COMMENT
Fed's pugnacious policies hurt economies
By Henry C K Liu

Alan Greenspan, chairman of US Federal Reserve Board, may be patting himself on the back a bit prematurely and undeservedly by claiming that the Fed correctly focused policies on trying to mitigate probable damage after the eventual bursting of the bubble of stock market speculation rather than taking measures to prevent the bubble itself.

At a meeting of the American Economic Association in San Diego on January 3 of the new year, Greenspan spoke on "Risk and Uncertainty in Monetary Policy", in which he asserted that Fed policies had been correct and successful in handling the bubble economy. He defended himself against criticism, saying policymakers would have damaged the economy in the late 1990s had they tried to prevent or later puncture that era's speculative stock market bubble. He gave his personal view as a veteran from "the policy trenches". It is a very peculiar topic, one that would be expected from the risk manager of commercial bank or a hedge fund, not a central banker whose job presumably is to ensure systemic stability by eliminating rather than managing, and therefore accepting systemic risk.

Greenspan paid tribute to the 1979 tightening of monetary policy by the Federal Reserve under Paul Volcker for "ultimately breaking the back of price acceleration in the United States, ushering in a two-decade-long decline in inflation that eventually brought us to the current state of price stability".

"Price acceleration" is an economics term describing the worst kind of vicious cycle in which prices push up wages which in turn push up prices, with the process accelerating through anticipation eventually into hyperinflation, the killer of economies and political systems. Typical of a central banker, Greenspan did not bother to mention the cost, or pain, of such a tight monetary policy, only the benefits. Volcker ended inflation in the early 1980s by administering wholesale financial bloodletting on the US economy. The victory was by no means a free lunch. A case can be easily made that the cure was worse than the disease.

Nor did Greenspan mention his role in causing the 1987 crash. There are those with less selective memories who will recall that Greenspan precipitated the crash by raising the discount rate 50 basis points to 6 percent at a time of extreme interest-rate sensitivity, and pushed the fragile economy over the edge. Portfolio insurance has been identified as having exacerbating the crash. This hedging technique involves selling stock futures when stock prices fall in order to limit or insure a portfolio against large losses. This hedging practice gives index arbitrageurs the speculative opportunity to profit from lower future prices by buying futures in Chicago and selling on the stock market in New York, adding horrendous selling pressure to the market in any downward trend.

But that was only the speculative cause. The fundamental cause of the 1987 crash was the trend of corporations moving to debt from equity financing. Corporate new debt tripled in a decade, with debt service taking up 22 percent of internal cash flow by 1987. Total non-financial debt was 200 percent of gross domestic product (GDP) in 1987, compared with about 120 percent in 1977, the year of high inflation, which favored borrowers by making their loans less valuable at maturity. When inflation moderated, debtors were caught with loans the principal of which was worth more than had been anticipated at the time of borrowing during high inflation. Corporate credit ratings deteriorated as a result but the lending did not cease because ample funds could be raised in the deregulated non-bank credit markets through securitization and hedging with derivatives, causing the credit market to run away completely from Fed control.

1987 crash: Fed injects $12b in banking system
In the 1987 crash when the Dow Jones Industrial Average (DJIA) dropped 22.6 percent in one day (October 19) on volume of 608 million shares, six times the normal volume then (current normal daily volume is about 1.6 billion shares), the US Federal Reserve under its newly installed chairman, Alan Greenspan, with merely nine weeks in the powerful post, flooded the banking system with new reserves. He accomplished this by having the Fed Open Market Committee (FOMC) buy massive quantities of government securities from the market, and announced the next day that the Fed would "serve as liquidity to support the economic and financial system". He created US$12 billion of new bank reserves by buying up government securities. The $12 billion injection of high-power money in one day caused the Fed Funds rate to fall by three-quarters of a point and halted the financial panic, though it did not cure the financial problem.

