Page 1 of
5 More than 20 years in the
making: By Doug
Noland
COMMENTARY
It all
began innocently enough: "The Federal Reserve,
consistent with its responsibilities as the
nation's central bank, affirmed today its
readiness to serve as a source of liquidity to
support the economic and financial system."
The newly appointed Federal Reserve
chairman, Alan Greenspan, released this statement
prior to the opening of market trading on Tuesday,
October 20, 1987. The previous day, "Black
Monday", the Dow Jones Industrial Average crashed
508 points, or 22.6%. All the major indices were
down in the neighborhood of 20%, with
S&P500 futures ending the
historic trading session down 29%.
The
1987 stock market crash was contemporary Wall
Street finance’s first serious market dislocation.
Stock market speculation had been running rampant,
at least partially fostered by new-fangled hedging
and "portfolio insurance" trading strategies. When
a highly speculative market began to buckle, the
forced selling of S&P futures contracts to
hedge the rapidly escalating exposure to market
insurance ("dynamic trading") played an
instrumental role in instigating illiquidity and a
market panic.
Following Black Monday,
there was of course considerable media attention
directed at the event's causes and consequences.
Some believed at the time that the stock market
was discounting a severe economic downturn. Others
recognized the reality that the situation had
little to do with underlying economic forces. The
economy was in the midst of a robust economic
expansion, while credit was flowing (too) freely.
Immediately post-crash, however, the financial
system was extremely vulnerable and the Greenspan
Fed acted decisively to ensure the marketplace
understood clearly that the Federal Reserve was a
willing and able liquidity provider.
Credit then really began to flow.
Greenspan’s assurances came at a critical juncture
for the fledging Wall Street securitization
marketplace; for Michael Milken, Drexel Burnham
and the junk bond market; for private equity,
hostile takeovers and the leveraged buyout (LBO)
boom; for the fraudulent savings and loan industry
and for many banks' commercial lending operations.
While it sounds a little silly after what we've
witnessed since, there was a time when the
eighties were known as the "decade of greed".
When the junk bonds, LBOs, S&Ls, and
scores of commercial banks all came crashing down
beginning in late-1989 to 1990, the Greenspan Fed
initiated an historic easing cycle that saw Fed
funds cut from 9.0% in November 1989 all the way
to 3.0% by September 1992. In order to
recapitalize the banking system, free up system
credit growth and fight economic headwinds, the
Greenspan Federal Reserve was more than content to
garner outsized financial profits to the fledgling
leveraged speculator community and a Wall Street
keen to seize power from the frail banking system.
Investment bankers, all facets of the
securitization industry, the derivatives market,
the hedge funds and the government-sponsored
enterprises such as Fannie Mae and Freddie Mac
never looked back - not for a second.
Birth of a 20-year myth In the
guise of "free markets", the Greenspan Fed sold
its soul to unfettered and unregulated Wall
Street-based credit creation. What proceeded was
the perpetration of a 20-year myth: that an
historic confluence of incredible technological
advances, a productivity revolution and momentous
financial innovation had fundamentally altered the
course of economic and financial history. The
ideology emerged (and became emboldened by each
passing year of positive GDP growth and rising
asset prices) that free market forces and
enlightened policymaking raised the economy’s
speed limit and increased its resiliency;
conquered inflation; and fundamentally altered and
revolutionized financial risk
management/intermediation. It was one heck of a
compelling - alluring - seductive story.
But, as they say, "there's always a
catch". In order for New Age Finance to work, the
Fed had to make a seemingly simple - yet
outrageously dangerous - promise of "liquid and
continuous" markets. Only with uninterrupted
liquidity could much of securities-based
contemporary risk intermediation come close to
functioning as advertised. Those taking risky
positions in various securitizations (especially
when highly leveraged) needed confidence that they
would always have the opportunity to offload risk
(liquidate positions and/or easily hedge
exposure). Those writing derivative "insurance" -
accommodating the markets’ expanding appetite for
hedging - required liquid markets whereby they
could short securities to hedge their risk, as
necessary.
There were numerous debacles
that should have alerted policymakers to some of
New Age Finance’s inherent flaws (1994's bond
rout, Orange Co, Mexico, SE Asia, Russia,
Argentina, LTCM, the tech bust, and Enron to name
a few). Yet the bottom line was that the
combination of the Fed’s flexibility to
aggressively cut rates on demand; ballooning GSE
balance sheets on demand; ballooning foreign
official dollar reserve holdings on demand; and
insatiable demand for the dollar as the world’s
reserve currency all worked in powerful concert to
sustain (until recently) the US credit bubble -
through thick and thin.
Despite his
(inflationist) academic leanings and some
regrettable ("Helicopter Ben") speeches as Fed
governor, I do believe Dr Bernanke aspired to
adapt Fed policymaking. His preference was for a
more "rules-based" policy approach of setting
rates through some flexible "inflation targeting"
regime, while ending Greenspan’s penchant for
kowtowing to the markets. Today, it all seems
hopelessly naive. Inflation is running above 4%,
while the rate-setting Federal Open Market
Committee (FOMC) is compelled to quickly slash the
funds rate to 3%. And never - I repeat, never -
have the financial markets been more convinced
that the Federal Reserve fixates on stock prices
when it comes to inflationary pressures.
