Fractional reserve banking
Centuries ago merchants would deposit their gold coins for safekeeping with a goldsmith. The goldsmith would give the depositor a note which could be used to redeem the gold. Soon merchants found it more convenient to exchange the notes rather than gold. Thus, cheques were born. At this point most economists would say paper money was born because the goldsmith’s notes could be used as money. But they were not money. Money then was actual gold coin. Distinguishing between money and debt is vital to distinguishing monetary inflation from credit inflation.
Of all the gold coins in the goldsmith’s vault, twenty of them actually belonged to him personally. Thus, bank capital was born. The goldsmith created notes representing his own twenty gold coins and loaned them out to borrowers in return for interest. Thus, the bank loan was born. One day the goldsmith noticed a curious thing. The number of coins in his vault never dipped below 200. Based on this realization, he created 100 false notes (for which there was no gold in the vault). He then loaned the false notes out to a farmer in return for interest of ten gold coins per year. Thus, fractional reserve banking was born. It is called fractional reserve banking because the goldsmith only had gold reserves to back up a fraction of the notes he put into circulation.
Emboldened by the success of this, the goldsmith created 300 more false notes and used them to buy a large house for himself. This caused suspicion and rumors among the depositors, who began to run to his vault to redeem their gold. They ran because they were afraid that if they walked, by the time they got there all the gold would have been redeemed by others and their bank notes would be worthless. Thus, the bank run was born.
At first the goldsmith was able to pay the depositors gold coins, but for the last 400 notes he had no gold coins. The holders of the remaining notes were very angry and were going to string him up, but he begged to be heard. He abjectly confessed his dishonesty. He explained that although their gold was gone, their wealth remained, as it had been converted into his house and the farmer’s loan. He promised to sell the house and when the farmer repaid his loan, he would give them their gold back. They calmed down and agreed to his plan. Thus, the creditors’ meeting was born.
The next day the goldsmith sold his house for 300 gold coins and paid out the holders of 300 notes. Unfortunately, the farmer refused to pay back his loan until it fell due a year later. So the goldsmith explained the situation to the holders of the remaining 100 unredeemed notes, and they agreed to wait a year for their gold. In return he agreed to give them nine gold coins from the interest he was earning. Thus, the term deposit was born.
Eventually the goldsmith’s reputation recovered, and he had won back a fair few depositors. He called a meeting of these depositors and pitched to them the idea that they give him permission to create more notes than he had gold. In return for them allowing him to take this risk with their gold, he agreed to pay them part of the interest he earned with the false notes. Thus, credit inflation was born.
Credit inflation is a necessary part of the market system
Credit (debt) is a vital component of the market system. Every contract calling for deferred payments is debt. It is how long-term projects, which pay off over thirty or fifty years, are funded. Credit is how trade is financed. Moreover, the vast majority of transactions in a modern economy are carried out with credit/debt. When people use any form of card, cheques, or bank transfer to pay for goods or services they are paying with debt.
Unlike money, there is not a fixed volume of debt. The market creates debt to suit its needs. Normally there are only a few bad debts, and most borrowed money gets paid back. This is because under normal circumstances the market does not take foolish risks with debt (because the money it represents is so valuable).
Credit inflation is distinct from monetary inflation
In the past gold was money. Therefore, nothing the goldsmith or his depositors could get up to with their bits of paper could increase or decrease the amount of gold in circulation (the stock of money). Therefore, it was impossible for them to create monetary inflation. Then when they created something which people accepted as being as good as money and which exceeded their gold holdings, they created credit inflation.
Credit inflation occurs when an instrument claiming to be redeemable in real money is printed in amounts which exceed the real money the issuer has in his vault. Thus, in the case of the goldsmith, it occurred when he issued more notes than he had gold. In the case of American Express, it would occur if that company issued more travellers cheques than it had reserves of greenbacks.
By contrast, monetary inflation is when the stock of actual money increases. In the goldsmith’s time, that would mean vast quantities of gold being discovered. Today it would mean the United States government printing vast amounts of greenbacks and spending them into circulation. The distinction is important because when credit collapses, real money (greenbacks) levels are unaffected and therefore are neither inflated nor deflated.
Credit inflation is distinct from price inflation
Price inflation occurs when a significant component of all goods in a country becomes more expensive in real terms. For example, in 1816, the famous ‘year without summer,’ a super volcano ejected dust into the upper atmosphere. This caused crops to fail in northern Europe, America, and Canada. The resulting shortages in food reduced supply, which drove up prices. People had to devote more of their real wealth to buying food. This inflation was not caused by the government turning on the printing press, nor could it have been solved in that manner. Likewise it was not caused by goldsmiths issuing excessive bearer notes or any other type of credit inflation.