If the government had been running a balanced budget in previous times and there were no government notes outstanding to be bought, the economy would have seized up, rather than merely falling into a recession. This shows that government deficits and sovereign debt are part and parcel of the modern financial architecture.

Greenspan built his reputation by his release of a single-sentence statement that said he would supply all the liquidity the banking system needed to stay afloat during the 1987 crash. He pumped billions of US dollars, a fiat currency that he could print at will, into US financial institutions by pushing down the overnight lending rate aggressively. Greenspan's move flooded financial markets with money, which helped preserve liquidity and restore confidence in the US financial system, but it started the bubble economy of the 1990s, which ended in Asia on July 2, 1997. Greenspan, in essence, did the same thing in 1998 and again after the terrorist attacks on September 11, 2001. Greenspan will go down in history as the central banker who revived moral hazard, a fatal virus in any banking system.

There is nothing wrong with deficit financing to keep the economy humming by smoothing out conventional business cycles. But providing liquidity to keep an undisciplined banking system afloat is another matter. It is an indulgence that the Fed itself has been criticizing the Bank of Japan (BOJ) for doing. The trouble is that the Fed under Greenspan thinks the banking system is the whole economy, or at least the part that really counts, and that the banking system should be or can be helped by risking the fundamentals of the economy. Greenspan is a permissive regulator who encourages systemic risk as an engine of growth by offering to bail out financial excesses that translate into unsustainable systemic risk.

Former president Ronald Reagan attacked the wrong target when he said that government does not make money, only the private sector does. Money is created only by government, which makes money through the issuance of sovereign credit to allow the money economy to operate. Banks, despite popular misconception, do not make money; they merely keep a percentage of the cash flow for their intermediary role, as a reward for channeling the money toward productive uses. When banks fail by indiscriminate lending to keep money productive, they deserve to be punished with losses. In fact, the health of the financial system depends on the fair punishment of wayward banks to avoid a moral hazard. It is a rule that the Fed under Greenspan seems to have forgotten.

One of the main causes of the 1987 crash as explained by tax economists was a threat by the House Ways & Means Committee to eliminate the tax deduction for interest expenses incurred in corporate takeovers. That explains the down side if one buys the theory, but it does not explain the volatility. The DJIA experienced its largest one-day percentage drop in history, 508 points or 22.61 percent, on October 19, 1987, which caused volume to surge to an unprecedented 604 million shares. The next day, volume reached 608 million shares.

Greenspan blames 'irrational exuberance', not US policy
Two decades later, Greenspan made his famous "irrational exuberance" speech at the Annual Dinner and Francis Boyer Lecture of the American Enterprise Institute for Public Policy Research in Washington, DC, on December 5, 1996, when the DJIA was at 6,437. On January 14, 2000, the DJIA peaked at 11,723, and on March 16, 2000, the DJIA experienced its largest one-day point gain in history - 499.19 points - to close at 10,630.60. On April 14, 2000, 22 trading days later, the DJIA plummeted 617.78 points, closing at 10,305.77 - its steepest point decline in a single day historically so far. This volatility came purely from speculative forces. The economy did not change in 22 trading days.

Experts note that each financial crisis is unique, which probably is true in detail. But there is one thing all financial crises have in common, and that is they are all caused by excesses. These experts also seek comfort in the observation that the identified excesses of past crashes have been dealt with through new regulatory measures, which is also undeniable. Yet financial crises have persistent common threads in that they tend to reappear as market participants find new ways to skirt existing regulations. These new ways are first hailed as benign innovations that cause more good than harm and are allowed to spread as a matter of technological imperative.

Regulators are put in a position of "if I don't smoke, someone else will." That has been the attitude of Greenspan on derivative trading by US banks. He argues in congressional testimony that regulating derivative trading would only force them offshore and the US economy would lose the benefit without reducing the risk. He takes the position that the Fed can act as a last-resort insurer to prevent a systemic meltdown, and he has since then done it several times. But financial crises seem to defy precise anticipation and their occurrence leaves serious structural damage even if total collapse is prevented. Thus the requirement of a conservative debt-to-equity ratio is needed to protect market participants from market misjudgment and the system from policy misjudgment by the Fed.

