The Daily Reckoning
Baltimore, Maryland
Wednesday, December 14, 2005
The Daily Reckoning PRESENTS: As Alan Greenspan’s reign as Fed Chairman gets closer to its end, people all over the press are either singing his praises or denouncing his practices. Today, Dr. Richebächer takes a look at the maestro’s policies and theories...THE TRUE GREENSPAN LEGACYby Dr. Kurt Richebächer
SourceReading so many ecstatic laudations on Fed Chairman Alan Greenspan, “the greatest of all central bankers,” two other names and occurrences came to mind. The one was John Law and his tremendous wealth creation through rigorously inflating the share prices of the Mississippi Company. And the other was former Fed chief Paul Volcker and his recent article in the Washington Post titled “An Economy On Thin Ice,” wherein he expressed his desperation about the economic and financial development in the United States. Though he never mentioned his successor’s name, it was all about him and his policies.
Just a few samples from Paul Volcker’s assessment:
Under the placid surface, there are disturbing trends: huge imbalances, disequilibria, risks - call them what you will. Altogether, the circumstances seem to me as dangerous and intractable as any I can remember, and I can remember quite a lot. What really concerns me is that there seems to be so little willingness or capacity to do much about it...
I don’t know whether change will come with a bang or a whimper, whether sooner or later. But as things stand, it is more likely than not that it will be financial crises rather than policy foresight that will force the change.
Alan Greenspan: The Conventional Great Merits of Mr. GreenspanWhat, after all, are the great merits of Mr. Greenspan, according to the conventional laudations? They are, actually, seen in two different fields: first, in the striking successes of his actual policies; and second, in notable contributions to both the theory and practice of monetary policy.
His policy successes seem, indeed, all too conspicuous: lower inflation rates than expected despite strong GDP growth; high gains in job growth; and low rates of unemployment. And yet only two mild recessions, of which the second one, in 2001, was so mild that it disappears when quarterly data are aggregated to a year.
His extraordinary successes are generally attributed to radically new practices in monetary policy. The Financial Times ran a full-page article under the big headline “Greenspan’s Record: An Activist Unafraid to Depart From the Rule.”
To quote the paper presented by Alan S. Blinder and Ricardo Reis of Princeton University at the Federal Reserve Bank of Kansas City symposium on this point: “Federal Reserve policy under his chairmanship has been characterized by the exercise of pure, period-by-period discretion, with minimal strategic constraints of any kind, maximal tactical flexibility at all times and not much in the way of explanations.”
It is true Maestro Greenspan disregarded any established rules in central banking. To escape the consequences of the equity bubble that he created in the late 1990s, he generated a whole variety of new bubbles that radically changed the U.S. economy’s growth pattern. What he achieved was the greatest inflation in asset prices in history, which became the economy’s new engine of growth. What about its inevitable aftermath?
Alan Greenspan: The Only RuleIf Alan Greenspan jettisoned all inherited rules, he nevertheless chose one predominant rule, actually, his only rule: a strictly asymmetric policy pattern. Every central bank has two policy levers at its disposal. The big lever is changing bank reserves, the banking system’s liquidity base. The little lever consists in altering its short-term interest rate.
Whenever monetary easing appeared opportune, Mr. Greenspan has acted rigorously with both levers. When it seemed to require some tightening, he always acted hesitantly and only with his little interest lever. He has never seriously tightened bank reserves. Though hard to believe, he has actually been easing the Fed’s reserve stance since last May.
This is most probably occurring because the continuous rampant credit expansion is increasing the banking system’s reserve requirements. Nevertheless, to keep the federal funds rate at its targeted level of 4%, the Fed has to provide the higher reserves.
What this means should be clear: The Fed is anxious to avoid any true monetary tightening in the apparent hope that the “measured” rate hikes will softly do the job over time, causing less pain. Most probably, though, this implies more rate hikes and more pain - later.
It was, as a matter of fact, precisely the same kind of experience that induced Volcker to abandon such strict funds rate targeting in October 1979 in favor of targeting bank reserves. It marked the fundamental divide in U.S. monetary policy from prior persistent monetary looseness and a strong inflation bias to genuine credit tightening, ushering in a secular decline in the inflation rates.
The Greenspan Fed has returned to dubious interest targeting, while explicitly restricting itself to “measured” - in other words, very slow - rate hikes. The true monetary ease shows in the continuance of the relentless credit deluge.
When Alan Greenspan took over as Fed chairman in 1987, outstanding U.S. debts totaled $10.57 trillion. According to the latest available data, they stand at $37.35 trillion. This is definitely Mr. Greenspan’s most conspicuous achievement.
To escape the aftermath of the equity bubble, the Fed created the housing and bond bubbles in 2001 and the following years. It is time, we think, to ponder the aftermath of these two asset and credit bubbles. The inverting yield curve is primarily threatening the huge existing carry-trade bubble in bonds. But the big housing bubble and the smaller car bubble too have plainly peaked. Rising interest rates and poor income growth are relentlessly taking their toll.
It should be immediately clear that the potential economic and financial aftermath of a bust of these bubbles will be many times worse than the potential aftermath of the earlier equity bubble. Spending and debt excesses have multiplied over the past four to five years to an extent that threatens the stability of the whole U.S. financial system.
Lately, Mr. Greenspan’s public speeches have insinuated that the high asset prices in the United States in recent years may, ironically, be due to the extraordinary success of his policies, by leading investors to demand lower risk premiums. Eventually, however, this reverses and asset prices fall reflecting “the all-too-evident alternation and infectious bouts of human euphoria and distress and the instability they engender.”
Alan Greenspan: Complete SilenceYet he emphasized that it is “simply not realistic” to expect the Fed to identify and safely deflate asset bubbles. The right response in his view is for all policymakers to keep markets as flexible and unregulated as possible. Flexible markets, he said, helped absorb recent shocks, such as stock-bubble collapse and the Sept. 11, 2001, terrorist attack.
We are not sure what shocked us more, this senseless, arrogant remark or the complete silence on the part of American economists. Exuberance, just by itself, is unable to inflate asset price levels. The indispensable primary condition is always credit excess, and Mr. Greenspan delivered that in unprecedented profligacy. By the nature of things, loose money and credit excess lead, and exuberance follows.
America’s reported economic recovery since 2001 has been its weakest by far in the whole postwar period. For the working population, there never was a recovery. They speak euphemistically of a shortfall of employment and income growth. It is better described as a fiasco for both.
Two acute dangers presently lurk in the U.S. economy and its financial system. One is the inverting yield curve threatening to pull the rug out from under the huge carry-trade bubble in bonds, and thereby from under the housing bubble. The other is the slump in consumer spending. Consumer borrowing is slowing, while employment and labor income growth are weakening again.
It seems that the carry-trade community is betting on prompt rate cuts by the Fed if something goes wrong in the economy or the financial system. We suspect that the Fed, grossly underestimating the enormous vulnerabilities in both sectors, will stick to its rate hikes. The interest “conundrum” is pretty much the only thing holding up this house of cards.
“Super-liquid markets” has become the common bullish catchphrase. It should be realized, however, that the existing liquidity deluge in the United States and some other countries has its sole source in the monstrous asset bubbles providing the collateral for virtually limitless borrowing. It needs a sharp distinction between earned liquidity from saving and borrowed liquidity accrued from asset bubbles. The latter kind of liquidity can vanish overnight.
The sharp surge in inflation rates is forcing the Fed to continual rate hikes. Doing so, it takes enormous risks with the existing bubbles. Bluntly put, it has lost control.
Regards,
Dr. Kurt Richebächer
for The Daily Reckoning