Given recent events, there has been growing criticism over Federal Reserve Policy. In today's print, Alan Greenspan defends his reign as Chairman of our Central Bank. I have dusted off a few thoughts on this period which, I believe point out some of the errors made during his tenure. This is the first.
In the early 1980's, the Reagan Administration pushed large tax cuts through Congress. The preponderance of the benefits of this legislation went to the wealthy. However, it was argued that much of this money would be reinvested in the economy so that everyone would benefit.
Metrics like the unemployment rate suggest that there was some truth to the argument. There has been another effect to this approach. Over the last two decades, the gap between the wealthy and everyone else, measured both by income and wealth, has grown enormously. Trickle-down economics is a primary suspect. I would like to suggest another cause: Trickle-down monetary policy.
The general mandate of most central banks is to fight inflation. The Federal Reserve has a broader mandate. It is asked to achieve both price stability and full employment. In practice, the latter objective is interpreted to mean sustainable growth. To accomplish this, the Fed has been given one main policy tool; the ability to set short-term interest rates. If you have watched economic and market events over the last dozen years, as well as the Fed's policy stance and response function over that period, one can conclude that the Fed has incorporated an unstated objective and policy tool into its' arsenal: asset prices.
It seems clear that rising asset prices create wealth and wealth generation in turn creates economic growth. Thus, with limited tools at hand, it is not surprising that our central bank might welcome other methods of providing economic stimulus. Board members have generally publicly maintained that asset prices are not a concern of monetary policy, particularly when prices are rising. However, in all of the asset bubbles dating to the mid-1990's, the Fed has found little reason to interfere with positive price action and every reason to aggressively react when over-extended markets go into a free-fall.
Actions speak louder than words. Governor Kohn acknowledged as much in a recent speech, noting that asset price booms tend to be asymmetric, with asset prices rising by "the escalator and falling by the elevator". He added that this tends to result in asymmetric policy behavior from the central bank. In other words, rates go up by the escalator and fall by the elevator.
What goes unsaid, however, is that this asymmetric posture has a disparate effect on the distribution of wealth in this country. The preponderance of the financial wealth in America is concentrated in a relatively small number of hands. The lion's share of the benefit that comes from escalating asset prices goes to the wealthy. As was the case with trickle-down fiscal policy, the residual economic effects seep into the broader economy. Everyone benefits, but not equally. The Fed's reaction to falling asset prices also has unequal consequences; the wealthy also get more benefit.
The consequences of all this are clear. Asset prices have generated enormous wealth which is highly concentrated. The growing income and wealth gaps will continue to grow as long as monetary policy takes its cue from asset prices, rather than broader, long term economic fundamentals.