Yet the US system prospers by living on the edge through the maximization and socialization of risk, thus building-in failure or collapse that hurts not just the willing risk takers, but the general public that has been put into risky situations it cannot afford - by the sales talk of sophisticated risk management. Part of that sales talk has been coming from Greenspan at the Fed.

Greenspan went on to list Volcker's accomplishments: "The fall in inflation over this period has been global in scope, and arguably beyond the expectations of even the most optimistic inflation fighters. I have little doubt that an unrelenting focus of monetary policy on achieving price stability has been the principal contributor to disinflation. Indeed, the notion, advanced by Milton Friedman more than 30 years ago, that inflation is everywhere and always a monetary phenomenon is no longer a controversial proposition in the profession."

This is like saying if you close the window fresh air will not come into the room, without explaining why the window needs to be closed or acknowledging that fresh air is desirable. The controversy with Friedman's notion is not with the link between inflation and monetary policy, but with his definitions of inflation and monetary policy, outdated by fundamental changes in a globalized financial system. With flexible exchange rates of fiat currencies and with domestic inflation directly affected by the price of imports, monetary policy managed by interest rate policy translates into exchange rate conditions that affect inflation through the international exchange value of the dollar, which sets its purchasing power, which in turn defines domestic inflation rate.

Stock market 'recovery' in 2003 a fiction
Domestic inflation in the US, then, is masked by an inflated exchange value of the dollar in a globalized market, thus allowing the Fed to lower US interest rates, which will in time lower the exchange rate of the dollar, which will unmask domestic inflation. There is no escaping that truism. If the dollar continues to fall, US interest rates will have to rise compensatorily, or there will be a run on the dollar. In fact, long-term interest rates, which the Fed does not directly control, have begun to rise from market forces, regardless of the Fed's vow to keep short-term rates low for a long as possible.

The alleged "recovery" of the stock market in 2003 - with the DJIA rising by 25 percent from its low in March, the Nasdaq rising a phenomenal 50 percent, the S&P 500 rising 26 percent and the Russell 2000 rising 45 percent - is tempered by the dollar falling 20 percent against the euro, 10 percent against the yen despite BOJ intervention, and a whopping 34 percent against the Australian dollar on rising demand on gold, iron ore and other commodities produced there.

In the first trading session in 2004, Monday January 5, the yen fell to a three-year low of 106.07 yen, despite repeated intervention by Japanese authorities. It was down from 106.95 yen late on the last Friday of 2003. The Bank of Japan, acting on behalf of the Ministry of Finance, was estimated by traders to have bought US$3 billion to US$5 billion to stem the dollar's slide versus the Yen during Monday's intervention.

The key comforting mantra now is a benign "orderly decline" of the dollar, but the current market is famous for anything but orderly behavior. With Fed Funds rate at 1 percent and zero inflation or even real deflation, all debts are instruments of negative returns. Thus debt has become a drag on the economy by its depressing effect on profitability. Yet the zero inflation or worse, real deflation, that justifies low interest rates seems to be the cause of many problems in the economy, such as falling corporate profits caused by the lack of pricing power.

Corporate profit in 2003 came mostly from the effect of a falling dollar on non-dollar revenue of US corporations whose stock prices and dividend payouts are denominated in dollars. A look at commodity prices shows some interesting trends. The DJ-AIG Commodity Futures rose from 110.276 to 135.269 in 2003. Comex spot Gold rose from $347.6 to $415.7 per troy oz. Gold futures traded above $425 an ounce for the first time in more than 15 years in New York Monday, extending its watershed rally on the first trading day of 2004 as investors continued to diversify out of the beleaguered dollar. But Nymex crude future oil rose only from $31.20 to $32.52 in 2003 and #2 hard KC wheat rose hardly from $4.1525 to $4.1725 per bushel. Anyway these data are sliced, agriculture is heading for trouble and agriculture and oil are the only two sectors not experiencing inflation.

