Greenspan, the Wizard of
Bubbleland By Henry C K Liu
The
Kansas City Federal Reserve Bank annual symposium
at Jackson Hole, Wyoming, is a ritual in which
central bankers from major economies all over the
world, backed by their supporting cast of court
jesters masquerading as monetary economists,
privately rationalize their unmerited yet enormous
power over the fate of the global economy by
publicly confessing that while their collective
knowledge is grossly inadequate for the daunting
challenge of the task entrusted to them, their
faith-based dogma nevertheless should remain above
question. That dogma is based on a
single-dimensional theology that sound money is
the sine qua nonof economic well-being. It
is a peculiar ideology given that central banking
as an institution derives its raison d'etre
from the rejection of a rigid gold standard in
favor of monetary elasticity.
In
plain language, central banking sees as its prime
function the management of the money supply to fit
the transactional needs of the economy, instead of
fixing the amount of money in circulation by the
amount of gold held by the money-issuing
authority. Thus
central bankers believe in sound
money, but not too sound please, lest the economy
should falter. Their mantra is borrowed from the
Confessions of St Augustine: "God, give me
chastity and continence - but not just now."
This
year, the annual august gathering in August took
on special fanfare as it marked the final
appearance of Alan Greenspan as chairman of the US
Federal Reserve Board of Governors. Among the
several interrelated options of controlling the
money supply, the Federal Reserve, acting as a
fourth branch of the US government based on
dubious constitutional legitimacy and head of the
global central-banking snake based on dollar
hegemony,
has selected interest-rate policy as the
instrument for managing the economy all through
the 18-year stewardship of Alan Greenspan, on whom
many accolades were showered by invited
participants in the Jackson Hole seminar in
anticipation of his retirement early next year.
Greenspan's formula of reducing market
regulation by substituting it with post-crisis
intervention is merely buying borrowed extensions
of the boom with amplified severity of the
inevitable bust down the road. The Fed is
increasingly reduced by this formula to an
irrelevant role of explaining an anarchic economy
rather than directing it towards a rational
paradigm. It has adopted the role of a cleanup
crew of otherwise avoidable financial debris
rather than that of a preventive guardian of
public financial health. Greenspan's monetary
approach has been "when in doubt, ease". This
means injecting more money into the banking system
whenever the US economy shows signs of faltering,
even if caused by structural imbalances rather
than monetary tightness. For almost two decades,
Greenspan has justifiably been in near-constant
doubt about structural balances in the economy,
yet his response to mounting imbalances has
invariably been the administration of
off-the-shelf monetary laxative, leading to a
serious case of lingering monetary diarrhea that
manifests itself in runaway asset price inflation
mistaken for growth.
Volcker's bloody
victory Paul Volcker, as chairman of the
Fed before Greenspan, caused a "double-dip"
recession in 1979-80 and 1981-82 to cure
double-digit inflation, in the process bringing
the unemployment rate into double digits for the
first time since 1940. Volcker then piloted the
economy through its long recovery that ended with
the 1987 crash. To his credit, Volcker did manage
to bring unemployment below 5.5%, half a point
lower than in the 1978-79 boom, and the
acknowledged structural unemployment rate of 6%.
To achieve his heroic, albeit bloody,
victory over intractable inflation, Volcker
adopted a "new operating method" for the Fed in
1980 as a therapeutic shock treatment for Wall
Street, which had been spoiled fearless by the
brazen political opportunism of Arthur Burns,
Volcker's predecessor during the Nixon-Ford era.
Wall Street had lost faith in the Fed's political
will to control inflation. The new operating
method concentrated on managing monetary
aggregates to levels deemed appropriate for a
given state of the economy, and let them dictate
Fed funds rate (FFR) swings to be authorized by
the Fed Open Market Committee (FOMC). For 1980,
this meant an FFR within a range from 13-19% in
the context of double-digit inflation. This new
operating method was an exercise in "creative
uncertainty" to shock the financial market out of
its complacency about the Fed's tradition of
interest-rate stability and gradualism. The market
had developed a habitual expectation that even if
the Fed were forced by inflation trends to raise
interest rates, it would not permit the market to
be volatile, lest the political wrath from both
the White House and the Congress should threaten
its existence. Banks could continue to create
money through lending as long as they could
profitably manage the gradual rise in rates,
foiling the Fed's policy objective of slowing the
growth of the money supply to contain inflation.
