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     Oct 28, '13

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Greenspan in dreamland
Commentary and weekly watch by Doug Noland

This from the Wall St Journal's Alexandra Wolfe on October 18: "[Former Federal Reserve chairman Alan Greenspan] said he is baffled by all the blame that has been piled on him. Since the recession, critics have said the increased money supply and low interest rates during his tenure at the Fed from 1987 to 2006 led to bubble investments. Mr Greenspan first heard that theory, he says, in 2007, when John Taylor, a professor of economics at Stanford University who has advised Republicans, made the connection between easy money and the housing bubble. 'It had absolutely nothing to do with the housing bubble,' [Greenspan] says. 'That's ridiculous.'" bubble "As they say, 'You just can't

make this stuff up'." Doug Noland, October 25, 2013
All of us go back for a long way, always understood that there's a lot of irrational exuberance and fear and all of those various aspects of human nature affecting the GDP and the market and everything else. But we all assumed, and in fact it's almost general, that those were random and that they would essentially wash out. And therefore you could set up your econometric models - or any model you want - looking only at the effects of people acting rationally in their long-term self-interest. And that was a general proposition - and that is what they were teaching in the universities. And that's basically what economics was all about going all the way back into the last two centuries ago.

We missed the timing badly on September 15, 2008. All of us knew that there was a bubble. But a bubble in and of itself doesn't give you a crisis. In the dot.com crisis, so to speak, the stock market collapsed, asset prices collapsed, there were huge losses - you can barely see it in the GDP. A date I will always remember, October 19, 1987: the Dow went down 22% in one day, by far the record of all time. I thought we were going to run into all sorts of problems. Nothing happened. To be sure, it was touch and go for awhile and the Fed opened up the spigots. But you can't see it in the GDP figures.

So bubbles, per say, are not what the issue is. It's turning out to be bubbles with leverage. And leverage is critically important. Obviously, it's the only way you can get the issue of contagion going. The bottom line is this, I said to myself when I saw what happened on September 15th [2008], that there's something fundamentally wrong with the way I and a lot of my colleagues look at the economy. So I tried to go on with what looked so much to me like a detective story, trying to unwind layer by layer. And the first layer I tried to unwind was the fundamental premise of everyone looking out for their own long-term self-interest." Alan Greenspan, October 24, 2013, CNBC.

I've been on my own little "detective story" for a while now. When I began my weekly chronicle of the credit bubble back in 1999, I argued that tech stocks were not THE bubble but instead only a primary consequence of what was the latest bout of mispriced finance and credit and speculative excess.

Why did the "dot.com crisis" have such minimal impact that one could "barely see it in the GDP"? Well, it's certainly worth recalling that GSE [government-sponsored enterprises such as Fannie Mae and Freddie Mac] securities (debt and mortgage-backed securities) increased US$431 billion in 2000, $642 billion in 2001 and another $547 billion in 2002, an unprecedented $1.62 billion three-year credit distortion that worked wonders - for a while.

The Fed slashed rates from 6.5% in December 2000 to 1.75% by December 2001 (to the low of 1% in June 2003). Total domestic financial sector borrowings expanded 10.7% in 2000, 10.6% in 2001, 9.6% in 2002 and 10.7% in 2003. Powerful inflationary biases throughout mortgage finance and housing provided the Fed significant capacity to readily reflate system credit.

Total non-financial system credit growth slowed only modestly after the tech bust, from 1999's 6.2% to 2000's 5.0%. Importantly, Total non-financial credit accelerated to a 6.4% rate during 2001, 7.4% in 2002 and 8.0% in 2003. This growth was primarily driven by household mortgage borrowings which expanded 8.7% in 2000, 10.6% in 2001 and 11.8% in 2002.

I began warning of the unfolding mortgage finance bubble back in 2002. It is worth noting that total mortgage debt expanded a then record $708 billion in 2001 and $901 billion in 2002, compared to average annual growth of $265 billion during the '90s. These numbers come directly from Fed data.

Mr Greenspan's recent epiphanies notwithstanding, there was never a mystery surrounding post-tech bubble economic resilience. The Fed and GSEs combined to ensure extremely loose mortgage finance, which provided a powerful backstop for leveraged speculation. This supported total system credit growth, asset price inflation and overall spending. It's worth noting that household net worth actually posted a small advance in 2000, with inflating house and bond values more than offsetting equity market losses.

And while we're on the subject, the Fed's opening of the liquidity spigot after the '87 crash ensured a continuation of booming late-'80s ("decade of greed") credit growth and asset inflation. The credit system and economy were demonstrating strong inflationary biases, a dynamic only exacerbated by the Greenspan Fed's post-crash reflationary measures. Total non-financial debt growth expanded 9.1% in 1987 and 9.1% in 1988, while household net worth increased in both '87 and '88.

I have previously noted a fascinating anomaly of credit bubbles: generally, the more conspicuous the effects the less systemic the financial and economic distortions. The price inflation of a narrow group of stocks during 1999 was spectacular, but that bout of excess was relatively contained to one segment of the economy.

Mr Greenspan these days makes a distinction: "Bubbles, per say, are not what the issue is. It's turning out to be bubbles with leverage." As a long-time analyst of credit and bubbles, I take strong exception with this analysis. The critical issue is to distinguish between the consequences of bubble excess and the much more important issue of the underlying credit, policy and speculative dynamics fueling the asset inflation. Understanding the driving forces behind the over-expansion of mispriced finance - the factors responsible for misperceptions and distortions in the marketplace - is absolutely fundamental.

