Behind Alan Greenspan's recession: the Federal Reserve Chairman's "attempt to head off recession through lower interest rates not only failed to prevent it, but actually slowed the economy's pace." - Economics - Statistical Data Included

USA Today (Society for the Advancement of Education), May, 2002 by Tim D. Kane

While short-term rates fell like a stone, long-term rates upon which capital investment depends declined little if at all. Aaa-rated corporate bonds dropped a half point, while 10-year bonds dipped initially before returning to their pre-December, 2000, levels. Unable to depress long-term rates, the Federal Reserve could not stimulate business investment in new capital equipment. Indeed, business fixed investment was lower in the third quarter of 2001 than it was before Greenspan moved to reduce rates. With the exception of a spurt of. new vehicle purchases, as consumers responded to manufacturers' 0% down incentives, consumer spending remained essentially flat.

Family finances

To understand why consumer spending was resistant to a 70% decline in short-term interest rates, let us examine the evidence on the wealth of American families, the impact of a deflating stock market, and family expenditure patterns. A review suggests that Greenspan's attempt to stimulate the economy through lower interest rates may have actually contributed to the onset of the recession. Data on the state of the American family's net worth is gathered every three years by the Board of Governors of the Federal Reserve System--Greenspan's turf.

A comparison of the state of family finances in 1995 to that in 1998, the latest year for which data is available, reveals that several ominous changes in family net worth were in progress well before the Fed's move to drive down interest rates. Between 1995 and 1998, the median value of the average family's net worth rose 17%, from $60,900 to $71,600. During this three-year period, the stock market, represented by the S&P Index of 500 common stocks, rose by more than 80%, from around 600 to the 1,100 range. In spite of the fact that 91% of all families had some financial assets, and over half of these financial assets were invested in stocks through a combination of personal holdings, mutual funds, and retirement accounts, the net worth of families with annual incomes below $25,000 fell by more than 20%. The net worth of families with incomes over $100,000 remained constant. Just two of the five income groups reported gains in their net worth between 1995 and 1998. The largest decline in net worth occurred in families headed by a person younger than 35. Contrary to Greenspan's now-famous quip that the American people were demonstrating an "irrational exuberance" in their love affair with stocks, the reality is that 46% of all families saw their net worth decline while the market soared!

The "wealth effect" refers to the observed tendency of people to spend more of their incomes in response to an increase in the value of their financial assets--even if their current incomes have not changed. It was this tendency that Greenspan called "irrational." Nevertheless, a reverse wealth effect was undoubtedly overshadowing spending decisions made by the 46% of families whose net worth was shrinking. These families were under increasing financial pressure well before Greenspan started to drive interest rates down, as evidenced by the fact that the percentage of their income required to service debt increased from 10.9% in 1995 to 12.7% in 1998. By then, eight percent of all families were more than 40 days past due in their obligations.