Business Cycles in a Financially Deregulated America

Albert M. Wojnilower

A very long time ago, in 1980, Brookings published my paper entitled "The Central Role of Credit Crunches in Recent Financial History" (Wojnilower 1980). Presumably the emphasis of this and subsequent articles on the transcendent role of financial institutions and credit in business fluctuations is what led the chairman to invite the present paper, although I am an economist practicing in the financial rather than the scholarly or government community.

The 1980 article concluded that

cyclically significant retardation or reduction in credit and aggregate demand occur only when there is an interruption in the supply of credit – a 'credit crunch.' Such interruptions may be prompted, intentionally or accidentally, by the destruction of lenders' incentives through regulatory rigidities … or the emergence of serious default problems in major institutions or markets. Following such episodes … the authorities … and the private markets … have deliberately reshaped the financial structure so as to prevent the recurrence of that particular form of credit supply interruption.
It went on to argue that removal of the regulatory constraints would lead to more frequent and inherently much more dangerous default crises. In fact this has happened, as will be recounted here, necessitating a series of breathtaking lender-of-last-resort rescues by central banks and governments. The potential for such crises continues to multiply, while the means for dealing with them are diminshing.

Although the Brookings paper included the business cycles of the essentially noninflationary period 1953-1965, while it was being written and published US inflation was racing toward double digits. American political and economic hegemony was eroding, and the chronically depreciating dollar spread the inflationary bias worldwide. Commodity prices in general and oil prices in particular were multiplying. Labor unions in the US and elsewhere applied relentless upward pressure on money wage rates.

Crucial to furthering the inflationary outcome, financial deregulation was inhibiting the tightening of Federal Reserve monetary policy. Removal of official interest rate ceilings kept credit flowing despite successive upsurges in nominal interest rates to unheard of levels -- levels so high that most experts took for granted they must be severely restrictive, when in actuality they were not. Meanwhile the new competition among deregulated financial institutions led to bankruptcies with potential for systemic disruption, deterring the authorities from pressing tight policies home.

How changed are today's circumstances! The Cold War is over. The hegemony of the dollar is unchallenged; left to its own devices, it tends to appreciate. American business and technology are viewed as leading a world economy globalized to an extent that would have been incomprehensible in 1980. In the industrial countries, inflation is subdued. Oil and other commodities are abundant: their relative and absolute prices have fallen. In the US, labor union power has collapsed, part of a pervasive rightward shift in political tastes.

With such a sea-change in political and economic climate, it is not surprising that the US business cycle has been gentler and kinder. From 1953 through 1982, as registered by the National Bureau of Economic Research, there were seven business downturns (plus at least one "close call"), each associated with a credit crunch due to governmental regulations or actions. Since then, notwithstanding ample turbulence and failures in financial markets, only a single mild recession of eight months has been recognized, and the timing of its onset was unrelated to any serious credit disruption. With the dollar free of pressure or challenge, and inflation markedly decelerated, it is an easy path of least resistance for the Federal Reserve to forestall recessions by responding openhandedly to threatened or actual financial crises. And so it has.

Thus, for the US, the narrow business-cycle aspect of my Brookings paper has been inapplicable. To this distant American observer, however, the model appears to have remained useful in explaining cyclical setbacks in many other nations that suffered severe banking shocks after 1980. The list, not necessarily accurate or complete, might include: Australia, New Zealand, and Japan; Scandinavia and the U.K.; as well as Canada, Brazil, Argentina, and Mexico. Obviously I am unqualified to pronounce detailed judgment on these instances.

But even for the US, the approach remains a useful way of examining the macroeconomic consequences of financial change. Although recessions have been largely avoided, the financial system continues to play a prominent role in shaping business fluctuations. Depending on its particular organization and response, real shocks will result in different economic outcomes. Reciprocally, shocks that originate in the financial sector can and do affect the path of the real economy. The process of mutual adaptation between finance and the economy never comes to rest. Nor, consequently, do asset prices or business conditions.

The present paper undertakes a highly selective review of the last fifteen years or so from this standpoint, focusing on the changes in financial institutions, instruments, and practice most influential on the ebb and flow of credit expansion and general business.


From the 1930s on into the 1980s, the American financial system resembled a well-run and orderly zoo. The various species -- banks, securities dealers, insurance companies, etc. -- were neatly caged within functional and geographical specialties, prevented and protected from competition with one another. Although competition remained active within each cage, specialized and benign keepers made sure it did not assume lethal proportions. And as in a real zoo, it was just as safe for the public to view a lion as a rabbit: deposit insurance and other safeguards were firmly in place.

This arrangement, which reflected the country's traditional agrarian localism and hostility toward bankers and monopoly, intensified by the disaster of the 1930s, worked well for the thirty years or more during which it was free from serious internal or foreign challenge. Inflation and interest rates remained low, and the rate of saving higher than it has been subsequently. But the tranquil zoo was doomed by technological innovations that rendered the geographical and functional separations grossly inefficient and impossible to preserve. The zoo was technologically and ideologically obsolete in a world increasingly dedicated to freedom and hostile to authority (Wojnilower 1992b).