Volcker's new operating method reversed
the traditional mandate of the Fed, which, as a
central bank, was supposed to be responsible for
maintaining orderly markets, meaning smooth,
gradual changes in interest rates. The new
operating method was an attempt to induce the
threat of short-term pain to stabilize long-term
inflation expectations. The reversal was necessary
because the market had come to expect the Fed only
gradually to raise interest rates to keep even an
unbalanced economy from collapsing.
Targeting the money supply generates large
sudden swings in short-term interest rates that
produce unintended shifts in the real economy that
then feed back into demand for money. The process
has been described as the Fed acting as a
monetarist dog chasing its own tail. Unlike the
Keynesian formula of deficit financing to reduce
unemployment in a down cycle, the Fed's easy-money
approach since the administration of president
Richard Nixon had been to channel the funny money
to the rich who needed it least, rather than to
the poor who would immediately spend it to sustain
aggregate demand to moderate the business cycle.
This supply-side easy-money approach led to an
economy of overcapacity, with idle plants unable
to produce goods profitably for lack of consumer
demand. Say's law, that supply creates its own
demand, is inoperative unless there is full
employment, which sound money deems undesirable.
Greenspan's reversal Greenspan's
measured-paced interest-rate policy is a reversal
back to the Fed's tradition of gradualism. The
trouble with a measured-paced interest-rate policy
in a debt-driven economy of overcapacity is that
the debt cancer is spreading faster than the
gradual doses of medical radiation can handle. Yet
fatality is a poor tradeoff for the avoidance of
hair loss from radiation. Greenspan's measured
pace represents a lack of political courage to
acknowledge that it is preferable by far for the
finance sector to take a huge haircut preemptively
than for the whole economy to collapse later.
Moral hazard is increased unless risk takers in
the finance sector are made to bear the
consequences of their actions, and not be allowed
to pass the pain from risk on to the economy at
large.
All economists agree that when
money growth slows, market interest rates go up.
Yet the emergence of unregulated credit markets
has cast doubt on the reverse causal effect.
Rising interest rates no longer necessarily slow
money growth. Often they merely make money growth
more costly to accelerate asset price
appreciation, curiously defined by economists as
growth, not inflation. This is particularly true
with the short-term rate, which is the only rate
that can be set directly by the Fed. An
excessively low short-term rate encourages banks
to borrow short-term to lend long-term to try to
profit from the interest-rate spread. Also, the
trouble with the use of the FFR target to control
money supply was that it had to be set by fiat,
which exposed the Fed to unwanted political
pressure for interrupting a boom. A case can be
made, and is frequently made, that the Fed's FFR
target tends to be a self-fulfilling prophecy
rather than a device to manage future trends. High
FFR targets deflate while low targets inflate, and
there is little argument about that relationship
beyond the dispute on the definition of inflation.
Because Greenspan had no hesitation in lowering
the FFR target in a less-than-measured pace to
reverse asset deflation in the 2000 recession, and
again in the summer of 2003, his subsequent
measured pace in bringing the FFR target back
above inflation rate represents an act of policy
cowardice.
Market demand for new loans,
expressed as the pace for new lending, obviously
would not be moderated by raising the price of
money, as long as the inflation/interest gap
remains profitable. Yet bank deregulation diluted
the Fed's control of the supply of credit, leaving
price of short-term funds (interest rate) as the
only operational lever. Price is not always an
effective lever against runaway demand, as
Greenspan found out in the 1990s. Raising the
price of money to fight inflation in a debt
economy is by definition self-neutralizing because
high interest cost is itself inflationary in a
debt economy. Deregulation also allows the price
of money to allocate credit in the market, often
directing credit to where the economy needs it
least, namely the speculative arena where
borrowers are more prepared to pay high rates.
The Fed might have had in its employ a
staff of very sophisticated economists who
understood the complex multidimensional forces of
the market, but the tools available to the Fed for
dealing with market instability were
single-dimensional by ideology and design.
Measured-paced interest-rate policy was the only
weapon available to the Fed to tame an
aggressively unruly market that increasingly
viewed the Fed as a paper tiger.
