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In this week’s Big Interview with the WSJ Alan Greenspan lashed out at his critics.  Dr. Greenspan also gave his latest economic prognosis saying the economy is improving, the wealth effect is positively contributing to the economy and that inflation will become a risk down the line.

Unfortunately, not 3 minutes into the interview, the former Fed Chief proves that he still has no idea how our monetary system actually works.  When asked if inflation is a problem he responds by saying:

“Down the road most certainly.  Unless we reign in the extraordinary amount of excess reserves in the monetary system which is what the Fed will be doing when it has to do that”

These are extraordinary comments from someone who ran the US central bank for 18 years.  The most important myth that has been busted in the last 24 months is the myth of the money multiplier.  Despite a dramatic expansion of reserves via the Fed’s operations over the course of the last few years we have seen no pick-up in lending.  Greenspan has long worked under a false premise so it’s not surprising that the US economy has the structural flaws that it currently has.  He believes an expansion of the monetary base should lead directly to an expansion of the money supply.  This is the same theory that most hyperinflationists have been working under for the last few years and it explains why their forecasts have been so far off the mark.  Greenspan is clearly still working under this flawed model.

As the Fed itself recently explained, the money multiplier is a myth.  Not only do banks not lend their reserves, but they only lend when there is demand for loans.  Loans create deposits.  Bank must have willing and creditworthy borrowers walk into their offices before any increase in the money supply can take place.  It takes two to borrow.  Dr. Greenspan clearly believes these excess reserves create some huge inflation risk down the line as the banks will just fire them out of their doors to the endless line of borrowers (which doesn’t currently exist).  Nothing could be farther from the truth.

Greenspan thinks these excess reserves now pose some risk to the banking system.  Despite acknowledging that the Fed is paying interest on excess reserves he still says the Fed has to remove these reserves.  These comments are extraordinarily wrong.  The fact that the Fed is now paying IOER means that they do not have to remove the reserves. Janet Yellen explained this just yesterday:

“In contrast, I disagree with the notion that the large quantity of reserves resulting from our asset purchases poses some special barrier to removing policy stimulus when the right time comes. The FOMC will be able to increase short-term rates by raising the interest rate that we pay on excess reserves–currently 1/4 percent. That ability will allow us to manage short-term interest rates effectively and thus to tighten policy when needed, even if bank reserves remain high.”

So you can see that Yellen could provide the old Fed Chief with a tip or two on how things actually work.

Much of the rest of the interview is spent fear mongering about a bubble in the bond market and its inevitable collapse:

“I think that the type of budget agreement that was put together by Alan Simpson and Erskine Bowles is the type of budget that will be passed by Congress…The only question is, will it be before or after the bond-market crisis.”

Of course, this isn’t the first time in the last few years that Dr. Greenspan has expressed his fears over the bond vigilantes.  Dr. Greenspan has long been concerned that the high US government debt levels are going to cause a Greek-like implosion in the USA.  This is another glaring example of his lack of understanding when it comes to the monetary system, but I’ve just recently covered this hysteria so there is no reason to rehash the discussion (see here if interested).

Dr. Greenspan says his legacy should not be viewed negatively and that his critics have not proven him wrong.  No sir Dr. Greenspan.  No one has to prove you wrong.  Your legacies of deregulation, a financialized US economy and the Greenspan put have spoken for themselves by helping to cause the world’s largest and most productive economy to suffer more than a decade of malaise, 10’s of millions unemployed and a near collapse of the entire system.

Source: WSJ

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