Credit inflation is deceptively similar to monetary inflation
Money inflation and credit inflation both seem similar, but they are fundamentally different. One is harmful, the other is beneficial. Unemployment caused by monetary inflation is destructive, whereas unemployment caused by the natural credit cycle is beneficial. For this reason the government should refrain both from causing monetary inflation and from attempting to interfere with the natural credit cycle.
Can we ban people from issuing paper redeemable as money if they do not have that money as greenbacks in their vault? No, because some people who issue paper sometimes do not have any greenbacks at all. Instead they have assets which can eventually be sold for greenbacks should the need arise. For example, a bank has mortgages over houses which can be converted to greenbacks when the loan is repaid.
Can we ban people from issuing paper redeemable as money unless they have greenbacks in a vault or assets equivalent to the monetary value of paper they have issued? The answer is no. This is because some people who issue paper sometimes do not have any greenbacks or any assets which can eventually be sold for greenbacks should the need arise. For example, a property developer may issue notes on the basis that he can repay the money once the property he plans to build is completed and sold. An electricity company may issue bonds to raise money to build a wind farm.
Can we ban people from issuing paper redeemable as money unless they have greenbacks in a vault or assets equivalent to the monetary value of paper they have issued or a sound sensible plan as to how they are going to spend the money raised so as to be able to pay it back? The answer is no. That would require the government to police every transaction in the market, and claim to know which transactions are wise and which foolish. It would involve assessing the merit of borrowers, valuing real estate, deciding what companies are winners and losers. In short it would mean communism.
The next question is, what can we do to prevent individual members of the public being ripped off when a particular company issues too much debt and to restrain widespread irrational exuberance? For example, an over-geared, thrice-bankrupted property developer using glossy brochures to sell debentures to moms and dads. The answer is nothing. It is the market that stops people being ripped off and reigns in irrational exuberance. The only thing government can beneficially do is enact laws to help the market by enhancing transparency.
- Requiring companies, which raise money from the public, to publish audited accounts and make fraudulent accounting illegal.
- Providing criminal and civil penalties for fraudulent or negligent representations in prospectuses.
- Publishing a register of individuals which discloses:
a. If they have been bankrupt.
b. If a company they have been a director of has become bankrupt.
c. If a company they have been a director of has not paid judgment debts.
- In conclusion, credit inflation (and the credit cycle) is not bad, but a necessary part of the market system.
Credit deflation and the natural credit cycle
Credit deflation occurs when the people who have created credit inflation apprehend that they will lose money if they continue to lend or borrow. They respond by ceasing or reducing their lending or borrowing. Eventually confidence recovers, and the correction (by reallocating resources in line with returns) brings back economic health. As Nathaniel Branden observed:
At worst, the economy may experience a mild recession, i.e. a slight general decline in investment and production. In an unregulated economy, readjustments occur quite swiftly, and then production and investment begin to rise again. The temporary recession is not harmful but beneficial; it represents an economic system in the process of correcting its errors, of curtailing disease and returning to health.
The impact of such a recession may be significantly felt in a few industries, but it does not wreck an entire economy. A nation-wide depression, such as occurred in the United States in the thirties, would not have been possible in a fully free society. It was made possible only by government intervention in the economy—more specifically, by government manipulation of the money supply. (Capitalism: The Unknown Ideal, 1966.)
When a natural credit cycle peaks, credit does not collapse. Instead it contracts slightly. The contraction is nevertheless sufficient to tip many low-profit or highly-geared businesses over the edge. In this regard a credit contraction acts like a lion chasing a herd of gazelle—only the old, tired, young, and sick are culled. Those who survive are the healthy and profitable. This is because in a natural credit cycle, the vast majority of credit involves sound investment. There tends not to be foolish risk-taking.
This contrasts with the observed phenomenon in a force-fed credit cycle where inordinate risks are taken by both borrowers and lenders. When the inevitable end of a force-fed credit cycle arrives, the collapse in credit and business activity is so severe that not just weak businesses are swept away, but also the strong. There is no benefit to a herd from indiscriminate slaughter and likewise no benefit to an economy from the indiscriminate ruin of businesses.
The force-fed credit cycle
The flood of paper money, as you well know, had produced an exaggeration of nominal prices and at the same time a facility of obtaining money, which not only encouraged speculations on fictitious capital, but seduced those of real capital, even in private life, to contract debts too freely.