US economy far from getting out of the woods
From the look of things, the economy is a long way from getting out of the woods, which is why Greenspan's self congratulation is premature.

Be that as it may, Greenspan did balance his optimism with some caveats in his speech on January 3:

"But the size and geographic extent of the decline in inflation raises the question of whether other forces have been at work as well. I am increasingly of the view that, at a minimum, monetary policy in the last two decades has been operating in an environment particularly conducive to the pursuit of price stability. The principal features of this environment included (1) increased political support for stable prices, which was the consequence of, and reaction to, the unprecedented peacetime inflation in the 1970s, (2) globalization, which unleashed powerful new forces of competition, (3) an acceleration of productivity, which at least for a time held down cost pressures."

"After an almost uninterrupted stint of easing from the summer of 1984 through the spring of 1987, the Fed again began to lean against increasing inflationary pressures, which were in part the indirect result of rapidly rising stock prices. We had recognized the risk of an adverse reaction in a stock market that had recently experienced a steep run-up - indeed, we actively engaged in contingency planning against that possibility. In the event, the crash in October 1987 was far more traumatic than any of the possible scenarios we had identified. Previous planning was only marginally useful in that episode.

"We operated essentially in a crisis mode, responding with an immediate and massive injection of liquidity to help stabilize highly volatile financial markets. However, most of our stabilization efforts were directed at keeping the payments system functioning and markets open. The concern over the possible fallout on economic activity from so sharp a stock price decline kept us easing into early 1988. But the economy weathered that shock reasonably well, and our easing extended perhaps longer than hindsight has indicated was necessary."

"Of course, these new developments brought new challenges. In particular, the prospect that a necessary cyclical adjustment was now behind us fostered increasing levels of optimism, which were manifested in a fall in bond risk spreads and a rise in stock prices. The associated decline in the cost of equity capital further spurred already developing increases in capital investment and productivity growth, both of which broadened impressively in the latter part of the 1990s. The rise in structural productivity growth was not obvious in the official data on gross product per hour worked until later in the decade, but precursors had emerged earlier.

"The pickup in new bookings and order backlogs for high-tech capital goods in 1993 seemed incongruous given the sluggish economic environment at the time. Plant managers apparently were reacting to what they perceived to be elevated prospective rates of return on the newer technologies, a judgment that was confirmed as orders and profits continued to increase through 1994 and 1995. Moreover, even though hourly labor compensation and profit margins were rising, prices were being contained, implying increasing growth in output per hour. As a consequence of the improving trend in structural productivity growth that was apparent from 1995 forward, we at the Fed were able to be much more accommodative to the rise in economic growth than our past experiences would have deemed prudent."

"We were motivated, in part, by the view that the evident structural economic changes rendered suspect, at best, the prevailing notion in the early 1990s of an elevated and reasonably stable NAIRU (non-accelerating inflation rate of unemployment). Those views were reinforced as inflation continued to fall in the context of a declining unemployment rate that by 2000 had dipped below 4 percent in the United States for the first time in three decades. Notions that prevailed for a time in the 1970s and early 1980s that even high single-digit inflation did not measurably impede economic growth were gradually abandoned as the evidence of significant benefits of low inflation became increasingly persuasive. Moreover, the variance of GDP growth markedly lessened as inflation tumbled from its double-digit high in the early 1980s.

"To preserve these benefits, we engaged in our most recent preemptive tightening in early 1999 that brought the funds rate to 6-1/2 percent by May 2000. Our goal of price stability was achieved by most analysts' definition by mid-2003. Unstinting and largely preemptive efforts over two decades had finally paid off. Throughout the period, a key objective has been to ensure that our response to incipient changes in inflation was forceful enough. As John B Taylor [undersecretary for international affairs at the US Treasury Department] has emphasized, in the face of an incipient increase in inflation, nominal interest rates must move up more than one-for-one."

