Page 1 of 3 CREDIT BUBBLE BULLETIN The Greenspan episode
Commentary and weekly watch by Doug Noland
Former US Federal Reserve chairman Alan Greenspan, once famed for his reticence
and oblique statements on the economy, seems to have spent the time since he
retired from the Fed in 2006 rebuilding his persona, at least the reticence
part.
Yet, though he now seems unable to decline an interview opportunity, it is
increasingly evident that Greenspan is not going to be of much help when it
comes to the critical issue of exploring
what went terribly wrong with monetary policy and the financial system.
Charlene Lee, (Dow Jones, April 8) reports:
Former Federal Reserve
Chairman Alan Greenspan continued to defend his legacy Tuesday, saying he has
"no regrets" over Fed policy conducted during his tenure. He added that there
was little the central bank or regulators could've done to avert the US housing
crisis. "I have said to many questions of this nature that I have no regrets on
any of the Federal Reserve policies that we initiated back then because I think
they were very professionally done," Greenspan said in an interview on CNBC.
Interestingly, some are rallying to his defense. From Martin Wolf of the
Financial Times: "Mr Greenspan remains the most successful central banker of
modern times. More important, blame distracts from the challenge, which is to
understand what happened, why it happened and what we should do."
We do not want to get distracted. But "the most successful banker of modern
times"? While the scope of the unfolding disaster has yet to be recognized by
Wolf or others, Greenspan was the undisputed governor, architect - the
promulgator of what will be recognized as an epic failure in central banking.
After all, he was for about 18 years the appointed guardian over a financial
system that perpetrated the greatest credit and speculative excess in history.
He dominated monetary policy like no other central banker in history. Chairman
Greenspan not only negligently failed to act to reign in dangerous excesses, he
became a vocal proponent for virtually all aspects of Wall Street finance.
Anyone that has read history related to central banking appreciates that Alan
Greenspan conveniently made up new rules as he went along. He evolved into the
absolute "maestro" at concocting sophisticated rationale for seemingly every
troubling development that took root in contemporary ("wildcat") finance.
Greenspan was an outspoken proponent of securities-based finance; of
models-based risk management; of the great benefits provided by derivatives
markets; of the liquidity benefits of leveraged speculation; of asymmetrical
"telegraphed baby-step" monetary management accept when Wall Street demanded
big and rapid cuts; and a proponent of "risk management"-based monetary
management (that is, ease aggressively to forestall even a low probability of
deflation).
Post-facto delusion
He trumpeted the profound benefits emanating from the capacity for contemporary
finance to better quantify, manage and disburse risk - in the process creating
a more stable financial sector. Most importantly, he championed the notion that
it was preferable for the system to let credit booms and asset bubbles run
their course - and then to treat their busts aggressively with monetary
stimulus to ensure little negative impact the real economy. He claimed bubbles
were only recognizable after the fact.
He evolved into the ultimate activist and micromanaging central banker, wrapped
bizarrely in the cloth of a free-market ideologue. It was a most precarious
amalgamation. On his watch transpired historic ballooning of the
government-sponsored enterprises, of Wall Street balance sheets, and of the
size, power and influence of the leveraged speculating community. Worse yet,
it's my view that he used these sectors as key inflationary mechanisms. The
Greenspan Episode will be seen from a historical perspective as central banking
lunacy. It was the exact intoxicant for market participants and politicians to
wallow in during a spectacular credit-induced boom.
The inherent instability of money and credit was the dominant focus from the
earliest thinking on matters of monetary management and central banking. The US
Federal Reserve was (belatedly) created specifically to reign in recurring boom
and bust cycles, of which it failed spectacularly during the 1920s. Even today,
the European Central Bank (ECB) and other central banks (read pronouncements
from the Reserve Bank of New Zealand!) remain steadfast in their focus on money
and credit analysis as a fundamental pillar in their mandate to maintaining
system stability.
Somehow, the Greenspan "New Age" doctrine was to completely disregard credit -
and disregard it they did during a period of unprecedented innovation,
experimentation and gross over-issuance of contemporary electronic and
market-based "money" and credit. In their distorted view, monetary instability
is a dynamic of the bust and not the preceding boom.
It was a policymaking regime destined for failure. Go back and read some of the
speeches by ECB officials - Bundesbank and ECB executive Otmar Issing, in
particular. It has been for awhile somewhat a battle of central banking
philosophies - the well-grounded and traditionalist ECB vs the New Age
Greenspan Fed. The ECB is clearly the victor, with euroland citizens (with
their valuable euros) winning in the process.
Excerpting from Dr Issing's February 2004 Wall Street Journal op-ed piece:
Huge
swings in asset valuations can imply significant misallocations of resources in
the economy and furthermore create problems for monetary policy. Not every
strong decline in asset prices causes deflation, but all major deflations in
the world were related to a sudden, continuing and substantial fall in values
of assets. The consequences for banks, companies and households can be
tremendous ... Prevention is the best way to minimize costs for society from a
longer-term perspective.
Central banks are confronted with this responsibility, but there is no easy
answer to this challenge. So far, only some tentative conclusions can be drawn.
