Aggregate Demand Bubbles and the Federal Reserve

May 30, 2012


Central banks are bubble blowers that use the inevitable bust to justify their existence.

Any academic study that starts off with “the Federal Reserve has a long history of creating aggregate demand bubbles in the United States (Niskanen 2003, 2006)” is going to be good. Steve Hanke, Professor at Johns Hopkins University, does not disappoint in “Monetary Misjudgments and Malfeasance.”

“Just what is an aggregate demand bubble? This type of bubble is created when the Fed’s laxity allows aggregate demand to grow too rapidly. Specifically, an aggregate demand bubble occurs when nominal final sales to U.S. purchasers (GDP + imports – exports – change in inventories) exceed a trend rate of nominal growth consistent with “moderate” inflation by a significant amount.”

Note: Ray Dalio says the long term trend rate of the US GDP is 2%, so add in inflation of say 2% and you get close to Hanke’s long term stable trend rate. image

In 2003, Greenspan hummed a familiar tune: “We face new challenges in maintaining price stability, specifically to prevent inflation from falling too low” (Greenspan 2003). “To fight the alleged deflation threat, the Fed pushed interest rates down sharply. By July 2003, the Fed funds rate was at a then-record low of 1 percent, where it stayed for a year.”

This lead to the creation of an aggregate demand bubble in the form of housing prices and commodity price appreciation.

“My estimates of the depreciating dollar’s contribution to surging commodity prices over the 2002–July 2008 period was 51 percent for crude oil and 55.5 percent for rough rice, two commodities that set record-high prices (nominal) in July 2008 (Hanke 2008).”


The dollar plunged, but “Chairman Bernanke has seen fit to ignore fluctuations in the value of the dollar. Indeed, changes in the dollar’s exchange value do not appear as one of the six metrics on “Bernanke’s Dashboard”—the one the chairman uses to gauge the appropriateness of monetary policy (Wessel 2009: 271).”

I would dispute this, Bernanke’s has spoken favorably of currency devaluations. Where he goes wrong is focusing on the short term boom, while ignoring the long term, inevitable, bust. 

For central bankers, the “name of the game” is to blame someone else for the world’s economic and financial troubles (Bernanke 2010, Greenspan 2010).  To understand why this is successful:

“Milton Friedman has pointed out that one of the basic reasons for the good press the Federal Reserve Board has had for  many years has been that the Federal Reserve Board is the source of 98 percent of all writing on the Federal Reserve Board. Most government agencies have this characteristic.”

This has even been studied. “In 2002, 74 percent of the articles on monetary policy published by U.S. economists in U.S.-edited journals appeared in Fed-sponsored publications, or were authored (or co-authored) by Fed staff economists (White 2005, Grim 2009).”

In summary: “The Fed has a propensity to create aggregate demand bubbles. These bubbles carry with them market-specific bubbles that distort relative prices and the structure of production. Contrary to the assertions of the stabilizers who embrace inflation targeting, these relative price distortions are potentially dangerous and disruptive.”

Monetary Misjudgments and Malfeasance

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