"Perhaps the greatest irony of the past decade is that the gradually unfolding success against inflation may well have contributed to the stock price bubble of the latter part of the 1990s. Looking back on those years, it is evident that technology-driven increases in productivity growth imparted significant upward momentum to expectations of earnings growth and, accordingly, to stock prices. At the same time, an environment of increasing macroeconomic stability reduced perceptions of risk.

"In any event, Fed policymakers were confronted with forces that none of us had previously encountered. Aside from the then-recent experience of Japan, only remote historical episodes gave us clues to the appropriate stance for policy under such conditions. The sharp rise in stock prices and their subsequent fall were, thus, an especial challenge to the Federal Reserve. It is far from obvious that bubbles, even if identified early, can be preempted at lower cost than a substantial economic contraction and possible financial destabilization - the very outcomes we would be seeking to avoid.

"In fact, our experience over the past two decades suggests that a moderate monetary tightening that deflates stock prices without substantial effect on economic activity has often been associated with subsequent increases in the level of stock prices. Arguably, markets that pass that type of stress test are presumed particularly resilient. The notion that a well-timed incremental tightening could have been calibrated to prevent the late 1990s bubble while preserving economic stability is almost surely an illusion."

US financial assets a bubble?
"The distinction between a bubble and reality can only be perceived after the bubble bursts. So the question is a conceptual dilemma.

"Some useful observations can be made about US financial assets at this juncture.

"US financial assets are built on debt. Debt is not intrinsically objectionable if it is properly collateralized by real assets. Yet as economists know, money is created whenever two parties enter into a mutual debt obligation (Hyman Minsky). The size of the invisible money pool created by financial derivatives is now many times (no one knows how many) the amount of M3. One firm alone, LTCM, commanded open positions of US$1.2 trillion financed by 100-fold leverage. That is the entire daily transactional value of the world's foreign exchange markets. Another hedge fund (Tiger Management) can suffer asset evaporation (loss) in the amount of US$20 billion in 6 hours by a 10 percent appreciation of a single currency (yen) against the USD.

"This invisible supply of virtual liquidity supports an artificial level of asset value very much detached from fundamentals, and the unbundling of their underlying open private contracts will inevitably cause drastic readjustments in asset prices in the formal markets.

"The securitization of debt blurs the all important dividing line between debtor and creditor, and allows an economy to borrow from itself, not just against its future, but against its current and less sophisticated debt. The collateralization of debt by more sophisticated debt has characteristics of a bubble. The broad dis-aggregation of risk to maximize transactional surplus (profit) ultimately leads to the socialization of risk (transferring it into systemic) while the privatization of profit (in the name of capital formation) remains a sacred prerequisite. Under the accounting rules of capitalism, capital cannot exist until ownership is specifically assigned. T

"Thus socialization of capital is a self contradiction in terms and must stay off the balance sheets of the system. To own assets, even the government must act as if it is a corporation, i.e. a "person". Public pension fund assets and other forms of collectively owned assets must have the governing characteristics of "private" capital in order to participate in the US economic system. Such assets enjoy no prerogative to invest negatively for the common good because the ultimate definition of the common good is profit.

"This formula will lead to the hollowing of the center - a classic definition of a bubble. Whether or when the bubble will burst depends on government's ability to extend its elasticity which is not unlimited. To support the market, government needs more power and intervention which in turn destroys the market. As is already apparent, the Federal Reserve is reduced to an irrelevant role of explaining the economy rather than directing it. With every passing month, Greenspan sounds more like a lecturer in Econ 101 rather than the central banker of the world's biggest economy. Another characteristic of a bubble is that no one inside can escape without bursting it or for that matter has any incentive to. Except that the laws of physics are generally not forgiving. Bubbles will burst by their very nature. [end of post]

"During 2001, in the aftermath of the bursting of the bubble and the acts of terrorism in September 2001, the federal funds rate was lowered 4-3/4 percentage points. Subsequently, another 75 basis points were pared, bringing the rate by June 2003 to its current 1 percent, the lowest level in 45 years. We were able to be unusually aggressive in the initial stages of the recession of 2001 because both inflation and inflation expectations were low and stable.