The Fed
protects itself from criticism of ideological bias
in its decision-making by depriving the public and
its critics of timely information paid for by tax
money. The Fed remains above criticism because its
decisions are always based on more current
information on the economy than that available to
the market, decisions that the market would
understand only if it had the same information,
although the rationale for depriving the market of
the latest information on the economy in the age
of instant communication and political
transparency has never been made clear.
According to the Minneapolis Fed, aside
from the color of their covers, the Fed's Red and
Beige books differed in one important way: the Red
Book was prepared for policymakers only, and was
not intended for public consumption.
The
Red Book became public in 1983 after a request by
the longtime congressman from the District of
Columbia, Walter Fauntroy, for public release of
the Green Book, which contains the Fed's closely
held national models and economic forecasts. The
Fed deemed this unwise and the Red Book was
offered in its place. To mark the change, the
color red was dropped in favor of beige (it was
for a time also called the Tan Book). To detract
from the implied importance of the document in
FOMC policymaking, the public release of the Beige
Book, published eight times per year containing
anecdotal information on current economic
conditions in all twelve districts through reports
from Federal Reserve District Banks and Branch
directors and interviews with key business
contacts, economists, market experts, and other
sources, is timed for two weeks prior to an FOMC
meeting, so that the media and others would
recognize that the information contained in it is
dated and, therefore, does not have a major
influence on future policy. The Fed's power of
decision is not based on a better understanding on
how the economy works than market participants,
but on more timely and privileged information. The
rationale for keeping the Green Book from public
view has never been explained - so much for policy
transparency in a democratic society. Perhaps, as
Greenspan has been saying recently, the state of
the art of economic forecasting is far from
reliable, thus there is no harm keeping it from
the public.
And there is plenty of
argument about the Fed's projection ability on the
economy. History has shown that the Fed, more
often than not, has made wrong decisions based on
faulty projection. Greenspan has been rightly
criticized for letting a housing price "bubble"
develop, equating it to the one that swept
technology stocks to stratospheric levels before
bursting in 2000. Greenspan argues the Fed's role
is to mop up after bubbles burst, since bubbles
are hard to spot and deflate safely. But accidents
are also difficult to predict, and that difficulty
is not a good argument against buying insurance.
There is no doubt that there is a price to be paid
for every policy action. But the price of
prematurely slowing down a debt bubble is
infinitely lower than letting the bubble build
until it bursts uncontrollably. In finance as in
medicine, prevention is preferable to even the
best cure. All market participants know pigs lose
money. And a monetary pig loses control of the
economy.
Greenspan has said on several
occasions that while he expected continued debate
over whether the Fed could and should use its
power over short-term interest rates to try to
influence asset prices, he did not see that as
feasible. "The configuration of asset prices is
already an integral part of our evaluation of the
large array of forces that influence financial
stability and economic growth," he repeated in his
speech at Jackson Hole, "but given our current
state of knowledge, I find it difficult to
envision central banks successfully targeting
asset prices any time soon." Yet his negative
real-interest-rate policy since 2000 to prevent
deflation was a clear policy of asset price
targeting.
Volcker's new operating method
in 1980 was designed to let the monetary
aggregates set the FFR targets mathematically to
provide political cover for the FOMC members if
the FFR target needed to go to high double digits.
This was monetarism through the back door, not by
intellectual commitment, but by political
cowardice. Volcker used the monetary aggregate
formula to deflect political heat to stay in the
monetary kitchen. Greenspan's one-note monetary
policy of relying on changing the FFR target is
not based on any definitive understanding of the
relationship between interest-rate levels and
economic growth, a deficiency he has repeatedly
acknowledged not just for himself but also for the
entire economics community. Yet after all is said
and done, the only instrument the most powerful
official in the financial world relies on to
manage the world's dominant economy is raising or
lowering the FFR.
Greenspan's
defense At a meeting of the American
Economic Association in San Diego on January 3,
2004, Greenspan spoke on "Risk and Uncertainty in
Monetary Policy", a speech 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. It is a
very peculiar position, one that would be expected
from the risk manager of a 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.
