Economist says Greenspan's actions may lead to recession

by Lew Harris

If history is any indication, Federal Reserve Board Chairman Alan Greenspan's decision to slow the speculative boom in the stock market by raising interest rates could do more harm than good, according to a Vanderbilt economist.

"When you're trying to break a speculative bubble, it's sometimes better not to do it with a policy instrument because it can cause severe and unintended effects on other sectors of the economy," said Peter L. Rousseau, assistant professor of economics.

Historical examples of speculative bubbles and consequences of "corrective" monetary policies can be instructive for current policy makers, Rousseau said. In a paper recently published by the National Bureau of Economic Research, Rousseau discusses Andrew Jackson's monetary policy that helped lead to the economic panic of 1837. He believes Greenspan's current monetary policies are similar to those practiced by Jackson.

"If Greenspan didn't do anything, it's likely that the present boom in the market would ultimately run its course," Rousseau said. "By raising interest rates a bit, it's unlikely that the person who's investing in tech stocks, someone who's perhaps risk-loving to begin with, is going to cut back on the amount of borrowing to purchase tech stocks. But raising interest rates can cause harmful effects on the general population, rather than those who have taken the risk and fueled the current mania."

Raising interest rates can reduce consumer demand, causing slowdowns in production, raise unemployment rates and discourage first-time homebuyers. While Rousseau said it's still too early to tell if Greenspan's approach will work, we are already beginning to experience some negative side effects.

In May, Labor Department statistics revealed that U.S. businesses lost 116,000 jobs, the worst showing in nine years. The Commerce Department said orders to factories fell by 4.3 percent in April, the biggest decline since November 1990, when the country was mired in the last recession. Orders for durable goods, items expected to last three years or more, fell 6.5 percent in April, the biggest setback since December 1991.

One of the most important early speculative episodes in U.S. history was the land boom of the 1830s. Land prices were appreciating at extraordinary rates in the 1830s, much like tech stocks have been during the last few years, Rousseau said. While there was no Federal Reserve at the time, there was a Treasury Department to implement monetary policies.

Andrew Jackson, a very popular and powerful president, had a natural aversion to banking, according to Rousseau. "He saw the speculative land boom happening in the Western states (the Western-most states of the day were Indiana, Illinois and Michigan) with the land being paid for with rapidly expanding issues of paper money." Like Greenspan today, Jackson engaged in a monetary policy to try to halt the speculation, Rousseau said.

Jackson issued an executive order, called the Specie Circular, in July 1836. The order required that all future public land purchases be paid for with either gold or silver (specie).

"Rather than break the speculative boom, requiring gold or silver for land purchases had a completely different effect," Rousseau said. "What ended up happening was that folks just started shipping gold and silver out to the Western states in order to continue purchasing public lands. It drained the banks in New York, the center of the nation's banking industry at the time, of their gold and silver reserves."

At the same time, the government had a surplus of revenue, like today, and decided to distribute it to the states according to their populations. That further depleted the gold and silver reserves in the New York banks.

Martin van Buren succeeded Jackson as president on March 4, 1837, and it was believed he would abolish the Specie Circular. He decided against repealing the order, however, and the tailspin began. There was a bank panic in 1837 with runs on the New York banks and another panic in 1839. Banks all across the country were forced to suspend payments. Farm prices plunged and factories closed. The resulting depression lasted six years, not ending until 1843.

"It was the second-worst downturn in U.S. history, trailing only the Great Depression," Rousseau said.