In 1987, President Ronald Reagan appointed economist Alan Greenspan to head the Federal Reserve. Greenspan would go on to serve under Democrat Bill Clinton and Republican George W. Bush. His would become the longest tenure of any chair. He was tested quickly. Only a few months after taking charge, the stock market took a sudden and extreme plunge. Fear was widespread that the entire financial system would collapse (see Perspective 28.1).
Greenspan arranged a large temporary injection of money into financial markets that helped quell fears and restore order. There would be other financial crises: a Mexican Debt Crisis in 1995 and an East Asian Debt Crisis in 1997. In both cases, Greenspan took measures to help contain the crisis. Greenspan’s overall approach to monetary policy is depicted in Figure 28.4, which shows the Federal Funds rate from January 1987 to July 2012. The Federal Funds rate—the interest rate at which banks lend reserves to each other overnight—is the chief operating target of the Federal Reserve Board. If the Federal Reserve wants to make credit more available, it adds reserves until the Federal Funds rate falls; if it wants to restrict credit, it withdraws.
The recessions defined by the National Bureau of Economic Research are shown as the short distances between the vertical dashed lines in Figure 28.4. When the economy went into a recession, Greenspan cut rates aggressively and then held them down until the all-clear was sounded, that is until there was widespread agreement that an economic expansion had firmly taken hold and there was no danger of a relapse.
The economic expansions on Greenspan’s watch were remarkable. In March 1991 (see Table 28.1), the economy reached a trough from which began the longest economic boom in U. S. history. It did not end until March 2001, a full decade later. The expansion
DO STOCK MARKET CRASHES CAUSE DEPRESSIONS?
For reasons that are still not entirely clear, a severe stock market crash occurred in 1987. The Dow Jones Industrial Average, a widely used index (shown in the following figure as the solid line measured against the right value axis) fell 26 percent between September and October 1987. In the immediate aftermath of the crash, many people expected a repeat of the events that had occurred in 1929 and 1930: a rapid slide into severe depression. This did not happen, however; the real economy, for example, as represented by the
Unemployment rate (shown in the figure as the dashed line measured against the left value axis) remained stable. Alan Greenspan and the Federal Reserve received considerable credit for responding immediately by pumping additional liquidity into financial markets. There is also a lesson to be learned from this case about the danger of jumping to conclusions based on limited evidence. Conclusions such as “stock market crashes cause depressions” cannot be based safely on a hasty reading of one historic event, however compelling. As Economic Reasoning Proposition 5, evidence and theory give value to opinions, reminds us, conclusions must be tested by a wide range of facts.
Was driven by a huge investment boom as the use of personal computers and the Internet changed the way Americans worked and played. To use the colloquial expression, America was “getting wired.” A stock market boom was a concomitant of the investment boom, as it had been in earlier investment booms, such as in the 1920s. From a level of 3,018 in March 1991, the Dow Jones Industrial Average nearly quadrupled to a peak of 11,750 in January 2000. The NASDAQ (National Association of Securities Dealers Automated Quotations) index, which contained more of the high-technology stocks, rose even more. Greenspan received considerable credit for keeping the expansion going without driving the economy into an inflationary spiral. A well-received biography of Greenspan was titled Maestro (Woodward 2000). The stock market boom, however, was a continuing worry: More than a few observers thought that there would be a major calamity when the bubble burst. Greenspan attempted to use some of his immense prestige to talk the market down. His characterization of the stock market as succumbing to “irrational exuberance” was widely quoted. Nevertheless, for a time, the market ignored even the famous chair of the Federal Reserve Board. All good things, at least all economic
Under Alan Greenspan, the Federal Reserve responded to economic downturns by lowering the Federal Funds rate.
FIGURE 28.4
The Federal Funds Rate, 1987-2008
Source: Board of Governors of the Federal Reserve System 2009.
Expansions, must end. At the beginning of the 2000s, the stock market fell, real investment fell, and unemployment rose. In March 2001, the unemployment rate was 4.2 percent; by the end of the year, it was 5.8 percent. According to the official dating, the recession that followed was not especially long; only eight months from March 2001 to November 2001 (Table 28.1). Once again the Federal Reserve followed a policy of lowering interest rates in a recession and keeping them low until the recovery was well under way. Once again Greenspan was praised for his wise handling of the economy.
Two worrisome problems, however, emerged. First, the expansion that followed this recession was somewhat anemic despite a major tax cut pushed through by President George W. Bush. Unemployment remained stubbornly high. It was, to use the term favored by critics of the administration, a “jobless recovery.” Second, the United States (as well as a number of other countries) experienced a tremendous real estate boom. Housing prices rose dramatically. Many home purchases, moreover, were financed with so-called subprime mortgages. Borrowers with low incomes and wealth were encouraged to take out mortgages. Often they could afford the initial payments because the initial “teaser rates” were low, but when the loan rates were later adjusted to the market rate, they found the loan payments hard to make. The stock market, moreover, climbed even higher than in the previous boom. Once again, some economists and pundits worried about what would happen when the stock market and real estate bubbles burst.
On January 31, 2006, Ben Bernanke was appointed chair of the Federal Reserve Board to replace Greenspan. An academic economist, Bernanke is an expert on monetary and financial policy in the Great Depression. (His views on the depression are discussed in chapter 23.) Bernanke was soon tested.
World History
