The Daily Switch

The Federal Reserve: How it Hurts You-Part 4

Posted by Ender on March 20, 2009

This is Part 4 of of a series on the Federal Reserve.   In Part 1, we discussed Money, Fractional Reserve Banking and a brief history of the Federal Reserve.  In Part 2, we discussed Inflation.  In Part 3, we discussed the Austrian Business Cycle.

The Tech Boom  (Cliff’s Notes at the Bottom)

The Backdrop

A few factors occurred prior to the actual bust cycle of 1995-2001 played a part in the bubble. The first was the Plaza Accord of 1985, which was an agreement between the G-5 powers (France, Germany, Japan, UK and the US) to “subsidize U.S. exporters by artificially lowering the exchange rate of the U.S. dollar.” (Callahan) This pulled the US out of the recession of the early 90s, by 1993 the stock market began to rise and the Fed in an effort to battle inflation started to raise their rates. From late 94 to early 95 the rate rose from 4.73 to 5.53.

In 1995, the US, Japan and Germany decided to bail out the Japanese manufacturing industry by agreeing to the Reverse Plaza Accord, which reversed the lowering of the exchange rate established in the original Plaza Accord. This is the problem with trying to control aspects of the economy. The “solutions” only cause more problems in the future. To help Japan, the three countries decided to subsidize German and Japanese products for the American buyer. To do this they lowered the Japanese interest rates, increased Japanese purchase of US Treasury bonds, Germany and the US purchased dollars as well. “Driving the dollar up against foreign currencies would allow the U.S. government to maintain a stance of monetary ease without raising the CPI, since the artificially lowered price of imported goods would tend to counter the price-raising effect on the increased liquidity.” (Callahan) They did this in an attempt to hide what would be rising prices from the CPI (Consumer Price Index.) Although they hid the extra liquidity from the CPI it had to manifest itself somewhere. One of the places it ended up was the US stock market.

In the middle of 1995 through early 96 the Fed lowered its interest rates from 6 to 5.22. Japan also lowered its rate from 1.75 to 0.5. This led to a situation where Asian investors could borrow yen to invest in US securities and make profit with no risk. The arbitrage situation created here further drove up the price of financial instruments in the US.

Scary, But True

Historically, the full employment level leads to an unemployment rate between 5% and 6%. During one of the longest “booms” in the Federal Reserve’s history the rate fell below 5% and stayed below until 2001. It bottomed out at around 3.9%. The chairman during this time of prosperity was Alan Greenspan. He took the lowering of the unemployment rate along with the growth in productivity to mean that we as a nation had reached a new level in economic progress. It was dubbed the “New Economy.” History buffs or extremely old readers of this site might recall that the US has gone down this path before. Anyone willing to guess when the term “New Plateau of Prosperity” was coined? Anyone? Well it was developed in the 1920s, (coincidentally?) prior to the Great Depression. Whether through arrogance or ignorance I know not, but Greenspan thought the macroeconomics of old no longer applied and there did not have to be a bust after a credit induced boom.

Feeding the Bubble

Attempts to control the worldwide economy such as the Reverse Plaza Accord always end in failure. In the late 90s, Japan (among other Asian countries), Germany and Brazil all went through financial crises. The economies could not afford to keep subsidizing US imports. They began to collapse. In the US, the Long Term Capital Management hedge fund which had a large stake in the Russian and East Asian financial markets started turning losses instead of profit.

To stem the panic, the Fed dropped the rate from 5.56 to 4.63 in eight months including a rate cut in between its meetings (which never happens.) During this timeframe (Jun 98-Jan 99) the NASDAQ Composite (tech heavy) went from a low of 1419 to a high of 2193. The tech composite rose over 80% in 1999. Again in the final quarter of 1999 to stem Y2K panic the Fed cut rates below 4%. From September 1999 to March of 2000 the NASDAQ tech composite rose 83% to hi 5048.

It is important to note that just because instruments like the CPI aren’t showing increases doesn’t mean we don’t have an inflation problem. One important measure to look at during all of this are the monetary supply calculations. These are described as M0, M1, M2, MZM etc. During the Tech Bubble M2, M3 and MZM all dramatically increased. The most important one to look at is MZM. See the graph below:

MZM

From 1995 to 2000 it grew 52%, is there any doubt that this was feeding the bubble?

But What About The Berries?

Think back to the situation that resulted with the “berry receipts.” The same thing happened in the US economy during the Tech Boom. The economy was driven forward by both an increase in consumption and investment, which was fueled by the Fed. In the berry scenario, we saw that only a savings induced boom can be sustained. Was there an increase in savings during the Tech Boom? The answer is a resounding NO. Brenner writes “Between 1950 and 1992, the personal savings rate had never gone above 10.9 per cent and never fallen below 7.5 per cent, except in three isolated years. But, between 1992 and 2000, it plummeted from 8.7 per cent to -0.12 percent.”

“The divergence of investment demand and savings supply [characterizes] the ‘policy-induced boom,’ where monetary expansion drives a wedge between savings and investment.” (Callahan) This wedge causes businesses (and consumers) to start spending more on capital investments than would normally be deemed reasonable. Business equipment (up 74%), construction (up 35%) and debt (reaching 9.9% of the GDP vs 3.4% in the early 90s) all rose during this timeframe.

The Collapse

Architect of the Bubble

Too much investment and current consumption leads to price increases as business compete for resources, which are becoming more and more scarce. For instance in the Tech Industry, prices started rising for programmers, developers, office space and web domains. In an effort to cool the economy the Fed raised the interest rates. This coupled with the rising prices popped the Tech Bubble. The companies scraping by on cheap loans now started to take losses. The NASDAQ lost over 77% of its value. The drastic drops did not only affect lesser known tech companies. Qualcomm dropped from 136.12 (‘00) to 25.18 (‘02). Cisco dropped from 136.37 (’00) to 12.07 (’02). Yahoo dropped from 178.06 (’00) to 11.50 (’02).

This also affected business that supported the Techs. Construction companies who purchased capital goods such as real estate, cranes, dump trucks etc. because their demand was so high now have to pay for all that investment even though the demand dropped off. Computer manufacturers now have rising inventories and no one to sell to because the bubble burst. People who were hired to deal with the new business are now laid off because business fueled by inflation and easy credit has ceased.

Cliff’s Notes

Cliff's Notes

In short, the Fed tried to control the economy through interest rate manipulation and credit inflation. This is clearly evidenced by the MZM’s insane rise over the 6 year stretch along with the Fed’s rate dropping. The extra liquidity was hidden (for a time) from measurements like the CPI, however, it needed an outlet which ended up being the stock market. Due to non-economic factors much of the growth went towards the new and seemingly profitable Tech Stock industry. Once, the Fed stopped its tactics and prices started dramatically increasing the bubble burst.  Misery ensued.

In Part 5, we will wrap up and take a look at a few odds and ends.

For sources and further reading:

Austrian Business Cycle, Callahan
ABCT, Best
Greenspan: The Liar, The Fraud, Karrlson
The Dot-Com Future, Rockwell
He’s Forever Blowing Bubbles, North
Money and the Stock Market: What is the Relation, Shostak
Sound Money and the Business Cycle, Cochran

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2 Responses to “The Federal Reserve: How it Hurts You-Part 4”

  1. […] is one thing, real life examples are another.  In Part 4, we will take an in depth look at the Tech-Stock Boom of the late 90s early 00s. Possibly related […]

  2. […] Geithner. You can learn all about how Geithner devastated the Indonesian Economy in the 90s. In a post on what caused the Tech Boom I briefly mentioned part of its cause was due to the Asian crisis. […]

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