Monetary misjudgments and malfeasance.

• Author: Hanke, Steve H.

The Federal Reserve has a long history of creating aggregate demand bubbles in the United States (Niskanen 2003, 2006). In the ramp up to the Lehman Brothers" bankruptcy in September 2008, the Fed not only created a classic aggregate demand bubble, but also facilitated the spawning of many market-specific bubbles. The bubbles in the housing, equity, and commodity markets could have been easily detected by observing the price behavior in those markets, relative to changes in the more broadly based consumer price index. True to form, the Fed officials have steadfastly denied any culpability for creating the bubbles that so spectacularly burst during the Panic of 2008-09.

If all that is not enough, Fed officials, as well as other members of the money and banking establishments in the United States and elsewhere, have embraced the idea that stronger, more heavily capitalized banks are necessary to protect taxpayers from future financial storms. This embrace, which is reflected in the Bank for International Settlements' most recent capital requirement regime (Basel III) and related country-specific capital requirement mandates, represents yet another great monetary misjudgment (error). Indeed, in its stampede to make banks "safer," the establishment has paradoxically rendered the economies of the Eurozone, the United Kingdom, and the United States--among others--weaker and, therefore, less "safe" (Hanke 2011).

Aggregate Demand Bubbles

Just what is an aggregate demand bubble? This type of bubble is created when the Fed's laxity allows aggregate demand to grow too rapidly, Specifically, an aggregate demand bubble occurs when nominal final sales to U.S. purchasers (GDP - exports + imports change in inventories) exceed a trend rate of nominal growth consistent with "moderate" inflation by a significant amount.

During the 24 years of the Greenspan-Bernanke reign at the Fed, nominal final sales grew at a 5.2 percent annual trend rate. This reflects a combination of real sales growth of 3 percent and inflation of 2.2 percent (Figure 1). But, there were deviations from the trend.

The first deviation began shortly after Man Greenspan became chairman of the Fed. In response to the October 1987 stock market crash, the Fed turned on its money pump and created an aggregate demand bubble: over the next year, final sales shot up at a 7.5 percent rate, well above the trend line. Having gone too far, the Fed then lurched back in the other direction. The ensuing Fed tightening produced a mild recession in 1991.

[FIGURE 1 OMITTED]

During the 1992-97 period, growth in the nominal value of final sales was quite stable. But, successive collapses of certain Asian currencies, the Russian ruble, the Long-Term Capital Management hedge fund, and the Brazilian real triggered another excessive Fed liquidity injection. This monetary misjudgment resulted in a boom in nominal final sales and an aggregate demand bubble in 1999-2000. That bubble was followed by another round of Fed tightening, which coincided with the bursting of the equity bubble in 9.000 and a slump in 2001.

The last big jump in nominal final sales was set off by the Fed's liquidity injection to fend off the false deflation scare in 2002 (Beckworth 2008). Fed Governor Ben S. Bernanke (now chairman) set off a warning siren that deflation was threatening the U.S. economy when he delivered a dense and noteworthy speech before the National Economists Club on November 21, 2002 (Bernanke 2002). Bernanke convinced his Fed colleagues that the deflation danger was lurking. As Greenspan put it, "We face new challenges in maintaining price stability, specifically to prevent inflation from falling too low" (Greenspan 2003). To fight the alleged deflation threat, the Fed pushed interest rates down sharply. By July 2003, the Fed funds rate was at a then-record low of 1 percent, where it stayed for a year. This easing produced the mother of all liquidity cycles and yet another massive demand bubble.

During the Greenspan-Beruanke years, and contrary to their claims, the Fed overreacted to real or perceived crises and created three demand bubbles. The last represents one bubble too many-and one that is impacting us today.

Market-Specific Bubbles

The most recent aggregate demand bubble was not the only bubble that the Fed was facilitating. As Figure 2 shows, the Fed's favorite inflation target the consumer price index, absent food and...