Fed on a limb of its own Today,
the contrast to the European and other central
bank could not be starker. The Fed has climbed way
out on a limb, and it is difficult at this point
to see how it can regain credibility as an
inflation fighter or supporter of the value of our
currency. It is not only trust in Wall
Street-backed finance that is being shattered.
The greatest flaw in the
Greenspan/Bernanke monetary policy doctrine was a
dangerously misguided understanding of the risks
inherent to their "risk management" approach.
Repeatedly, monetary policymaking was
dictated by the Fed’s focus on what it considered
the possibility of adverse consequences from
relatively low probability ("tail") developments
in the credit system and real economy. In other
words, if the markets (certainly inclusive of New
Age structured finance) were at risk of faltering,
it was believed that aggressive accommodation was
required. The avoidance of potentially severe real
economic risks through "activist" monetary easing
was accepted outright as a patently more
attractive proposition compared with the
(generally perceived minimal) inflationary risks
that might arise from policy ease. As it was in
the late 1920s, such an accommodative ("coin in
the fuse box") policy approach is disastrous in
bubble environments.
The Fed's complete
misconception of the true nature of contemporary
"inflation" risk was a historic blunder in
monetary doctrine and analysis. To be sure, the
consequences of accommodating the markets were
anything but confined to consumer prices. Instead,
the primary - and greatly unappreciated - risks
were part and parcel to the perpetuation of
dangerous credit bubble dynamics and myriad
attendant excesses. Importantly, the Fed failed to
recognize that obliging Wall Street finance
ensured ever greater bubble-related distortions
and fragilities - deeper structural impairment to
both the financial system and real economy. In the
end, the Fed’s focus on mitigating tail risk
guaranteed a much more certain and problematic
tail - a rather fat one at that.
Fundamentally, the Greenspan/Bernanke
doctrine totally misconstrued the various risks
inherent in their strategy of disregarding bubbles
as they expanded - choosing instead the aggressive
implementation of post-bubble mopping-up measures
as necessary. They were almost as oblivious to the
nature of escalating bubble risk as they were to
present-day complexities incident to implementing
mop up reflationary policies. Mopping up the
technology bubble created a greatly more
precarious mortgage finance bubble. Aggressively
mopping up after the mortgage/housing carnage in
an age of a debased and vulnerable dollar, US$90
oil, $900 gold, surging commodities and food
costs, massive unwieldy pools of speculative
global finance, myriad global bubbles, and a
runaway Chinese boom is fraught with extraordinary
risk.
Furthermore, the Fed's previously
most potent reflationary mechanism - Wall
Street-backed finance – is today largely
inoperable.
I'm not going to jump on the
criticism bandwagon and excoriate Dr Bernanke for
his panicked 75 basis point inter-meeting rate
cut. From my vantage point, the wheels were coming
off and I would expect nothing less from our
increasingly impotent central bank. Yet it is
silly to blame today’s mess on recent
indecisiveness. The Fed has not been behind the
curve, unless one is referring to the learning
curve. The unfolding financial and economic crisis
has been more than 20 years in the making. It’s a
creation of flawed monetary management; egregious
lending, leveraging and speculating excess;
unprecedented economic distortions and imbalances
on a global basis. And I find it rather ironic
that Wall Street is so fervidly lambasting the
Fed. For 20 years now the Fed has basically done
everything that Wall Street requested and more.
It is also as ironic as it was predictable
that Alan Greenspan - Ayn Rand "disciple" and
free-market ideologue - championed monetary
policies and a financial apparatus that will
ensure the greatest government intrusion into our
nation’s financial and economic affairs since the
New Deal. Articles berating contemporary
capitalism are becoming commonplace. I fear that
the most important lesson from this experience may
fail to resonate: that to promote sustainable
free-market capitalism for the real economy
demands considerable general resolve to protect
the soundness and stability of the underlying
credit system.
Bears survive
squeeze And, speaking of the credit system,
some brief market comments are in order. Stocks
generally rallied last week, yet it was a backdrop
that provided little comfort that the system has
begun to stabilize. Sure, the banks rallied 10%,
the homebuilders 20%, the retailers 7%, the
transports almost 7%, and the restaurants 5%. One
could easily assume that the bears were squeezed
and leave it at that.
There are, however,
surely more complex and problematic dynamics at
work. Notably, many of the favorite sectors were
hit this week - the utilities, technology and
biotechs all posted notable weakness. Coupled with
this week’s extreme volatility, I will assume that
the huge "market-neutral" and "quant" components
of the leveraged speculating community have
suffered even greater losses so far this month
than those from last August. It is also
worth noting that some important credit spreads
have diverged markedly, most notably many
corporate, junk and commercial mortgage-backed
securities' spreads have widened as dollar swap
spreads have narrowed. The spectacular Treasury
melt-up must also be causing havoc for various
strategies, ditto the recently strong yen and
Swiss franc.
I'll stick with the view that
an unfolding breakdown in various trading models
and hedging strategies is at risk of precipitating
a crisis of confidence for the leveraged
speculating community. I suspect hedge fund
trading was much more responsible for chaotic
global securities markets this week than a rogue
French equities trader. There is, unfortunately,
little prospect for markets
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