"We thought we needed to be, and could be, forceful in 2002 and 2003 as well because, with demand weak, inflation risks had become two-sided for the first time in forty years. There appears to be enough evidence, at least tentatively, to conclude that our strategy of addressing the bubble's consequences rather than the bubble itself has been successful. Despite the stock market plunge, terrorist attacks, corporate scandals, and wars in Afghanistan and Iraq, we experienced an exceptionally mild recession - even milder than that of a decade earlier. As I discuss later, much of the ability of the U.S. economy to absorb these sequences of shocks resulted from notably improved structural flexibility. But highly aggressive monetary ease was doubtless also a significant contributor to stability."

"The Federal Reserve's experiences over the past two decades make it clear that uncertainty is not just a pervasive feature of the monetary policy landscape; it is the defining characteristic of that landscape...As a consequence, the conduct of monetary policy in the US has come to involve, at its core, crucial elements of risk management. This conceptual framework emphasizes understanding as much as possible the many sources of risk and uncertainty that policymakers face, quantifying those risks when possible, and assessing the costs associated with each of the risks ...

"However, despite extensive efforts to capture and quantify what we perceive as the key macroeconomic relationships, our knowledge about many of the important linkages is far from complete and, in all likelihood, will always remain so. Every model, no matter how detailed or how well designed, conceptually and empirically, is a vastly simplified representation of the world that we experience with all its intricacies on a day-to-day basis...A year ago, these considerations inclined Federal Reserve policymakers toward an easier stance of policy aimed at limiting the risk of deflation even though baseline forecasts from most conventional models at that time did not project deflation; that is, we chose a policy that, in a world of perfect certainty, would have been judged to be too loose.

"As this episode illustrates, policy practitioners operating under a risk-management paradigm may, at times, be led to undertake actions intended to provide insurance against especially adverse outcomes. Following the Russian debt default in the autumn of 1998, for example, the FOMC eased policy despite our perception that the economy was expanding at a satisfactory pace and that, even without a policy initiative, it was likely to continue doing so. We eased policy because we were concerned about the low-probability risk that the default might trigger events that would severely disrupt domestic and international financial markets, with outsized adverse feedback to the performance of the U.S. economy...

"The 1998 liquidity crisis and the crises associated with the stock market crash of 1987 and the terrorism of September 2001 prompted the type of massive ease that has been the historic mandate of a central bank. Such crises are precipitated by the efforts of market participants to convert illiquid assets into cash....In the crisis that emerged in the autumn of 1998, pressures extended beyond equity markets. Credit-risk spreads widened materially and investors put a particularly high value on liquidity, as evidenced by the extraordinarily wide yield gaps that emerged between on-the-run and off-the-run U.S. Treasuries....

"No simple rule could possibly describe the policy action to be taken in every contingency and thus provide a satisfactory substitute for an approach based on the principles of risk management....Our problem is not, as is sometimes alleged, the complexity of our policymaking process, but the far greater complexity of a world economy whose underlying linkages appear to be continuously evolving."

"Under the rubric of risk management are a number of specific issues that we at the Fed had to address over the past decade and a half and that will likely resurface to confront future monetary policymakers. Most prominent is the appropriate role of asset prices in policy. In addition to the narrower issue of product price stability, asset prices will remain high on the research agenda of central banks for years to come. As the ratios of gross liabilities and gross assets to GDP continue to rise, owing to expanding domestic and international financial intermediation, the visibility of asset prices relative to product prices will itself rise. There is little dispute that the prices of stocks, bonds, homes, real estate, and exchange rates affect GDP. But most central banks have chosen, at least to date, not to view asset prices as targets of policy, but as economic variables to be considered through the prism of the policy's ultimate objective."