Janet Yellen Is Right: Expansions Don't Die of Old Age
"I think it's a myth that expansions die of old age… So the fact that this has been quite a long expansion doesn’t lead me to believe that… its days are numbered." - Janet Yellen, Dec. 16, 2015
"The trouble with thinking that expansions don't die of old age is that they do." - Robert Samuelson, Washington Post, Feb. 21, 2016
Who's right? Washington Post columnist Robert Samuelson, claiming that Janet Yellen is wrong about the probable cause of death of an economic expansion, is taking on not just the Federal Reserve but most of the economic establishment. Much as I hate to side with conventional wisdom, in this case it happens to be correct.
Samuelson uses the two longest business expansions in U.S. post-war history to make his case that old age can be "fatal": the record 120-month expansion from March 1991 to March 2001; and the 106-month runner-up from February 1961 to December 1969. The thrust of his argument is that the longer the expansion, the greater the changes in "economic behavior," which conspire to doom the expansion.
Something drives those changes. That something is monetary policy. The changes Samuelson sees as the cause are really the effect.
Let's start with the 1990s, a great decade for the U.S. economy. Growth was strong: real GDP averaged 3.8%. A revolution in information technology revitalized productivity growth after a two-decade slump. Low unemployment and low inflation maintained a peaceful coexistence. And the federal budget swung into surplus in the latter part of the decade, the result of a capital gains tax cut and subsequent revenue windfall.
Spring 1997 witnessed the onset of the Asian financial crisis, followed in quick succession by Russia's debt default and the near-collapse of hedge fund Long Term Capital Management. Pretty soon, then-Fed chief Alan Greenspan assured us that help was on the way.
"It is just not credible that the United States can remain an oasis of prosperity unaffected by a world that is experiencing greatly increased stress," Greenspan said in a Sept. 4, 1998 speech.
It was credible, and the U.S. did remain an oasis of prosperity, sailing through multiple crises. The Fed's three 25-basis-point rate cuts in the fall of 1998, unnecessary from an economic perspective, sent the Nasdaq Composite Index on a tear, more than tripling in value by the time it was all over in March 2000. It took 15 years for the Nasdaq to exceed those heights.
Were there behavioral changes? You bet. Margin debt soared as soccer moms, motivated by soaring share prices, bought stocks in Internet companies that had no revenues, no profits and, in many cases, no prospect of either.
By 1999, inflation was starting to accelerate. The Fed reversed course, raising rates from 4.75 percent in mid-1999 to 6 percent a year later. The yield curve inverted, money and credit growth slowed, and the economy fell into a short, shallow recession. Before the Fed was done ministering to the economy, the funds rate had fallen to a half-century low of 1 percent.
Viewed through today's lens, the 1960s were an upside-down era for monetary policy. Keynesians were in charge of both fiscal and monetary policy, which were coordinated. Raising taxes seemed to be interchangeable with raising interest rates as a policy option. Milton Friedman's insight that inflation was "always and everywhere a monetary phenomenon" had yet to find an audience in Washington.
Maximum employment became the official policy and responsibility of the federal government, including the Fed, pursuant to the Employment Act of 1946. Rapid economic growth was necessary to finance President Lyndon Johnson's Great Society programs and the Vietnam War. The result was a 20-year period of "stop-go" monetary policy, with the Fed alternating between efforts to expand and to contract aggregate demand, according to Robert Hetzel, senior economist and research adviser at the Richmond Fed.
As Hetzel explains in his book, "The Monetary Policy of the Federal Reserve: A History," the Fed pursued expansionary monetary policy when unemployment was high under the assumption that economic slack would prevent an acceleration in inflation. The policy tool was a target for free reserves, or excess reserves minus required reserves. Inflation control, through "voluntary" credit restraint and government influence in wage and price negotiations, was left to the federal government.
Inflation remained low for most of the 1960s but started to accelerate in 1967. The Fed raised short-term rates aggressively toward the end of the decade, which once again inverted the yield curve, ushering in a recession.
In terms of behavioral changes, the Fed was the change agent, and not a very good one at that. Once again, a period of expansionary monetary policy overstayed its welcome and was followed by a contraction in money, credit and economic output.
At 80 months, the current expansion, which began in June 2009, is already longer than the post-war average of 58.4 months, according to the National Bureau of Economic Research, the official arbiter of the business cycle. There is no evidence to support the idea that a long recovery is more likely to slip into recession than a short one. To the contrary, "like Peter Pan, recoveries appear never to grow old," writes Glenn D. Rudebusch in a Feb. 8 Federal Reserve Bank of San Francisco Economic Letter.
Rudebusch uses "survival analysis," a statistical method popular in the used-car market, to prove his point. A review of Fed policy associated with Samuelson's two death-by-old-age expansions supports Rudebusch's findings.
Even the analogy of the business cycle to the human life cycle seems misplaced. When humans age, the organs cease to function properly, dementia sets it, eventually people stop eating and even breathing correctly. Medical intervention via a feeding tube can delay but not prevent death.
Not so with the economy. Its organs - factories, for example - may deteriorate but are easily replaced. A lack of pent-up demand is a fiction: Humans have unlimited wants and limited means. As long as the central bank provides adequate oxygen, hydration and nutrition, the patient will keep kicking.
Caroline Baum is a contributor to e21. You can follow her on Twitter here.
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