Deregulation smashed the constraints on deposit and lending rates, geographical scope, portfolio behavior, and other practices that had segregated and sheltered the various financial intermediaries. Each previously secure and tame animal suddenly became both prey and predator. The population within the cages, already excessive by competitive standards, was hardly suited to life in the wild. And now each species had to compete with every other. Some fell extinct, others adapted, and new ones emerged. Although institutions named banks, insurance companies, securities dealers, and so forth, survive to this day, their appearance and behavior would be largely unrecognizable to a 1960s observer.

For firms suddenly facing vanishing profit margins, finding new revenue sources became a desperate matter of survival. The predictable consequence was a rush of lending in unfamiliar fields, unfamiliar instruments, and to unfamiliar clientele. The risks were unavoidably enormous, but preferable to the certain death most deregulated financial businesses faced were they to stand still.


Just when the inflationary experience of the 1970s and early 1980s was generating virtually insatiable credit demand, financial deregulation made it easy for would-be borrowers to obtain command over "other people's money" cheaply and with few strings attached. Inordinate credit demand was matched by extraordinary eagerness to lend.

During the first half of 1980, the US experienced a sharp but brief recession triggered by 20 per cent loan interest rates and the imposition of direct credit controls on an already shaky economy. As soon as the recession became visible, however, interest rates were lowered and the controls lifted soon after. The resurgence in credit growth and economic activity -- and inflation -- was immediate and substantial (Figure 1).

Notably failing to participate in the recovery, however, were the thrift institutions and homebuilding industry which depended on these intermediaries for mortgages. Savings banks and savings and loan associations were hampered in attracting deposits because the rates they were allowed to pay remained partly regulated. Meanwhile their income from fixed-rate mortgages, mostly acquired in the low-interest rate past, was barely adequate to meet interest rate expense. The "crunch" in the mortgage industry became crippling as short-term interest rates rebounded to near 20 per cent by mid-1981, touching off yet another, more severe, and longer-lasting recession (Wojnilower 1985).

Renewed easing of monetary policy in 1982 launched a strong and durable business expansion that lasted almost eight years until the oil price eruption caused by the Iraqi seizure of Kuwait in 1990. The 1982 business revival featured a virtual explosion in credit. At the trough of the recession and onset of the recovery, consumer price inflation collapsed down to 2 per cent, while virtually all except money-market interest rates remained in double digits. But even in this economy just emerging from recession, double-digit real rates did not perceptibly deter credit expansion. It happened to be the time when the regulatory authorities, frightened by the consequences of their own measures explicitly intended to exterminate specialized home-mortgage lending institutions, undertook to liberalize the prudential rules and to ignore if not encourage violations. From a severely depressed 1.06 million housing starts in 1982, homebuilding vaulted to 1.70 million starts a year later. Consumer credit also surged, fueled in part by new legislation that forbade (previously pervasive) discrimination against female borrowers, a liberalization propitiously timed to suit lenders frantically seeking new clients. Similar credit eruptions took place later during the 1980s in the financing of mergers and acquisitions, so-called "leveraged buy-outs", junk (low quality) bond issuance, real estate investment trusts (REITs), and even "emerging markets", notwithstanding the recency of the Mexican crisis of 1982 and other country credit disasters that effectively decapitalized several of the largest banks.

With so much lending to novel borrowers in novel instruments, pushed by inexperienced lenders spurred by high liquidity and desperate need for income, major defaults were to be expected -- and materialized. The authorities, rightfully concerned about systemic collapse, were kept busy putting out fires. Each time they succeeded, market participants became more complacent with respect to risk-taking. With widespread economic slack prompting relatively easy monetary policies in much of the industrial world, and the dollar appreciating strongly until late 1985, the US authorities had little difficulty in cauterizing the problems (the most serious of which was the failure of the Continental Illinois Bank, the 17th largest in the country). By the same token, however, market participants had little difficulty in accumulating fresh tinder to ignite.


In the fall of 1985, at the notorious "Plaza" meetings in New York, the major powers agreed on policies to bring down the dollar in the context of world-wide monetary easing. Thus was the stage set for a classic credit-inflation business cycle, including a boom in stock prices.

But as we know by hindsight, the game did not play out quite so simply. In the early stages, the inflationary implications were overwhelmed by a collapse in oil prices. Also the US and Japanese monetary authorities were initially reluctant and laggard participants (Volcker and Gyohten 1992). But after mid-1986, US inflation began to creep up. The falling dollar (eventually down 40 per cent from its peak) became a matter of serious international concern and dispute, and the Federal Reserve raised short-term interest rates several times. Nevertheless, stock prices continued to advance until August 1987, when US Treasury bond yields began one of the most intense rises in history, shooting up nearly 3 percentage points to almost 10 1/2 per cent in October.

It appeared that some sort of credit panic, to be followed by recession, was in the offing, just as had happened at previous business cycle peaks. What gave way first, however, was neither the credit structure nor the economy, but the stock market. From the August peak to the low plumbed early afternoon Tuesday, 20 October, New York stock prices plummeted 37 per cent, of which 23 percentage points took place on notorious Black Monday, 19 October, 1987 (Brady 1988). Virtually instantly, the crash spread worldwide.