—Thomas Jefferson. Letter to Albert Gallatin, Monticello, December 26, 1820.
The force-fed credit cycle is triggered by credit inflation created by the government
The natural credit cycle involves mild increases in private debt being followed by mild contractions. Where there is force-fed credit this process becomes deranged, lenders issue too much debt on risky loans, and borrowers take on more debt than they can comfortably service and spend it on fictitious capital. The trigger for this behavior is when the government itself drives down interest rates and swamps the economy with easy credit. The easy credit that then abounds is not just the government-issued debt, but also private debt, which multiplies excessively in response to the government’s lead.
Some observers argue that the various stock market crashes (which always presaged or followed a collapse in credit) of the eighteenth and nineteenth centuries were caused by the government printing excess money, not by the government creating debt. However, in those days money was gold and paper money was debt redeemable in gold. Therefore, the excessive printing of paper money was really the creation of excessive debt.
Why force-fed credit inflation is bad
Common sense could have told them, that credit is the most uncertain and most fluctuating thing in the world, especially when it is applied to stock-jobbing; that it had long before been exalted higher than it could well stand, even before it was come to twenty above par; and therefore always tottered, and was always tumbling down at every little accident and rumour. A story of a Spanish frigate, or of a few thieves in the dark dens in the Highlands, or the sickness of a foreign prince, or the saying of a broker in a coffee-house; all, or any of these contemptible causes were able to reduce that same credit into a very slender figure, and sometimes within her old bounds: But particularly, they might have seen, that it was now mounted to such an outrageous height, as all the silver and gold in Europe could not support; and therefore, when people came in any considerable number to sell (and to sell was the whole end of their buying), it would have a dreadful fall, even to the crushing of the nation.
—Thomas Gordon. Cato’s Letters No. 16, How easily the people are bubbled by deceivers. Further caution against deceitful remedies for the public sufferings from the wicked execution of the South-Sea scheme, Saturday, December 10, 1710.
To illustrate how force-fed credit works, consider the experience of a janitor named Bob during the ‘dot com boom’ (1995–2000). At the beginning of the dot com boom, Bob was training part-time to be a mechanic. One day, while he was mopping floors, Bob heard on his transistor radio that tech companies were desperate for website programmers and that after just one week of training he could become a certified website programmer. He dropped his mop and just two weeks later was employed by a newly-listed website company.
Bob’s salary as a website programmer was twenty times greater than his salary as a janitor. He soon learned he did not even have to do any real work. His employers were mostly interested in impressing the stock market with the size of their payroll. Bob and his equally talented colleagues lounged around all day on brightly colored furniture, ‘brainstorming’ ideas for new Internet products. His employer had never made a cent of revenue, and instead of ‘cash flow’ it had a ‘burn rate’—the rate at which the company was spending its start-up capital. Investors were told not to expect dividends for at least three years, as the company’s strategy was to “rush the technology to the market and then gain as much market share as possible.” The corporate headquarters were magnificent, no expense was spared; as well as a marble foyer there were some paintings by old masters in the boardroom. The CEO and founder, an inspired charismatic genius, spent most of his time flitting about the country in the company jet making speeches to financial planners and analysts. At Christmas there were lavish parties with champagne and generous stock-options for all the employees.
Bob loved his new life. He sold his apartment in a poor suburb and purchased a large waterfront property. He paid significantly higher than the house was worth because he needed to outbid another website programmer. The bank was happy to lend him the money, not just because of his high salary, but also because of the value of his stock options. With his new-found wealth Bob bought new clothes, ate out at fancy restaurants, purchased a giant television, and went skiing in Aspen. During these happy days he ‘injected’ an extra $200,000 into the economy.
The benefits to the economy from Bob and his industry’s profligate spending were impressive. The prices of houses spiralled in value. This meant his neighbors ‘felt richer’ and borrowed against the ‘new’ equity in their houses to buy dot com shares. Meanwhile the clothes shops put on new staff, the restaurants employed more people, even the gondola engineers in Aspen got a pay raise. Naturally the politicians were as pleased as punch. They held press conferences and told reporters that their ‘technology-friendly policies’ were responsible for all this ‘prosperity.’
Unfortunately, the dot com bubble did not last. Bob’s company went into liquidation with no dividend available for creditors. Bob lost his waterfront house (which was sold by the bank for a shortfall). His car was repossessed, and with his bad credit rating he could not borrow to buy even a modest replacement. He is once again mopping floors and is currently unable to afford to complete his mechanic’s training. The clothes shops and restaurants all sacked their extra staff and some went bankrupt as a result of their borrowings to fund expansion. Even the gondola engineers in Aspen were not immune to the fallout.