Especially during the '70s, there was a major push within the economic community to raise the "dismal science" to a higher "hard" science status, incorporating sophisticated statistical analysis and econometric modeling. If this wasn't problematic enough, there was another historic development about to really complicate the matter: contemporary finance began transforming from the traditional bank-centric form to a non-bank, market-based credit (securitizations, GSEs, "repo"/securities finance, derivatives, hedge funds and "Wall Street finance") dynamic. Ironically, no one individual had more influence on this epic change than the accommodative chairman Greenspan.

I guess it took the 2008 crisis for economists to finally acknowledge that their models might be deeply flawed, though one would have thought the previous 20-years (plus) of serial global booms and busts would have raised some concerns.

I have argued that we've been witnessing a unique period in history: for the first time, during recent decades there have seen no constraints on either the quality or quantity of credit issued on a global basis. No one should expect that unlimited cheap credit would prove conducive to system stability, and we're now privy to sufficient history to be certain it's not. All along the way, policymakers have seemed to go out of their way to avoid learning lessons.

US and global finance were going through epic changes. Meanwhile, policymakers and the economics community stuck their heads in the sand, clinging steadfastly to their outdated old models and analytical frameworks. Greenspan became a vocal proponent for derivatives and Wall Street risk intermediation. He also used the rapidly expanding global leveraged speculating community as the most powerful monetary policy transmission mechanism ever (spur risk-taking and "wealth creation" with a mere hint of a 25bps rate cut!).

And with Greenspan (along with the GSEs) backstopping the markets, the bubbling derivatives marketplace could mushroom to hundreds of trillions on the specious assumption of "continuous and liquid markets". Opportunistic hedge fund managers could incorporate enormous leverage on (Fed-assured) high probability bets - and become billionaires.

Greenspan (above) noted the traditional assumption that "irrational exuberance and fear... were random and that they would essentially wash out." Well, in this New Age of unfettered cheap global finance and central bank market backstops, exuberance became the perfectly rational response for investor and speculator alike. Speculative leveraging blossomed like never before, and I would argue that market perceptions became dominated by the "Greenspan put" and the general perception that central banks would not tolerate market crisis (as was demonstrated repeatedly).

The greater the bubble in market-based credit and asset prices, the greater was market confidence that central bankers would steadfastly support the markets. Why would we expect anyone to act in their "long-term self-interest" when the monetary backdrop was ripe for incredible fortunes to be accumulated in the short-term?

In such a backdrop - replete with historic market distortions, speculative excess and financial leveraging - one can simply toss the old models and notions of "normal distributions" right out the window. At the end of the day, it's a "fat tail" world. The proliferation of flawed models with faulty assumptions of "normal distributions" and "normal" Fed market support ensure extraordinary excess with abnormally bad outcomes. This issue is when.

To be sure, financial speculation won the day; asset bubbles inflated worldwide across major asset classes; the Fed and BOJ combined for $160 billion of QE a month; European Central Bank president Mario Draghi backstopped European debt; the Chinese perpetrated their own historic credit bubble; and everyone was forced to jump on board in the greatest financial bubble in the history of mankind.

Greenspan and others focus generally on "leverage", "too big to fail" banks and the money-market fund complex - in a classic "fighting the last war". The key issue today is similar to the root cause of previous system fragilities, except it is just on a much greater global systemic scale: mispriced finance.

The big banks and their speculative holdings are an important issue. Yet I worry much more about a global leveraged speculating community employing leverage across various asset classes on a worldwide basis. I worry about the ongoing proliferation of derivative strategies and the recent bout of "structured products" which generally incorporate leverage. I fret that the perception of cheap derivative market "insurance" once again emboldens aggressive leveraging and risk-taking. I think I see speculative leveraging about everywhere I look.

I have argued that today's bubble is by far the most dangerous yet (the "granddaddy"). Unprecedented concerted efforts by the Bernanke Fed, Draghi ECB, Haruhiko Kuroda's Bank of Japan, the Chinese and others have fomented a systemic mispricing of finance around the globe and throughout most asset classes. This creates another key fragility that was not nearly as prevalent in previous bubble periods.

The Fed and global central bankers collapsed short-term interest-rates, forcing savers out of "money" and into the risk markets (or, in the case of Chinese savers, to "shadow banking"). Initially, central bankers were hoping that a shot of monetary stimulus and some asset inflation would stoke "animal spirits" and spur economic recovery. Their plan just didn't work. So we're now well into the fifth year of unprecedented stimulus, with the initial shot becoming a long-term binge addiction. This has nurtured a most dangerous "Monetary Process", whereby generally risk-averse finance has flowed for years (and in increasing quantities) into progressively more distended bubble markets.

We saw an indication in June of how quickly sophisticated "hot money" and the unsuspecting small investor can clog up the exit in the event of even modest market losses. How long do central banks believe they can sustain levitated markets? Do they realize that the more these markets inflate the more prone they become to instability and dislocation?

"Fat tails" are the product of extended periods of distorted risk perceptions. When central banks ensure access to cheap speculative finance, the resulting leverage buildup is conducive to "fat tails." Moreover, when generally cautious investors assume unappreciated risks on such a grand scale, central bankers have created a compounding "fat tail" risk.

When ultra-loose finance fuels record issuance of junk debt and leveraged lending at record low yields - in the face of major global financial and economic risks - that's pro-"fat tail." When abundant cheap finance fuels a mergers & acquisitions boom with attendant impacts on equities prices, markets (and M&A premiums) become vulnerable to risk aversion and a tightening of finance. When abundant cheap finance stokes aggressive company stock buybacks, the marketplace becomes susceptible.

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