Irenic. Adj: favoring, conducive to, or operating toward peace, moderation, or conciliation. Notes from a Politics and Economics undergraduate just back from somewhere in the MidWest. "You said you were going to Ohio? Where the Hell's that?"

Monday, October 6, 2008

Did the Millennium Bug help cause the Credit Crunch?

The view that the Credit Crunch is all a bit hyped up, like Bird Flu and the "Millennium Bug", is common at the moment, not least in the US House of Representatives. But the FT's John Authers, writing in Saturday's "Long View" column makes a substantive link between Y2K and the current financial crisis:

Other long-ago technical decisions now loom large. When computers were in their infancy, programmers saved space by feeding only the last two digits of the year into computers’ clocks; that prompted widespread fear that the world’s computer infrastructure would collapse at the turn of the millennium; that prompted the Federal Reserve and other central banks to flood the market with cheap money, just in case; that fuelled the boom and bust in technology stocks; that prompted fears of a downturn and led to even cheaper money from the Fed; and that made all kinds of manoeuvrings in the credit market possible that would not have made sense had base rates been higher. We are learning about the consequences of that one too.

Is this really true? Did the Fed systematically lower interest rates for fear of a worldwide meltdown should PCs fail to wake up at 00:00 on 01/01/00?

It certainly makes sense that fears about Y2K could have led to a liquidity crisis. Worries about cash machines not working on January 1st led deposit banks to fear mass withdrawals at the end of 1999. Companies may have had similar fears and could have been reluctant to buy other corporations' short term commercial paper, especially if it came due at the turn of the millennium. In a bid to have cash on hand to satisfy both retail and corporate customers, banks may have sought to exchange illiquid, long term securities for shorter term government bonds.

Such fears are nothing out of the ordinary. Indeed, a very similar set of concerns is responsible for the subzero conditions in the money markets at the present moment. However, the evidence suggests the Fed's policy in 99/00 was well off-trend. This graph shows the growth in the monetary base since 1985:

Source: Von Mises' Institute (

You can clearly see a sharp rise in the growth of the monetary base in 1999 and a correspondingly sharp contraction in the year 2000. That is to say, the Fed lowered rates and then returned them to almost exactly their pre-Y2K fear levels. Indeed, target levels were actually rising throughout the period. If Authers is right, what central bankers thought was a surgical intervention to allay a specific concern clearly had an unintended consequence, for which only now are we paying. If nothing else, this suggests using monetary policy in such a way is fraught with danger.

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