"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," Greenspan boasted
prematurely. Yet 20 months later at Jackson Hole,
Greenspan said: "This vast increase in the market
value of asset claims is in part the indirect
result of investors accepting lower compensation
for risk. Such an increase in market value is too
often viewed by market participants as structural
and permanent. To some extent, those higher values
may be reflecting the increased flexibility and
resilience of our economy. But what they perceive
as newly abundant liquidity can readily disappear.
Any onset of increased investor caution elevates
risk premiums and, as a consequence, lowers asset
values and promotes the liquidation of the debt
that supported higher asset prices. This is the
reason that history has not dealt kindly with the
aftermath of protracted periods of low risk
premiums." But the source of the mistaken view
held by market participants is traceable to
Greenspan's declared refusal to prevent the bubble
and to his adherence to a measured-paced
interest-rate policy to manage the bubble once it
has become undeniable.
Greenspan,
notwithstanding his denial of responsibility in
helping through the 1990s to unleash the equity
bubble, had this to say in 2004 in hindsight after
the bubble burst in 2000: "Instead of trying to
contain a putative bubble by drastic actions with
largely unpredictable consequences, we chose, as
we noted in our mid-1999 congressional testimony,
to focus on policies to mitigate the fallout when
it occurs and, hopefully, ease the transition to
the next expansion."
By "the next
expansion", Greenspan meant the next bubble, which
manifested itself in housing. The mitigating
policy was a massive injection of liquidity into
the US banking system. There is a structural
reason that the housing bubble replaced the
high-tech bubble. Houses cannot be imported like
manufactured goods, although much of the content
in houses, such as furniture, hardware, windows,
kitchen equipment and bath fixtures, is
manufactured overseas. Construction jobs cannot be
outsourced overseas to take advantage of wage
arbitrage. Instead, some non-skilled jobs are
filled by low-wage illegal immigrants. Total
outstanding home mortgages in 1999 were US$4.45
trillion and by 2004 this amount grew to $7.56
trillion, most of which was absorbed by
refinancing of higher home prices at lower
interest rates. When Greenspan took over at the
Fed in 1987, total outstanding home mortgages
stood only at $1.82 trillion. On his watch,
outstanding home mortgages quadrupled. Much of
this money has been printed by the Fed, exported
through the trade deficit and re-imported as debt.
Greenspan went on: "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 [4.75] percentage points.
Subsequently, another 75 basis points were pared,
bringing the rate by June 2003 to its current 1%,
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 40 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 US 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." Structural flexibility
and aggressive monetary ease are significant
contributors to stability? One might as well claim
that drug addiction calms nerves.
The
growth of capital markets was responsible for the
long boom that began with the Greenspan era in
1987, rather than bank lending. Banks' share of
net credit markets, according Fed data on flow of
funds, dropped from a peak of more than 62% in
1975 to 27.5% in 2004 while securitization's share
rose from negligible in 1975 to more than 60% in
2004. Securitization now stands at more than $3
trillion, up from $375 billion in 1985. It shows
the effect of a shift of importance from banks as
funding intermediaries to the capital/credit
markets. Nasdaq companies rely less on banks for
funds and are thus less affected by Greenspan's
interest-rate policy.
Greenspan has been
vocal in explaining that his monetary policy of
gradual moves of rising FFR was not specifically
targeted toward the stock markets but toward the
unsustainable expansion of the economy as a whole,
although with the same breath, he decried the
dangers of the wealth effect if it ever ended up
heavier on the consumption side than on the
investment side, which of course was exactly what
happened. Consumer spending has been holding up
the US economy in recent years, while most of the
supply-side investment has gone overseas. This has
caused a separation between the dollar economy and
the US economy. The dollar economy expands from
global dollar hegemony while the US economy is
hollowed out of manufacturing. Dollar hegemony has
deprived the US economy of real productivity from
manufacturing and forced it into virtual
productivity from finance manipulation.
It
is a curious position, as most of Greenspan's
positions seem to be: asset inflation is good
unless it is spent by consumers rather than to
fuel more asset inflation. He continues to try
halfheartedly to restrain demand in favor of
supply in an economy already plagued by
overcapacity. He ignores the glaring fact that
supply-side investment while staying in the global
dollar economy through dollar hegemony has largely
skirted the US economy, leaving it with an
unsustainable debt bubble. Greenspan seems to
think it does not matter who owns the dollars the
Fed prints, as long as most debts are denominated
in dollars that the Fed can print at will. In a
sense, he is the wizard of dollar hegemony, which
in addition to impoverishing all non-dollar
economies, is beginning to impoverish the US
economy as well.