Had the dot com boom not occurred, Bob would have become a mechanic, tripled his wage, paid off his original apartment, and invested in sensible blue chip shares.
It would be tempting to consider that no other harm came from Bob’s adventure. At first blush we might even think there must have been some spin-off advantages. However, the massive economic dislocations caused by the dot com bubble had detrimental consequences. Someone had to pay for Bob to live it up for those few heady years. The economy had to pay an opportunity cost for all those able-bodied janitors lounging around in those brightly colored chairs pretending to be website programmers. The $200,000 that Bob ‘injected’ into the economy must have come from somewhere. The value of the shares may have been an illusion, but the champagne was real, the labor of the restaurant staff was real, the ski holidays were real. So where did Bob’s $200,000 injection into the economy come from?
The answer is Mr. and Mrs. Jones. They were a typical mom and dad who had saved for over thirty years to pay off their home. They heard about the incredible profits being made in dot com stocks from their neighbors and on television. Then one day they were visited by a financial adviser. He told them they were dullards to sit on the wealth locked in their unencumbered house. He told them they had to ‘unlock the equity’ so they could properly look after themselves in retirement. They looked at each other while the broker repeated various seductive phrases he had been taught to say. They were mutually reassured by what they saw and excited to be finally making easy money, so they agreed to take out a mortgage on their home. They borrowed exactly $200,000 and put it into shares in the company that employed Bob. When the company went bust they lost it all.
Was it worth it? In hindsight it would have been better if the $200,000 had stayed in the Jones’s house. None of the ‘gains’ were permanent. All the jobs created were lost; the extra value of the houses in his suburb was illusory. It was not real growth, it was mal-investment, it was the misallocation of resources. Mr. and Mrs. Jones will now have to spend the next thirty years paying off their house all over again. That means for them there will be no surplus income for holidays, no new clothes, no renovations, no eating out. They are unable to help with their children’s college education. Despite having had good incomes all their lives, they are now destitute and fearful of the future.
It follows that the happiness brought to society by the Federal Reserve lending money is like the happiness brought to society by a cocaine dealer. It is transitory, focused on a few people, and followed by disproportionate misery for all. The evidence is so compelling that the Federal Reserve no longer claims to be stimulating the economy beyond its normal growth ability. It now claims that it sets interest rates in order to prevent booms from getting too crazy or busts from getting too low. Yet that is like blocking someone’s airway, whipping an oxygen mask on when they start to pass out from lack of oxygen, then whipping the mask off when they start to pass out from too much oxygen… and then blocking their airway again. In the long run it is best to let people’s autonomic systems regulate their breathing. Likewise, in the long run, the market is best left to itself to regulate the credit cycle. As Ludwig von Mises remarked:
Credit expansion initially can produce a boom. But such a boom is bound to end in a slump, in a depression. What brings about the recurrence of periods of economic crises are precisely the reiterated attempts of governments and banks supervised by them to expand credit in order to make business good by cheap interest rates. (The Theory of Money and Credit, 1912.)
The consequences of the force-fed credit cycle
A ‘cheap money’ policy was the guiding idea and goal of these officials. Banks were no longer to be limited in making loans by the amount of their gold reserves. Interest rates were no longer to rise in response to increasing speculation and increasing demands for funds. Credit was to remain readily available—until and unless the Federal Reserve decided otherwise …
Throughout most of the 1920s, the government compelled banks to keep interest rates artificially and uneconomically low. As a consequence, money was poured into every sort of speculative venture. By 1928, the warning signals of danger were clearly apparent: unjustified investment was rampant and stocks were increasingly overvalued. The government chose to ignore these danger signals …
The boom and the wild speculation … were allowed to rise unchecked, involving, in a widening network of mal-investments and miscalculations, the entire economic structure of the nation. People were investing in virtually everything and making fortunes overnight—on paper.
—Nathaniel Brandon. Capitalism: The Unknown Ideal, 1996.
A force-fed cycle leads to excessive risk-taking and mal-investment, which spreads throughout the whole economy. When the bubble bursts, instead of it being mild and restricted to a few industries or geographic areas, it drags the whole country into a long and enduring recession.