The plunge threatened to bring down both the credit and the payments system. The natural reaction for banks and others who normally finance securities dealers and clearing houses would have been to reduce credit lines, an action that would have precipitated still more forced sales of stock and, very likely, some spectacular bankruptcies. The danger was, if anything, most pronounced late Tuesday morning, when it appeared as though the previous day's catastrophic losses might be repeated. It was conceivable that checks due from some brokers and clearing houses might not be forthcoming or honored, and that the banks failing to pay such checks might themselves come under suspicion.

Had this disaster been allowed to happen, subsequent economic history might have been very different. The episode would have fit neatly into the "credit-crunch-to-business-downturn" schema. But there was no crunch and there was no downturn.

Federal Reserve Chairman Greenspan publicly guaranteed the liquidity of the market. The White House persuaded major companies to buy back their own stock. Near 2 PM Tuesday the tide was turned by major buying in the stock option and futures markets from sources that have not been identified. What rules may have been bent or broken to prevent disaster, and who made these resolute decisions (perhaps against the advice of legal counsel) is not known.

Soon market functioning was back to normal. But central banks understandably feared the drop in asset values might lead to a recession and a stock market relapse. The Federal Reserve relaxed its posture of restraint and lowered interest rates. The economy continued onward and upward. In such odd fashion, the stock market crash actually forestalled the cyclical downturn the authorities earlier had been prepared to accept.


Because there was so little economic impact, some important lessons of the experience are in danger of being overlooked. The key propellant of the headlong plunge was selling by some fifteen "portfolio insurers", institutional investors who were following a program of automatically selling futures in response to declines in the market value of their portfolios. Three such institutions and one mutual fund reportedly accounted for a major proportion of total market sales (Brady, op.cit.). Every successive drop in value triggered an exponentially increasing quantity of such sales.

Actual (as opposed to textbook) markets consist of human dealers willing to risk capital on bids and offers, and of lenders willing to finance them. Facing a literal selling avalanche, these mortals figuratively and often literally refused to answer the telephone. Trading breakdowns and halts occurred in all stock-related markets. Some of these interruptions are believed to have accentuated the decline, others may have helped to cushion it. Be that as it may, markets are a human institution and as such have limited ability to withstand unbounded waves of one-way orders.

The experience exemplifies the systemic risk inherent in the practice of multiplying "derivative" securities -- futures, options, and mixes thereof -- which embolden market participants to take larger and more leveraged positions (partly by using derivatives to circumvent rules designed to limit risky exposures). By now the "notional" value of derivatives contracts is in the trillions (millions of millions) of dollars. To be sure, today's leading derivative-market participants have developed more sophisticated computer models to guide their operations, which extend far beyond the stock markets. Although these models are for the most part proprietary and not subject to outside examination, they are constructed by leading experts and probably are as good as the state of the art permits. Whether that is good enough may be questioned, but is not the critical issue. The lesson of 1987 is that such programs are apt to be quite similar to one another. In time of stress they give identical instructions to all users, to sell the same or similar instruments on a grand scale. But when market makers are overwhelmed, the instantaneous liquidity assumed by the models vanishes, and with it the allegedly hedged character of the portfolios.

Insofar as financial futures, options, and derivatives have a function beyond offering enticing betting opportunities, it is to enable the public to buy insurance, however illusory, against macroeconomic risks such as tight money or recessions. To the extent market participants thereby feel relieved of the need to worry about such eventualities, the authorities’ difficulties in economic stabilization are escalated. That a derivatives crisis will occur sooner or later, I regard as virtually certain. Whether the economic consequences turn out to be small or large will depend, as in 1987, not on the monetary regime but rather on (among other random factors) the willingness, competence, and freedom of the relevant officials to provide immediate and effective lender-of-last-resort relief.


With monetary policy eased worldwide after the crash and stock markets regaining their footing, the US economy barely paused in its climb. In Spring 1988 the Federal Reserve had to resume pushing rates up, as growth and inflation reaccelerated. The consumer price index reached a year-over-year increase of 5 1/2 per cent in summer. (This may seem low relative to the double-digit increases of 1980-1982, but recall that in 1971 the Nixon Administration had felt impelled to impose wage and price controls at a time when inflation was 4 per cent and abating.)

The rise in short rates brought to a head the savings-and-loan-association crisis, as it became evident that vast numbers of depositors stood to lose their money. But so serene was the public's confidence in deposit insurance, that no runs developed. This gave time to marshal a political consensus for a huge governmental bail-out that successfully protected depositors.1 Many commercial banks also came under pressure, the smaller ones because they too were essentially thrift institutions oriented toward real estate, and the larger ones mainly because of involvement in real estate and other financing undertaken on unrealistic assumptions, including permanently low short-term interest rates. Through merger and failure, thousands of depository institutions were eventually liquidated. Yet despite some sensational bankruptcies, nothing resembling a credit crunch transpired.