Greenspan also supported
President George W Bush's $1.3 trillion tax cut of
2001 and the additional $674 billion tax cut of
2003, which instead of helping the economy merely
shifted debt from the private sector to the public
sector in the form of fiscal deficits and
sovereign debt. Instead of increasing savings from
the tax cut, the private sector promptly took on
more debt. The tax cut so favored the rich that
the tax savings from the low-income earners mostly
go to pay interest on the loans funded by tax
savings of the rich.
The bifurcation
bubble The so-called "bifurcated" market
indexes of the late 1990s, dividing the so-called
New Economy from the Old Economy, with one group
of companies contributing to new highs, the other
to new lows, clearly indicated that the Fed, whose
sole weapon was monetary measures, had lost
control of the New Economy, which appeared
impervious to short-term interest rates, while
unable to help the Old Economy. Under such
conditions, the only way the Fed could slow the
economy was to overshoot the interest-rate target
to try in vain to rein in an interest-impervious
Nasdaq at the peril of the whole economy.
Interest-sensitive stocks were battered badly,
including banks and non-bank lenders, such as GE
and Amex. This group of financial-services
companies, including commercial banks, brokerage
firms and mortgage lenders, had produced some of
the biggest profits in the post-1987-crash bull
market. The combination of rising interest rates
and the hefty leverage on the books of these
businesses proved hazardous to their stock prices.
Money-center banks and broker dealers were most
vulnerable because they were the most exposed to
interest-rate-related products such as swaps and
mortgages.
The most popular of all
derivative products is the interest-rate swap,
which in essence allows participants to make bets
on the direction interest rates will take.
According to the Office of the Comptroller of the
Currency (OCC), interest-rate swaps accounted for
three out of four derivative contracts held by
commercial banks at the end of 1999. The notional
value of these swaps totaled almost $25 trillion;
2-3% of that ($500 billion to $750 billion)
reflected the banks' true credit risk in these
products. Monetary economists have no idea whether
notional values are part of the money supply and
with what discount ratio. As we now know from
experience, creative accounting has legally and
illegally transformed debt proceeds as revenue.
The
OCC 2005 Report on Condition and Performance of
Commercial Banks shows that loan demand grew at
11% in the first quarter of 2005 while core
deposits grew at 7%, producing a 4% gap. That
meant that banks' loan growth was not fully funded
by deposits. The report identified possible risks
as: cooling off in housing markets accompanying
slower loan growth; past regional housing price
declines lingering; credit quality problems in
housing spilling over to other loan types. Not a
comforting picture. Derivatives of all kinds weigh heavily on
banks' capital structures. But interest-rate swaps
can be especially toxic when interest rates rise.
And since only a few business economists predicted
a jump in rates for the first half of the year
when 1999 began while yields in fact rose 25%,
these institutions found themselves on the wrong
side of an interest-rate gamble by 2000. Moreover,
as interest rates rose, banks' income diminished
from interest-rate-related businesses, such as
mortgage lending. Interest-sensitive sources of
income were the revenue disappointment in 2000, as
trading was in 1999. The banks' response was to
lower credit requirement for loans.
When
Treasury yields were at their highest levels
before the US Treasury under Larry Summers
launched its long-term debt buybacks in 2000, rate
increases from the Fed seemed a consistent if not
rational policy. Stock investors in the Old
Economy did not get spooked by the expected rising
rates. But when the gap between the Treasury and
the Fed left Telephone bonds at 8.22% while
30-year Treasuries were at 6.14% (5.38% a year
earlier), investors jumped ship.
Moreover,
even as the Nasdaq suffered a substantial
correction, its impact on the wealth effect was
not expected to be total. Major investment banks
had been pitching to high-tech/Internet founders
and early shareholders to hedge their
multimillion-dollar winnings-to-date by signing
away their future upsides to risk investors. So,
for many high-tech swimmers, this amounted to
second-layer swimming trunks on which they could
depend and not risk being caught naked when the
tide receded suddenly. Unfortunately, much of the
diversification stay within the New Economy, where
high returns from capital gain could be achieved.
