The Fed and a Bubble: Flashback to 1927-1930

In recent discussions around effects and consequences of the Fed's monetary policy, a bubble in stock market has attracted attention. Even though the Fed's conventional and unconventional easy monetary policy, along with fiscal policies, has been keeping the U.S. economy from slipping into another Great Depression, unintended consequences of the Fed's recent policy, specially QE3, could be a big problem on its own as the policy sustains the recovery. The full effect of QE on the economy and the financial system isn't still fully known. Victoria McGrane quotes San Francisco Fed President John Williams from his recent paper on the zero lower bound:

Added to this uncertainty, the programs also raise “nagging concerns that large-scale asset purchases carry with them particular risks to the economy or the health of the financial system that we still don’t understand well,” he said.

Warning of a stock bubble has already been voiced by some of the Fed's policy makers. They argue that today's historically low federal funds rate has been fueling the stock prices. Therefore, they argue the Fed should pull back its bond-buying program to stop the potential stock bubble. However, the Fed shouldn't, in my opinion, tighten its monetary policy  so quick to just stop any potential bubble.

Here, Economist's 1998 article, "America's Bubble Economy", says:

In the late 1920s the Fed was also reluctant to raise interest rates in response to surging share prices, leaving rampant bank lending to push prices higher still. When the Fed did belatedly act, the bubble burst with a vengeance. The longer that asset prices continue to be pumped up by easy money, the more inflated the bubble will become and the more painful the economic after-effects when it bursts.

Now, let's try to see what was the Fed's action in the years prior to the Great Depression. In 1927, the Fed decreased its federal funds rate in the face of a mild recession in the U.S. and Britain's balance of payments crisis. Following this policy, the stock market prices gained 39% and the price-dividend ratio rose by 27% in 1928 (FYI: IN 2013, the Dow and S&P500 stock prices gained 26.5% and 29.6% respectively.) Worrying about a potential stock market bubble, the Fed raised the discount rate from 3.5% to 5% in the first half of 1928. The contractionary policy seemed to be working as the price-dividend ratio continuously fell until July 1929, when it started to increase again. Acting against this increase in the stock price, the Fed further increased the discount rate to 6% in August 1929. We know what happened next: the stock market crashed in late October of 1929. Here, we can see the Dow Jones Industrial Average price and price-dividend ratio in late 1920s.

As we briefly discussed the actions that the Fed took to cool down the stock market in the late 1920's, we should study further what this Fed's actions led to.

Today, the Fed faces the same problem even though Fed Chairman Ben Bernanke doesn't see an evidence of a bubble. Therefore, today's one of the biggest problems is whether the Fed can manage its bond-buying program in a way such that it's action doesn't burst or sustain any dangerous bubble.

The Income Inequality and the Economic Downturns

When we look at the similarities between the Great Depression and the Great Recession, one stark phenomenon that only these two economic downturns saw was the high income inequality in the U.S. that preceded these economic disasters. If we look at the graph showing the historical percent share of income of the top 10%t, this share was at the record high levels right before the Great Depression, in 1928, and the Great Recession, in 2007. In fact, during those times, the income share of the top 10% was almost 50%. As we look from the graph, this high level of income inequality was not seen during the time between the two great crises. This high level of inequality was seen first time at the onset of the Great Depression, and the next one coincided with the beginning of the Great Recession.

Could the increasing income inequality have been a root cause of the greatest economic panics the U.S. economy has faced in the 20th and 21st century? Let me try to see the potential link between the high level of inequality and the economic downturn. When people at top of the income ladder get bigger share of the total income, the folks at the bottom of the ladder would get less share of the total income. However, when, the top, let’s say, 10% get more income, their propensity to consume would decrease. In other words, the money that would have otherwise been spent for the consumption by the bottom 90% wouldn't be spent for the consumption by the top 10%. This leads to a decrease in total consumption in the economy which could have caused the downturns.

The most interesting data we can see is that since the official end of the Great Recession, the income share of the top 10% has only gone up until 2012, in which the latest data is available. Not only did the income share of top 10% go back to the pre-crisis level, but also it is now greater than 50%. In 2012, the top 10%t collected more than a half of the total income for the first time during the time of data. In other words, the income inequality in the U.S. is going to the same direction as it went to before the crisis. In that sense, I doubt the recovery that U.S economy is going through is healthy one. Not only has the income inequality in the U.S. been increasing, but also that in other countries has increased since the 2007-2009 recession. ( Harold James, Project Syndicate) This increase in income inequality in the U.S. has been facilitated by the Fed's non-conventional monetary policy, which has been potentially creating an asset price boom. The Great Recession challenged everyone in the U.S. in some ways, but the top 1% has already recovered what it has lost during the recession. Meanwhile, the increase in the income of the bottom 99% has been very low if there was any.  (Moran Zhang, IB Times)