Neither, until August 1990, was there a recession. Until then business fluctuated narrowly, while aggregate labor and industrial capacity utilization held at high pitch. For most of 1988 and 1989, the dollar tended higher, particularly against the yen. World stock markets soared, with New York surpassing its 1987 high in August 1989 on the way up to a crest reached a year later.

The US economy is judged by the National Bureau of Economic Research to have started to contract in August 1990, immediately before the Iraqi invasion of Kuwait and upspike in world oil prices. Was the minimal August decline just noise, or was it the onset of a genuine cyclical recession that would have unfolded even had there been no oil shock? I share the opinion expressed by Chairman Greenspan that, absent the oil crisis, no recession would have begun then. Whether, when, and in what circumstances a recession might have developed had there been no oil shock (or for that matter, 1987 stock market crash) will forever remain a mystery.


The analysis is muddied by the contemporary emergence of a new regulatory phenomenon. It was expedient for politicians and the public to blame the supervisors for the financial turbulence and its costs. Although these charges were partly warranted, it was at least equally true that the supervisors’ warnings often went unheeded, and that their preventive efforts sometimes were thwarted by political pressure. To forestall repetition of yesterday's disasters and deflect future criticism, the authorities reacted by developing more formal regulatory criteria. The most notable instance was the 1988 Basle accord among the major financial powers. This set an eight-per-cent-of-risk-assets capital requirement for commercial banks. The accord pleased the major Western commercial banks because it was seen as restraining competition from Japanese banks, and it also suited the Japanese authorities trying to rein in their financial bubble.

American bank examiners applied a harsher standard. The Basle accord defined Government securities holdings as free of default risk, therefore requiring no capital. The US authorities imposed an additional "leverage ratio" standard that stipulated capital against all assets, and in rising proportion as a bank's soundness was deemed to be threatened (Syron and Randall 1991). Subsequent legislation added an interest-rate risk factor (penalizing holdings of longer-dated maturities) to the capital requirement.

How much, if at all, this "revenge of the supervisors" might have slowed credit expansion and the economy in the run-up to the 1990-91 recession is unclear. But statistical and anecdotal evidence is ample that it materially impeded the economy during the recession and the unusually sluggish early years of the subsequent recovery. Bank stock prices gave little warning that particular banks were in trouble. But once the lightning began to hit, almost all banks found it difficult to raise additional capital, whether from the public or through increased earnings. With higher capital ratios being aggressively enforced, the only available response was to reduce risk assets, notably loans. The best loans were terminated first -- because they were the ones that borrowers could repay. New business and mortgage lending, especially to smaller customers, was severely curtailed. The sale of securitized packages of consumer and other loans, which improved capital ratios by removing these assets from balance sheet totals, accelerated greatly. Since they were trying to reduce rather than expand assets, banks also bid much less aggressively for deposits and other funds, opening wider the door for mutual funds (of which more below) (Wojnilower 1992a).

The insistence on higher capital ratios when capital was inaccessible forced banks to shrink their balance sheets, with adverse consequences to the flow of credit. The impact paralleled that of a central bank open-market sale of securities that absorbs bank reserves and compels banks to reduce assets and liabilities. Although the economic effects were particularly severe (and well documented) in the northeastern part of the US known as New England, where banks had been deeply involved in financing a defunct real estate boom, they were national in scope (Brown and Case 1992). It was to these problems that Chairman Greenspan was referring when, on several occasions, he described the economy as battling "a fifty mile an hour headwind." The bank capital squeeze was an important reason why the Federal Reserve kept short-term rates unusually low for a long time, enabling banks to refurbish capital from earnings generated by the large differential between money market and other interest rates.

The state of affairs became known as the "credit crunch". Any resemblance to the crunches of earlier years, however, was in name only. Coming during a time of easy money, the early 1990s capital crunch was fundamentally different from the earlier liquidity crunches triggered by monetary tightening. In the early 1990s the Federal Reserve would have preferred faster expansion of credit. The previous crunches were credit contractions desired by the authorities, but which got out of hand.

In the course of administering all these rules, the official supervisors became involved in detailed private managerial decisions to a degree that, in the days of the financial zoo, would have been regarded as intolerable government meddling. Not surprisingly, the private-sector managers became determined to rebuild capital to levels that would rule out vulnerability to such official interference in the future. This prolonged the crunch, but in the event they largely succeeded. Thus a classic pattern was repeated: supervisors were determined to avoid recurrence of a loss of control -- and supervisees to avoid loss of self-determination.

Today many banks view themselves as overcapitalized and again have become aggressive lenders at exceptionally low returns for added risk.


The prolonged weakness of the depository institutions -- thrifts and commercial banks -- opened the door to new competitors. Of these, so-called money market funds are probably the most important, not only because of their success in attracting household balances, but also for their significant role in drawing consumers into other mutual funds, especially equity investment funds.