It was the financial version of a flat-proof
tubeless tire that can get the motorist to the
next gas station or 50 kilometers (whichever is
closer) in the event of a puncture. It does not,
however, guarantee the driver the existence of a
gas station that has not been forced into
bankruptcy within 50km. It does not protect the
motorist from a systemic collapse. Greed always
neutralizes fear.
There was a near-total
disconnect between the Old and New economies in
1999. The Dow Jones Industrial Average (DJIA) was
falling, according to analysts, because of
investor disappointment over earnings, which would
be further impacted adversely by rising interest
rates. Yet the Nasdaq remained impervious to both
interest-rate hikes and near-perpetual negative
earnings.
Globally, other markets were
catching the Wall Street greed affliction. Hong
Kong, which traditionally followed US markets
because of its currency peg to the US dollar and
its export reliance on US markets, saw the Hang
Seng Index (HIS) shoot through 17,000 (coming from
a low of 6,600 in August 1997) while the Dow broke
above 9,000, primarily because of a tulip-like
hysteria on Internet startups and telephone
mergers. One grandmother in Hong Kong was reported
to have asked a 20-year-old broker what the
Internet was while she was writing out a
six-figure check to buy the IPO (initial public
offering) shares of an Internet startup. It was
not likely that the company she was investing her
retirement money in would show a positive cash
flow in her lifetime. The odds were that the
longevity of the grandmother was greater than that
of the new company.
Meanwhile, back in the
United States, mutual funds were forced to
jettison their old-fashioned balanced portfolios
in favor of all-tech strategies. In one week in
1999, an additional $1.6 billion went into
high-tech funds, $1.2 billion went into biotech,
and $1 billion into aggressive growth funds.
S&P 500-linked funds lost investors. 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,
it 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 finance by debt. The
economy did not change in 22 trading days.
Now, who are the investors in the Old and
New economies? Institutions such as pension funds
and endowment funds are prevented by law or
internal rules to detach themselves from broadly
based portfolios, when "qualified investors" -
those with net worth of $2 million or more,
depending on the US Securities and Exchange
Commission (SEC) definition - are the investors in
the New Economy. Many who gained from the rise of
the New Economy used their new wealth to acquire
assets in the Old Economy at fire-sale prices, and
the excess brought down both the Old and the New.
Investors in the Old Economy did not benefit from
the speculative rise of the New Economy, but they
nevertheless had to pay for the losses.
Illustrating the merger of the New and Old
economies, America Online (AOL) announced on
January 10, 2000, a merger with Time Warner Inc,
paying $182 billion for the media giant. The offer
from AOL, whose market value was $163 billion,
valued Time Warner at a premium of $164.75
billion, about double the target company's $83
billion market capitalization at the close of
market trading. The US Federal Communication
Commission approved a $350 billion merger between
AOL and Time Warner a year later, on January 19,
2001. Two years after that, on January 30, 2003,
AOL-Time Warner reported a $45.5 billion quarterly
loss to account for the declining value of its
flagship America Online property, bringing the
company to post an annual loss of nearly $100
billion, the largest annual loss in corporate
history.
From the start of 2002 until the
end of the same year, the Nasdaq composite index
fell 49.5%. The S&P 500 dropped 23% in 2002.
On December 31, 2002, the Nasdaq was 80% below its
peak in 2000. From 2001 through March 2003, the
total number of civilian jobs rose only 0.3%,
against an average annual increase of 2.4% during
the 1990s. The United States lost 1.5 million
non-farm jobs from 2001 to March 2003, a drop of
1.2%. Unemployment rose to 6%. What Greenspan did
was to punish the general public by devaluing
their future pension and cash flow, to pay for the
sins of the aggressively investing rich who
continued to add to their wealth with Greenspan's
blessing as long as the ill-gained riches from
speculation were reinvested for more speculation
for more ill gains.
