Dr. Greenspan, turn off the bubble machine!

The Federal Reserve Governors are said to have a primary responsibility for preventing inflation or deflation in the economy and maintaining a stable economic environment free of recessions and bubbles, through the use of monetary tools like regulating interbank interest rates and controlling the money supply. Their activities are closely linked with the Treasury Department, whose Secretary meets with the Fed Chairman, Alan Greenspan on a regular basis. Since the Fed is a quasi-independent organization linked to the Federal Reserve banking system it tends to look out for banking and securities interests, and government interests, while trying at the same time trying to make responsible decisions protecting the economy at large. This can be a daunting task so criticism of its actions should never be levied without caution and qualification.

In recent years, the threat of inflation has been minimal, while the economy has been sluggish, so the Fed has dropped interbank interest rates to very low levels. In turn, bank prime rates, mortgage rates, and consumer credit rates have dropped accordingly. This results in temporary dislocations, which later result in more long term effects. For example, when mortgage rates drop, existing homeowners refinance, dropping their monthly mortgage payments so they have more to spend on consumer goods. Consumers run up their credit buying balances since interest payments are lower. This stimulates a sluggish economy. Senior citizens and others whose income derives substantially from investments tend to shift their investments out of interest bearing instruments and into equities or real estate where returns may be higher, at least temporarily. As this process progresses, home buyers also make adjustments. Since their payments are less, they can afford to pay more for the real estate they buy. This drives up real estate prices, offsetting to some extent the effects of low interest rates. Eventually, bubbles start to develop. The real estate market starts to inflate, creating a real estate bubble, and the demand for equities in the stock markets begins to outstrip earnings, creating a stock market bubble.

Meanwhile the sluggish economy is causing a reduction in tax revenues, and federal and state deficits start to develop, the effects of which are often discounted because interest rates are low. But, eventually, either the economy picks up and inflation rears its ugly head and interest rates are increased to meet it, or as in the current environment, the economy contines to be sluggish, employment refuses to pick up, and the bubbles get larger and larger and eventually burst.

If the Fed continues to view only aggregate inflation rates to trigger interest rate increases, the bubbles (inflation in real estate and equity prices) continue to grow. The government will continue to run deficits which will threaten federal retirement programs like social security and medicare, and the seniors, who rely on these programs and regular investment income will be put in jeopardy. Dr. Greenspan has recently called for reductions in these retirement benefits at the same time as his low interest rates are driving seniors away from stable long term interest based investments into speculative equity investments.

It is my contention that interest rates should start to be increased now. Although aggregate inflation rates are still low, real estate and equity price inflation rates are high. The real estate market is already overheating in growth areas, and the P/E ratios of stocks are at historically high levels. The markets have recognized this so the stock market volatility has increased markedly with fits and starts on every news story hitting the press. These low interest rates, and the stock and real estate market bubbles that develop from them, discourage long term investment and encourage speculation, and puts those dependent on investment income in jeopardy.

Dr. Greenspan, it’s time to turn off the bubble machine!