In the US, retail money-market fund balances, which comprised over $600 billion in September 1997, typically are subject to check-writing for transactions over $500. As such, they are included in, and account for some 15 per cent of M2. Money market funds are useful also to many wholesale investors: so-called "institutional" money market funds held another $335 billion. Money market funds were created in the early stages of deposit-rate deregulation, when banks were allowed to pay market rates only on deposits of at least $100,000, for the purpose of pooling smaller amounts into sums exceeding that threshold. The decision of the authorities not to prohibit such pooling, as they could have, reflected their desire for the eventual abolition of all deposit rate regulation, which now has been substantially accomplished. In this as other instances (Eurodollars come easily to mind), a device designed to circumvent regulation turned out to have strong staying power long after the regulatory obstacle had lapsed. But unlike at the beginning, only a small fraction of money market funds currently is invested in domestic bank deposits. The bulk is in commercial paper and other short-term credit instruments, replacing funds that used to be provided by commercial banks.

Although the market value of money market fund investments necessarily fluctuates, individual subscribers always buy and redeem shares, on demand, at exactly $1. In the few instances in which market values of the underlying assets have dropped materially below $1, the fund sponsors have contributed additional capital to make up the difference. Unlike the other components of M2 or M3, the funds are backed by neither an official lender of last resort nor deposit insurance. Nor are there legally required reserves, only some prudential investment rules.

By introducing millions of people to mutual funds, money market funds spearheaded an enormous expansion of mutual fund investment. Bond-type mutual funds now are about as large as money-market funds, and equity mutual funds somewhat larger than money and bond funds put together, for a combined aggregate over $4,200 billion -- exceeding 10 per cent of the country's total financial assets. Twenty years ago mutual fund assets were a mere $50 billion. Over 40 percent of American households now own equities through mutual funds or directly (indirect holders through defined contribution pension plans or variable annuities issued by insurance companies not included). Fewer than 3 per cent of the population, a US Treasury official estimated at the time, may have owned stock in 1927 (Sobel 1968).

Within most of the large mutual fund groups, shareholders may make overnight transfers by telephone at minimal or no cost between stock and other funds, including money market funds subject to check. Much of the stock acquisition by mutual funds necessarily has come from the household sector, and is an intra-sector transfer in the flow-of-funds accounting sense. But from the public’s point of view, there is a large gain in liquidity. It is much simpler and cheaper to rearrange or liquidate mutual fund than stock portfolios. How volatile might be the public's management of fund shares during a time of persistent inflation, recession, or stock price decline has not been tested, because we have not experienced such times since mutual funds became so important. In the aftermath of the 1987 crash, withdrawals were small and did not continue for long. But after the Japanese stock market crash two years later, Japanese mutual funds suffered prolonged major outflows.

The risk of selling panics probably is more pronounced on the part of the funds' youthful professional managers, whose median age is said to be under thirty. Their compensation depends on outperforming one another and they have prompted many large securities price fluctuations by their herd-like response to "news". But whether the panic originates with mutual fund shareholders or managers, this is yet another sector in which the Federal Reserve’s lender-of-last-resort responsibilities are liable to be tested.

An interesting question is whether the novel political configuration in which a powerful segment of voters owns shares may eventually constrain monetary policy. The criticism hurled at Chairman Greenspan from all political sides (and his lack of defenders) for mild cautions as to the elevated stock price level, and for a 1/4 percent federal funds rate increase in March 1997 at a time of full employment, is ominous.2

Another financial intermediary that, like mutual funds, is not new but has grown to global importance is the hedge fund. A hedge fund is, in effect, a private unadvertised mutual fund limited to wealthy investors willing to incur high risk for high return. Unlike US mutual funds, hedge funds may engage in unlimited short-term trading, take short positions, and borrow.3 Because hedge funds are essentially unregulated and many are legally domiciled in Caribbean and other tax havens, reliable data are few. Their aggregate capi the market. (Of course the funds do not always operate in moblike fashion; anecdotes relate how, near quarterly statement dates, managers have engaged in uneconomic transactions for the purpose of damaging the market valuation of competitors' holdings.)

In most hedge funds, investors must put up sizable minimum investments, but in

an interesting analogy to the birth of money market mutual funds, there are instances of investors in non-US funds fractionating their holdings and reselling them in smaller participations. US-domiciled hedge funds hitherto were limited to a maximum of 100 investors to avoid having to register and be regulated as a mutual fund, but this limit has just been raised to 500 for individuals with financial assets of at least $5 million and fiduciaries with $25 million. Significantly, institutional investment in hedge funds is increasing rapidly, and the formation of new funds is being facilitated by sophisticated servicing provided by some securities dealers who are assuming the transactional burdens. There is thus the potential for this intermediary to become significant for its mass as well as its velocity.


Hedge funds provide perhaps the purest illustration how the spread between short and long-term interest rates acts as a pivotal incentive for the financial sector to expand or contract the quantity of credit. A market participant able to borrow at or only slightly over the money market rate is virtually always able to reinvest at a higher rate, but the wider the "spread", the more likely it is to exceed transactions, information, and other costs of business. This is the case not only for hedge funds but for all market "insiders". The money market for wholesale participants is, of course, worldwide. The lowest cost of funds is that which happens to prevail anywhere, although for borrowings in one currency destined for investment in another, the foreign exchange risk (or its cost of hedging) must be taken into account.