Central bankers always think they are smarter than the market; otherwise they would decline the job. They think they can create steady growth without the need for periodic recessions, but the market is infinitely complex, so they cannot hope to outsmart it, they can only derange it. Anything they do will increase volatility, not moderate it. Anything they do will reduce prosperity, not increase it. Central banks are not great moderators, they are great boat rockers. As Thomas Gordon explained:
National credit can never be supported by lending money without security, or drawing in other people to do so; by raising stocks and commodities by artifice and fraud, to unnatural and imaginary values; and consequently, delivering up helpless women and orphans, with the ignorant and unwary, but industrious subject, to be devoured by pick-pockets and stock-jobbers; a sort of vermin that are bred and nourished in the corruption of the state. (Cato’s Letters No. 4, Against false methods of restoring public credit, Saturday, November 26, 1720.)
The sub-prime mortgage crisis and credit crunch of 2008
None of the arguments that economics advances against the inflationist and expansionist doctrine is likely to impress demagogues. For the demagogue does not bother about the remoter consequences of his policies. He chooses inflation and credit expansion although he knows that the boom they create is short-lived and must inevitably end in a slump. He may even boast of his neglect of the long-run effects. In the long run, he repeats, we are all dead; it is only the short run that counts.
—Ludwig Von Mises. The Theory of Money and Credit, 1912.
The sub-prime mortgage crisis of 2008, which triggered the worldwide credit crunch known as the Global Financial Crisis, was a classic example of a force-fed credit cycle. The Federal Reserve progressively lowered interest rates from 6.5 percent in 2000 down to 1 percent in 2003, then kept them at less than 3 percent until May 2005. The Federal Reserve claimed that these low rates were needed to ‘cushion’ the economy from the effects of the September 11, 2001 terrorist attacks and the bursting of the dot com bubble. This was true in as much as those two factors threatened to act as catalysts to end an existing force-fed credit inflation boom. However, prescribing low interest rates as a fix for a force-fed credit inflation boom is akin to prescribing a bottle of whiskey to cure a threatened hangover—it may delay the inevitable but it only makes it far worse.
With so much cheap credit (low interest rates), the banks and shadow banking sector had no choice but to begin lending on risky loans once the market for good borrowers had been saturated. So extreme was the situation that lenders could not even pretend to be lending wisely. So instead they created a name for what they were doing to give it credibility: ‘sub-prime.’ They told investors that through a combination of new arrears-tracking-technology and mortgage insurance, they could (for the first time in history) make risky loans safe. As a result of the hallucinogenic effect of Reserve Bank force-fed credit, investors were not thinking straight and swallowed these delusional claims. The bursting of the credit bubble was inevitable, and should have taken place in 2001—and would have done so with far less damage to worldwide prosperity. The longer it was forestalled, the higher the rates of delusion grew, the more mal-investment, and the worse the fallout was when the end finally came. Yet, despite the clear and repeated lessons of history, when the bubble finally did burst in 2008, the demagogues in the United States Congress did not blame the Federal Reserve. Instead they blamed:
- Drops in the housing market;
- High-risk mortgage loans;
- Wall Street greed and risky new financial products;
- Fraudulent loan brokers;
- Predatory lending practices;
- Securitization practices;
- Incentive structures;
- Mortgage insurers;
- Inaccurate credit ratings;
- Financial institution over-gearing.
However, all these were merely symptoms of force-fed credit—not the cause. The basic observed phenomenon of economics is “have cheap money, will invest,” and if there is nothing real to invest in, then the surplus credit will be invested in fictitious capital.
In the case of the 2008 crash, the fictitious capital was house prices. These were bid up way beyond their real value by over-geared borrowers wielding their non-conforming loans.
After the crash, the U.S. Federal Reserve, instead of allowing the credit markets to find their own equilibrium, began offering credit at 0 percent. As Japan discovered in the 1990s, prescribing whiskey to cure a hangover simply leads to lost decades.
The Great Depression
The cause of the Great Depression of the 1930s was the cheap money provided by the Federal Reserve during the 1920s, which led to an unsustainable credit inflation boom. By the time the Federal Reserve tried to stop it in 1928, it was far too late. The issue was no longer interest rates but rather the deeply flawed structural changes that had been brought about in the economy through mal-investment. The need to correct these flawed structures was inescapable. No amount of tinkering with interest rates was going to solve the problem.
When a vehicle loses traction while rounding a corner, flips, and begins rolling down the embankment, it makes no difference what the driver does with the accelerator, brake pedals, clutch, or steering wheel. There is no logic in the driver reasoning, “The accelerator, brake, clutch, and steering wheel got me into this trouble, they should be able to get me out if I can just get the combination right.” This is where Milton Friedman and most economists go wrong. They imagine that the structural problems caused by force-fed credit over many years can be fixed, and disaster arrested or averted, by continued, but this time more clever, manipulation of interest rates.