The alleged "recovery"
of the stock market in 2003 - with the DJIA rising
by 25% from its low in March, the Nasdaq rising a
phenomenal 50%, the S&P 500 rising 26% and the
Russell 2000 rising 45% - was tempered by the
dollar falling 20% against the euro, 10% against
the yen despite Bank of Japan (BOJ) intervention,
and a whopping 34% against the Australian dollar
on rising demand on gold, iron ore and other
commodities produced there. This explained why it
was a jobless recovery.
On Greenspan's
18-year watch, GSE (government-sponsored
enterprises) assets ballooned 830%, from $346
billion to $2.872 trillion. GSEs are financing
entities created by the US Congress to fund
subsidized loans to certain groups of borrowers
such as middle- and low-income homeowners, farmers
and students. Agency MBSs (mortgage-backed
securities) surged 670% to $3.55 trillion.
Outstanding ABSs (asset-backed securities)
exploded from $75 billion to more than $2.7
trillion. Greenspan presided over the greatest
expansion of speculative finance in history,
including a trillion-dollar hedge-fund industry,
bloated Wall Street firm balance sheets
approaching $2 trillion, a $3.3 trillion repo
(repurchase agreement) market, and a global
derivatives market with notional values surpassing
an unfathomable $220 trillion. Granted, notional
values are not true risk exposures. But a swing of
1% in interest rate on a notional value of $220
trillion is $2.2 trillion, approximately 20% of US
gross domestic product (GDP).
Reality
and denial Under Volcker's new operating
method in 1980, banks became vulnerably exposed to
risks that interest rates might suddenly and
drastically go against even their short-term
credit positions. Also, banks had been expanding
new loans beyond the growth of deposits, by
borrowing shorter-term funds at lower interest
rates. This practice was given the benign label of
"managed liability", allowing banks to profit from
interest-rate spreads over the yield curve, which
had seldom been allowed by the Fed to get
inverted, that is, with short-term rates higher
than longer-term rates. Because of the large size
of outstanding long-term debts in the credit
market, long-term interest rates are normally set
by supply and demand. Moreover, long-term debts
are issued by the Treasury and by private
enterprises, not by the Fed. The Fed's power over
interest rates is limited to the overnight Fed
funds rate, which defines the annualized
short-term cost of borrowings between banks.
This practice of borrowing short-term at
low interest rates to lend long-term at higher
interest rates, known as "carry trade" in bank
parlance, when globalized by deregulated
cross-border flow of funds, eventually led to the
Asian financial crisis of 1997 when interest-rate
and exchange-rate volatility became the new
paradigm. Today, there are undeniable signs that
the same interest-rate risks have infested the
housing bubble in recent years. And the Fed's
traditional gradualism, now revived as "measured
pace" in raising the FFR targets in response to
rapid asset price inflation, has had little effect
in curbing bank lending to fund rampant
speculation.
In recent months, Greenspan
has repeatedly denied the existence of a national
housing bubble by drawing on the conventional
wisdom that the US housing market is highly
disaggregated by location, which is true enough.
Disaggregated markets are normally not exposed to
contagion, a term given to the process of
distressed deals dragging down healthy deals in
the same market as speculator throw good money
after bad to try to stem the tide of losses. But
the bubble in the housing market is caused by
creative housing finance made possible by the
emergence of a deregulated global credit market
through finance liberalization. The low cost of
mortgages lifts all house prices beyond levels
sustainable by household income in otherwise
disaggregated markets.
Under cross-border
finance liberalization, negative wealth effects
from asset-value correction are highly contagious.
For example, the Dallas Fed Beige Book released on
July 27 states: "Contacts say real-estate
investment is extremely high in part because the
district's competitively priced markets are
attracting investment capital from more expensive
coastal markets." The nationwide proliferation of
no-income-verification, interest-only, zero-equity
and cash-out loans, while making financial sense
in a rising market, is fatally toxic in a falling
market, which will hit a speculative boom as
surely as the sun will set. Since the money
financing this housing bubble is sourced globally,
a bursting of the US housing bubble will have dire
consequences globally.
Volcker's new
operating method in 1980 greatly increased the
banks' risk exposure to interest-rate volatility.