From late 1992 to early 1994, a prodigious incentive for such "transformation" of short-term funds into longer credits was provided by the low 3 per cent federal funds rate maintained by the Federal Reserve to bolster a sluggish economy and, as described earlier, the banking system. When to the surprise (one wonders why?) of money market participants this rate was raised in early 1994 under circumstances auguring further increase, the market shock was profound. Distress selling of government bonds was widespread, sharply lifting long-term rates around the world with little respect for the substantially differing fundamentals from country to country (Massaro 1997). In the US the drop in bond prices precipitated a number of financial failures, principally through a panic in the market for mortgage-related securities. Treasury bond prices suffered severely because markets for morgage-backed and some other interest-bearing securities dried up under the selling pressures. Not being able to raise required cash by selling the securities they would have liked to sell, many managers had to liquidate what could be sold, namely US government obligations. This is exactly what we should expect whenever a broad sell signal is given by the derivatives models.

After the shock of the 1994 rate increase had worn off, the situation became in some respects even more attractive for hedge funds. US longer-term rates had gone up but, despite the higher money rates, the cost of wholesale financing fell. This was because of the problems of Japan, which produced an extraordinary and destructive rise in the yen/dollar exchange rate. In September 1995 the Bank of Japan responded by lowering its discount rate to a mere 1/2 of one percent. (Although this was labeled an "emergency measure", the rate remained there as of October 1997.) Both the persistence of low money rates in Japan and a fall in the yen seemed assured -- the yen did in fact plunge from a Summer 1995 peak of 80 per dollar to a trough of 127 in March 1997. Thus borrowing yen and investing outside Japan was hugely profitable. Punctuated by the occasional interruption, the proceeds of this "carry trade", as it has become known in market parlance, have poured into the securities and credit markets of the world ever since. In this way low Japanese rates have generated a worldwide bubble in securities prices and credit growth resembling the earlier "bubble economy" in Japan itself.

More generally, whenever the spread between the relevant short and long rates widens, the quantity of short-term funds demanded by the financial sector, consisting of the individuals, firms, and institutions seeking income from interest-rate spreads, enlarges. A wider spread induces such "arbitrageurs" to borrow more at short-term for the purpose of lending more at longer term. Their additional demand for longer-term claims tends to lower long-term rates. A narrowing of the spread, conversely, discourages the lengthening of asset maturities and raises long-term rates. These financial sector reactions explain why short and long rates usually move in the same direction. The opening and folding of the interest rate accordion, the changes in rate levels, and the associated flux in credit extensions and contractions move nominal and real GDP.

As is well documented, the spread between US long-term and short-term interest has been arguably the best (though far from precise) single leading indicator of business downturns (Estrella and Mishkin 1995). A narrowing or, more reliably, inverting of the normally positive spread foretells an impending recession. The financial sector is under restraint. Conversely, a widening spread signals greater credit supply and economic revival (Figure 2).

When interest rate ceilings still prevailed, a rise in short rates beyond certain thresholds impaired or literally cut off the ability of depository institutions to hold and attract deposits. Because many assets held by the institutions were nonmarketable, because the Treasury was legislatively restrained from issuing new longer-dated obligations, because Treasury obligations were "locked in" by having to be valued at least at par on bank balance sheets, because there were no futures and options markets, and so on, long-term bond yields tended to rise much less than short-term rates. The long-term markets simply ceased to function normally. Actual inversion of the yield curve corresponded to near-paralysis of financial intermediaries, since any activity in such conditions produced losses. Recessions followed. But because these began before financial institutions had time and opportunity to become badly overextended, and were immediately accompanied by lower short-term interest rates, there were no serious financial failures.

Since 1982, with deregulation and the growing perfection of the markets, no deep inversion has occurred. This is partly because there has been no draconian tightening of money. But also, in the deregulated environment, rises in short rates are quickly translated into higher long rates, although not necessarily on a one-for-one basis. When the cost of inputs simultaneously rises for all firms in the financial industry, why wouldn't they raise their prices? Since the amount of reserves the monetary authority stands ready to supply at the official short rate is unlimited, the constraint on the economy now operates primarily through the interest elasticity of the demand for credit.

An interesting paradox lurks here. When the authorities raise the short-term rate, to restrain an actually or potentially overheating economy, should they prefer long-term rates to rise a good deal, not at all, or even to decline? The larger the rise in long rates, the more the public's spending decisions will be deterred. On the other hand, the wider the spread between long and short rates, the greater the incentive for the financial sector to continue to borrow at the new short rate and to extend credit, on easier noninterest terms if need be. Should long rates happen to rise more than short rates, the economy may even be stimulated, the predictive power of the long-short differential suggests. Conversely, a fall in long rates might actually be contractionary if it sharply curtails borrowing and lending by the financial sector.

Suppose that demand for credit is elastic to the level of rates, but supply to the long-short differential. Keeping in mind that the supply of funds at the official short rate is theoretically infinite, all sorts of outcomes are possible depending on the (potentially highly variable) shapes of the curves. In actuality, long and short rates move in the same direction most of the time, the long rate moving less (although, of course, with larger effect on the value of long-term assets). An implication is that short-term rate increases may be of little moment until they no longer provoke significantly higher bond yields, presumably because only then have the latter reached a level at which credit demand is highly elastic. If long rates keep rising in step with short, then credit growth may persist substantially unrestrained -- until short rates soar high enough to cause default problems.