What caused the great recession to become the Great Depression was the massive ongoing interference by the U.S. Federal Reserve and U.S. Federal Government against the forces of the market. These interferences, on a scale which would be disastrous during prosperous times, were catastrophic when taken in the middle of a heavy recession. They prevented necessary adjustments being made and thereby made recovery take longer as resources continued to be misallocated and incentives undermined.
Why politicians like force-fed credit booms
Politicians love force-fed credit booms for the same reason disk jockeys love cocaine dealers: they know it will make the crowd feel good and they will get the kudos. This was the motivation behind George H. W. Bush’s hostility towards Alan Greenspan when Greenspan kept interest rates high in 1991.
Why central bankers like force-fed credit booms
Let us hear from the architect of the 2008 Global Financial Crisis, Alan Greenspan, in his farewell book, The Age of Turbulence:
If securitised U.S. sub-primes had not emerged as the weak link in the global financial system, some other financial product or market would have. Eventually, the underpricing of risk had to collide with innate human risk aversion: the crisis was a psychological certainty.
The asset bubble was destined to follow the course of tulip mania and all the other bubbles of economic history—prolonged euphoria culminating in an abrupt and destabilising outbreak of fear. Even the most sophisticated private sector risk management was unable to neutralize the burst of euphoria and its inevitable consequences.
The clear evidence of underpricing of risk did not prod private sector risk management to tighten the reins. In retrospect, it appears that the most market-savvy managers, although conscious that they were taking extraordinary risks, succumbed to the concern that unless they continued to “get up and dance”, as ex-Citigroup CEO Chuck Prince memorably put it, they would irretrievably lose market share. Instead, they gambled that they could keep adding to their risky positions and still sell them out before the deluge. Most were wrong.
But I am also increasingly persuaded that governments and central banks could not have importantly altered the course of the boom either. To do so, they would have had to induce a degree of economic contraction sufficient to nip the budding euphoria. I have seen no evidence, however, that electorates in modern democratic societies would tolerate such severity in macroeconomic policy to combat a prospective problem that might not even materialize.
This is the same man who in 1966 wrote the essay, “Gold and Economic Freedom.” He is the same man who kept interest rates high during the presidency of George H. W. Bush, knowing that to do so would cost the president any chance of a second term in the 1992 election. President Bush protested, but Greenspan ruthlessly preferred the interests of his country to those of the U.S. president. In that incident, Greenspan demonstrated the theoretical strength of an independent Federal Reserve: it was not answerable to the electorate.
So what went wrong? Surely in 2001 Greenspan ought to have tightened interest rates and popped the bubble that had been forming. The timing was exquisite: he could have denied President George W. Bush a second term. Why did he go the other way? Why did he create an even bigger force-fed credit bubble that would inevitably lead to speculation in sub-primes, real-estate, shares, and other fictitious capital? And why did Greenspan write, “I am … persuaded that … central banks could not have importantly altered the course of the boom … electorates in modern democratic societies would [not] tolerate such severity in macroeconomic policy”?
What is he talking about? Central bankers are not chosen by the electorate. He could have done the right thing with impunity, as he had done before. The answer is that Greenspan, who in his youth was hard as granite, had by then become a vain old fool. When he wrote “Gold and Economic Freedom” in 1966, he was espousing his principles. When he dumped Bush Sr. out of the White House he was acting on his principles. Then he got old and listened to the press accolades saying he was a genius; he began to indulge in theatrics with his briefcase; he became a ‘celebrity.’ He posed for television documentaries, claiming to read dozens of reports and factory output statistics, as though he understood the market (which is impossible). He posed for photographs for the front page of Time magazine. He accepted accolades from the media as “the man who is going to save the world.” Above all, as his own words demonstrate, he began to see public opinion as his electorate. He feared that if he raised interest rates in 1999 or any time after and triggered a recession he would no longer be hailed as a wizard and genius. His biggest worry became a drop in his own popularity and the loss of his mythical ‘financial wizard’ status. In other words, he preferred his own vanity to the economic welfare of the whole planet.
This is proof that no one, not Alan Greenspan, not a president, not a board of governors, not Congress, not the World Bank, not even the electorate, can usefully interfere with the market. The power to set market rates belongs with the market. Only there can it be safely trusted, only there is it in perfect balance.