Volcker also set an additional 8% reserve on
borrowed funds for lending, on top of the normal
10% required, to curb the creation of money
through partial-reserve banking lending and thus
to slow the growth of the monetary aggregate. In
1980, the repo market was not a significant
factor. A quarter of a century later, a 2002 study
by the New York Fed showed banks now appeared to
be managing their cash inventories less to comply
with regulatory reserve minimums than to meet
business needs with borrowed funds, mostly from
the repo market.
In the age of finance
globalization, exchange-rate movements have become
a critical channel through which monetary policy
affects the economy, and they tend to respond
promptly to a change in the provision of reserves
and in interest rates. Information on exchange
rates, like that on interest rates, is available
almost continuously throughout each day in the
repo and futures markets.
Interpreting the
meaning of movements in foreign-exchange rates,
however, is not always straightforward. A decline
in the foreign-exchange value of the US dollar,
for example, could indicate that monetary policy
had become more accommodative, with possible risks
of inflation. But foreign-exchange rates respond
to other influences, such as market assessments of
the strength of aggregate demand or developments
abroad. For example, a weaker dollar on
foreign-exchange markets could instead suggest
lessened demand for US goods and decreased
inflationary pressures. Or a weaker dollar could
result from higher interest rates abroad - making
assets in those countries more attractive - that
could come from strengthening economies or the
tightening of monetary policy abroad. The US
inflation rate has been held down by low-price
imports. A fall in the exchange value of the
dollar will lead to inflationary pressures in the
US. The distortion of the exchange rate of the
market by dollar hegemony is substantial.
Determining which exchange-rate level is
most consistent with the ultimate goals of policy
can be difficult if not impossible. Selecting the
wrong level could lead to a sustained period of
deflation and high levels of economic slack or to
a greatly overheated economy. As the US Treasury
views a strong dollar as a matter of national
interest, the exchange rate of the dollar in an
otherwise free market is viewed by the United
States as a matter of national security, on which
the Fed is obliged by law to defer to the
Treasury. Also, reacting in an aggressive way to
exchange-market pressures could result in the
transmission to the US of certain disturbances
from abroad, as the exchange rate could not adjust
to cushion them. Consequently, the Fed does not
have specific targets for exchange rates but
considers movements in those rates in the context
of other available information about financial
markets and economies at home and abroad. However,
the debt-driven US economy requires a strong
dollar to keep foreign lenders from selling the
dollar debts they hold. Exchange-rate policy is
set by the Treasury as a matter of national
economic security to which the Fed is obliged by
law to support.
Knowing that, the Fed is
engaging in self-delusion when it relies on a
measured-paced interest-rate policy to deal with a
runaway debt bubble sourced globally. For the Fed,
the debt bubble is already too big to burst. The
only option is to keep feeding it, albeit at a
slower pace. The measured-pace interest-rate
policy is merely an attempt to slow the bubble's
rate of expansion, not to stop it, much less to
burst it. But a measured-paced interest-rate
policy will not slow the economy enough for a soft
landing. It will only prolong the bubble for a
bigger bang at the end. What Greenspan did at
Jackson Hole was to give warning that the end is
at hand.
Through mortgage-backed
securitization, banks now are mere loan
intermediaries that assume no long-term risk on
the risky loans they make, which are sold as
securitized debt of unbundled levels of risk to
institutional investors with varying risk appetite
commensurate with their varying need for higher
returns. But who are institutional investors? They
are mostly pension funds that manage the money the
US working public depends on for retirement. In
other words, the aggregate retirement assets of
the working public are exposed to the risk of the
same working public defaulting on their house
mortgages. When a homeowner loses his or her home
through default of its mortgage, the homeowner
will also lose his or her retirement nest egg
invested in the securitized mortgage pool, while
the banks stay technically solvent. That is the
hidden network of linked financial landmines in a
housing bubble financed by mortgage-backed
securitization to which no one is paying
attention. The bursting of the housing bubble will
act as a detonator for a massive pension crisis.
Next: The repo time bomb
Henry C K
Liu is chairman of a New York-based
private investment group.
(Copyright
2005 Asia Times Online Ltd. All rights reserved.
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has selected interest-rate policy as the
instrument for managing the economy all through
the 18-year stewardship of Alan Greenspan, on whom
many accolades were showered by invited
participants in the Jackson Hole seminar in
anticipation of his retirement early next year.