In today's US, where mutual fund shares have replaced deposits in household portfolios to a considerable extent (Figure 3), stock as well as bond returns may need to be considered. If short-term rates rise but stock prices rise as fast or faster (the cost of capital falls), is policy restrictive? In the Estrella and Mishkin study cited above, stock prices are the next-most-successful predictor to the interest-rate spread, and the two used together dominate all other combinations.

In addition, as pointed out above in relation to the Japanese money rate, central banks cannot afford to focus solely on domestic interest-rate and stock-price levels and differentials, but need to consider (and influence, but how?) their important international permutations.

Central bankers tend to be elasticity optimists, but I have not been a central banker since 1963. In good times, it seems to me, borrowers tend to be insensitive to rising interest rates until they rise enough to create cash flow problems. Then default problems are generated, rendering it difficult to discriminate between the price and the credit-quality consequences of the higher rates. At high rates, lenders perceive higher credit risk and become more reluctant. This is consistent with the observation that, at the onset of recessions, the decline in other rates lags behind the peak in short rates which, ever since creation of the Federal Reserve, has tended to coincide with the business cycle peak (Figure 4). At and immediately after the upper business-cycle turning point, everyone knows that the economy and inflation will soon be declining, yet long-term and loan rates fall late and reluctantly. It must be because the financial sector is inhibited from responding to its improved incentives by its own capital and credit concerns. That is what I found for the pre-deregulation period, and nothing in the subsequent experience suggests any change.

How else to explain the curious result that subtracting a series coincident with the business cycle (short rates) from a lagging one (long rates), produces a leading indicator (the spread)?

In sum, the economic impact of an increase in official short rates is difficult to predict because so much depends on what happens to long rates and the reaction of the financial sector. To the extent that credit demand is inelastic, and large borrowers have hedged themselves against interest rate increases, large increases in rates will be needed to achieve restraint. Large rises in rates mean large drops in asset prices, which in turn render major defaults and serious recessions – and lender-of-last-resort interventions -- more likely.


The problems of assessing the thrust of monetary policy when the policy instrument is the short-term rate have led all central banks to seek a quantitative intermediate money or credit aggregate to target. However, the deregulation and innovation of recent years have rendered such targets largely useless. They are likely to remain so until there is a return to a more orderly (i.e., regulated) environment. Ironically the most ardent advocates of narrow (as opposed to broad) money definition and targeting also were the most ardent enthusiasts for deregulation -- which, step by step, has forced central banks to broaden the definition of money. This in turn has led back to more emphasis on targeting credit and, indeed, national income or price aggregates that are almost impossible for monetary policy to fine tune. In the US, M2, the principal monetary aggregate still being monitored, albeit perfunctorily, now includes eight components in addition to the currency, demand deposits, and travelers checks that defined the original M1 (Anderson et al 1997). None of these eight, it may be noted, are identical to any of the ten components that were added to M1 to arrive at M2 during 1982-1985.

Deregulation has made it more difficult for central banks to maintain control over the quantity of the means of payment as that is perceived by the public. In the financially advanced countries, we have become accustomed to take for granted that checks will be honored regardless of the institution on which they are drawn, and that the total quantity of money can and will be modulated so as to substantially preserve its purchasing power and maintain economic stability. We also assume that certain assets are immediately convertible into universally accepted means of payment at minimal risk and cost. But it is only reluctantly conceded, if at all, that accomplishing this requires a degree of governmental control over the relevant institutions.

Not everyone can be allowed to accept or create checking deposits and, in effect, to print money. The system has to be protected, just as people cannot hook up indiscriminately to the electricity grid, or dump in or draw on the water reservoirs. The club of institutions allowed access, which long consisted exclusively of commercial and central banks, is obliged to accept certain constraints that are costly. If others not subject to such constraints are allowed to mimic the privileges, they will be more profitable and better able to raise capital (Wojnilower 1991). The current tendency, perversely, is not only to let outsiders enjoy the benefits of the club without paying dues, but also, in the name of free markets, to take away from or charge the members for their special privileges such as direct access to central bank credit and payments facilities, governmental deposit insurance, and monopoly over the checking account business.

For the US, the rise of money market mutual funds is probably the most egregious example of this trend. Money market funds are not subject to reserve requirements and other expensive constraints imposed on banks. Nevertheless, they are allowed to offer "deposits" fixed in nominal value and subject to check. Although money market fund balances are not covered by deposit insurance, the public nevertheless assumes that prominent funds are as much within the governmental safety net as are banks falling into the too-large-to-fail category, since the systemic risk from a fund or a bank failure would be identical. (Perhaps even stock index funds are coming to be perceived as quasi-insured.) When outsiders over whom the central bank has no jurisdiction proliferate and flourish, how are the members of the club (the banks) to preserve their profitability, access to capital and, indeed, their lives, except by resigning? Yet the public continues to hold central banks and governments responsible for the integrity of the payments machinery and the currency, as well as for the maintenance of stable prosperity. That is a large order for central banks to accomplish solely through adjustments in the overnight interest rate.

