic upturn at some point, and most likely raging inflation later.

\"The market ultimately determines interest rates….\"

This is absolutely false. Due to the nature of Fractional Reserve banking (FRB), any amount of savings is multiplied by the inverse of the reserve requirement. Using the real savings as reserves, banks create credit out of thin air, pyramiding newly created banking deposits on top of the reserves. The interest rate set by the banks is therefore always lower then the natural interest rate that would have prevailed if only the real savings would have been used. Fractional Reserve banking is coordinated and regulated by the FED. FRB in conjunction with further injection of money into the system by the FED mainly through open market operations, the FED system expands credit mostly fueled by artificial credit, as apposed to real credit coming from real savings. It is this excess of credit created by the system out of thin air that causes the interest rates to be lower then the natural rate of the free market. The great mistake of the authors is that they do not distinguish between investments fueled by real savings and investments fueled by artificial credit. It is this critical distinction that is the heart of the business cycle.

Rather then to cast doubt on the artificial credit expansion explanation, the author reinforces it, by clearly showing that credit expansion has indeed occurred between 2001 and 2006. Since the inflation cannot continue indefinitely, the tightening of the expansion by the Fed is actually expected. As expected, shortly afterwards, the damage caused by the previous expansion is revealed, and sets off the necessary correction phase (recession).