In No Inflation? Look Again, George Reisman and Bob Klein clarify the concept of inflation. They point out that while Greenspan made some valid observations about the boom in the ‘90s, he failed to recognize that neither the optimism nor the rising asset prices would have been possible without the Federal Reserve creating large amounts of new money during this period.
While the Federal Reserve’s main intent is not to create a rising stock market, it is usually an inevitable outcome of its easy-money policy. From 1994 to 1999, the Federal Reserve expanded the money supply about 60% which led to a boom in stock prices.
In Greenspan’s article, Gold and Economic Freedom, he describes how the same process worked in the late 20s. Greenspan highlights how the Federal Reverse tried to lower interest rates by inducing a surplus of reserves into the banking system, thus triggering a boom in the stock market and the economy. However, when the Federal Reserve later tightened in an attempt to rein in the boom, it led to a crash in the market.
The boom in the late 90s was restricted to a rise in stock and real-estate prices. Most of the money during this time was spent on Wall Street rather than Main Street. Due to this, there was less concern, since most people assumed that a rise in stock prices was indicative of a healthy economy.
Whether it is the 20s, 90s, or today, when easy-money policies induce stock prices to rise, over time, prices will also rise in throughout of the economy. This should happen as long as there is no interceding implosion in the economy or in stock prices. As people’s portfolios increase in value, people will be more likely to spend their savings, exhibiting the wealth effect.
George Reisman and Bob Klein explain when stock prices are high, you will often find businesses taking advantage of these high stock valuations by selling equity or borrowing against the rising market value of their existing equity. In this fashion, the money that these companies spend moves from the stock market to the rest of the economy.
A rising stock market makes it easier for businesses to obtain funds. This makes it possible for businesses to undertake new projects, that may not have been possible otherwise.
According to George Reisman and Bob Klein, the stock market acts as a transmission belt where the newly-created money pushes up prices throughout the economic system. When this happens, the Federal Reserve will forcefully restrict the money supply which will then raise short-term interest rates and in turn, can create downward pressure on stock prices.
While critics will tend to blame bankers for the fall in the market, the cause is often the Federal Reserve’s easy-money policy.
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