The process illustrates a historical pattern. All societies have restricted the privilege of money creation, in olden times mainly to harvest seigniorage, today to protect the integrity of the payments system and to limit price level and business cycle fluctuation. The private sector tries to circumvent these restrictions by creating means of payment alternative to, or routinely convertible into the officially recognized money. Unless the authorities stamp out these alternatives, or at least refrain from supporting them in times of trouble, the innovations take root and become established. They become money, much as bank notes and deposits emerged as money in environments in which coins were the only officially recognized legal tender. If the authorities wish to maintain control over the quantity of money, they must somehow bring the innovations under their regulation. The worldwide broadening of money supply concepts in recent years displays this process, although the authorities may not fully appreciate the implications because there has been little occasion for severe monetary restraint. If when money is tightened, it is mainly the growth of the traditional component that is inhibited but not that of the newer alternatives (which not being "taxed" offer the higher returns), then eventually the traditional regulated sector will atrophy and only the free-riding newcomers survive.

One sometimes hears it argued that if the market were left unregulated without a governmental safety net, the need to preserve reputation would inhibit undue risk-taking by agents and intermediaries and make investors more cautious about where they place their funds. This is a curious reading of financial history. At best, perhaps some smaller crises would be self-correcting without severe systemic damage, but the large ones would be cataclysmic. Even small crises claim many innocent victims and, not least because they often threaten to become big ones, are politically intolerable.


With the growing size and scope of markets and transactions, the value of a good reputation is diminishing. No longer is it unusual to see bankrupt firms or countries raising large sums within a few years (sometimes months) after having defaulted. From the standpoint of the individuals who make the markets, the need for a good reputation to attract a steady stream of business is much reduced. Much as with athletic or entertainment stars in a global market, the rewards to be gained from a single major success (like one outstanding season or recording album) often suffice to make the performer rich for life. The temptations to bend ethical standards to score such a deal approach the irresistible.

Reflecting excesses by individual employees, several major institutions have recently incurred colossal losses (Aglietta 1996). Since the environment has been one of easy money and the victims were strongly capitalized, the firms involved did not default or could be absorbed by competitors who assumed their obligations. In times of tight money and wobbly stock markets, such events are much more systemically dangerous. That is when weak credits are forced to default even without fraud coming into play, and also when defensive fraud -- fraud for the sake of institutional and personal survival -- proliferates.

Economists and regulators stress the need to enforce prompt disclosure of honest information. That is all to the good, but why has the market not compelled firms to make such disclosure? Often investors don’t care: few people are thieves, but many or most don’t seem to mind doing business with thieves thought to be offering a bargain price. Disclosure does not matter as much as the will and authority of the police to inhibit unacceptable behavior.

So hungry are debt and equity investors these days to place their overflow of funds that credit standards and risk differentials have narrowed to the vanishing point. Huge loans are made on cursory investigation and documentation. The financial sector once again considers itself immune to supervisory restraint. Participants feel secure that political pressures and the great potential for calamity due to market interlinkages will bring prompt lender-of-last-resort support in case of trouble.

In a profound recent analysis, Joseph Bisignano emphasizes that "Technologies subject to increasing returns, which also includes financial intermediary structures, have the property that the resulting market configuration is unpredictable." (Bisignano 1997.) Increasing-returns industries are hard to keep competitive and prone to overexpand. In the financial sector, competitive overexpansion contributes to excessive credit growth and eventually financial-sector defaults that may necessitate lender-of-last-resort intervention.

It is not only the supply side of credit that tends to excess, but the demand side as well. Myopia, optimism, and inclination to gamble are hardwired into humanity and have proved highly resistant to legal and social efforts to contain them. In the financial markets the constraints on these propensities are fewer than elsewhere. As a result, quantities many times the GDP are traded daily. Speculation offers better odds than any other gambling of which I know, and is much more respectable to boot. There can be no doubt that, literally like narcotics, it attracts and creates many addicts. Together these form a crowd and sometimes a mob, albeit the crowd is "virtual", joined mainly by electronics rather than physical proximity. Individuals in crowds take "irrational" actions they would never elect on their own. And everyone knows that it is suicidally irrational to stand in the way of a mob.

There has been no good opportunity to retest my 1980 hypothesis as to the central role of credit crunches -- partly because of the stock crash of 1987 and the oil shock of 1990 and partly because world-wide upswings in aggregate demand have been infrequent. But even though credit crunches have not triggered a recession for a long time, disruptions in credit markets have continued to exert strong influence on business conditions. I remain convinced that liquidity "crunches" will occur again, most likely as a result of unexpected bankruptcies. With the regulatory restraints that used to serve as early "circuit breakers" abolished, the burden on lenders of last resort is greater. And with central banks no longer commanding a powerful club of "inside" institutions through which to respond to trouble, future financial embolisms will be more dangerous than the regulatory crunches of the past.


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