First, in their communication, central banks should certainly avoid
contributing to unsustainable collective euphoria and might even signal
concerns about developments in the valuation of assets. Second, the argument
that monetary policy should consider a rather long horizon is strengthened by
the need to take into account movements of asset prices. Finally, it should not
be overlooked that most exceptional increases in prices for stocks and real
estate in history were accompanied by strong expansions of money and/or credit.
Just as consumer-price inflation is often described as a situation of "too much
money chasing too few goods", asset-price inflation could similarly be
characterized as "too much money chasing too few assets".
This
was the focal point of an historic debate. Dr Issing and the ECB had history
and sound analysis firmly on their side. The Fed had hope. And I do believe
that as runaway credit excess and asset bubbles gained only further momentum -
and as the consequences of dealing with these bubbles became increasingly more
problematic for our central bankers, the financial sector, and real economy -
the Greenspan Fed became only more intransigent with respect to their flawed
doctrine.
Punch bowls stays
They would not act; Wall Street knew they would not take the punch bowl away;
and the credit bubble’s "terminal phase" was let to run its own fateful course.
While decisions at the Fed may have been made "professionally", they were
nonetheless made from a deeply flawed analytical framework with predictable
results.
Even today, Greenspan chooses to avoid a meaningful discussion about credit.
From his op-ed piece in Monday’s Financial Times ("The Fed is blameless on the
property bubble"): "I am puzzled why the remarkably similar housing bubbles
that emerged in more than two dozen countries between 2001 and 2006 are not
seen to have a common cause. The dramatic fall in real long-term interest rates
statistically explains, and is the most likely major cause …" He goes on reject
those that place blame on the Fed for the housing bubble, including arguing
against the claim that the Fed’s 1% funds rate triggered "a massive credit …
expansion." Greenspan wrote: "Both the monetary base and the M2 indicator rose
less than 5 per cent in the subsequent year, scarcely tinder for a massive
credit expansion."
Tinder or no tinder, what transpired was indeed unprecedented credit expansion.
The Greenspan Fed cut rates aggressively in 2001, and total mortgage debt (TMD)
growth accelerated to what should have been an alarming rate of 10.4%. With
rates dropping to as low as 1.25% in 2002, TMD expanded 12.1%. With rates
dropping to 1.0% in 2003, TMD increased another 11.9%. Despite TMD increasing
by a stunning 38% in three years, Fed funds remained at 1% through the first
half of 2004. TMD growth surged to 13.5% in 2004, followed by 13.4% in 2005,
and 11.6% in 2006. The Greenspan Fed sat idly as mortgage credit doubled in
just six years.
Meanwhile, massive credit expansion led, characteristically, to ballooning
current account deficits. After averaging a large US$122 billion annually
during the '90s, the deficit swelled to more than one-half trillion dollars
during 2003. It then jumped to $640 billion in 2004, $755 billion in 2005, $811
billion in 2006, and $739 billion in 2007. As a consequence (and in combination
with speculative dollar outflows to play attendant dollar devaluation/global
asset and commodities inflation), rest of world (ROW) holdings of US financial
assets - after increasing on average $374 billion annually during the '90s -
expanded $788 billion (10.6% growth) in 2003, $1.518 trillion (18.5%) in 2004,
$2.263 trillion (23.3%) in 2005, $1.868 trillion (15.6%) in 2006, and $1.573
trillion (11.4%) in 2007. ROW holdings surged $8.0 trillion, doubling in just
five years. Conspicuous excess in mortgage credit, current account deficits and
ROW holdings should have been a focal point of monetary policy - flashing clear
warnings of the looseness of monetary policy.
Greenspan's Z1 blindspot
The above data are from the Federal Reserve’s Z1 "flow of funds," a report I
can only assume Dr Greenspan is intimately familiar with (yet curiously never
addresses). That he can today cite moderate growth in the monetary base and M2
and imply the Fed was not culpable for the credit bubble is beyond me.
Greenspan blames the worldwide "dramatic fall in real long-term rates". Even
the FT’s Martin Wolf concurs: "So what might explain these bubbles? I would
point to four causes: very low long-term real interest rates because of the
global savings glut; low nominal interest rates because of both low real rates
and the benign inflationary environment; the lengthy experience of economic
stability; and, above all, the liberalization of mortgage finance in many
countries."
First, I am surprised the "global savings glut" thesis is still being bandied
about. This was a notion (concoction) of Greenspan/Bernanke New Age central
banking that was happily adopted by Wall Street. And Greenspan still refers to
the interest-rate "conundrum". There was none, but instead a global liquidity
glut that was foremost a product of the massive credit bubble-induced dollar
outflows (represented well enough by the Rest of World accumulation of our
financial claims).
Not only did this massive dollar recycling exercise significant pressure on our
long-term rates and currency, the unrelenting accumulation of dollar reserves
globally proved a major impetus for overheated domestic credit systems the
world over - creating even greater liquidity excess in the process. I find it
repulsive today that Mr Greenspan claims global forces were at work. In
reality, the Federal Reserves disregard for credit excess, current account
deficits, and the dollar’s role as the world’s "reserve currency" rest at the
heart of what remains today escalating global monetary disorder.
Not surprisingly, Greenspan is content to frame the debate in an "academic"
context - ensuring any resolution (proof) is impossible. The (Greg Ip) Wall
Street Journal article highlighted a disagreement between Greenspan and
Stanford's (and former Treasury official) John Taylor on the "global savings
glut" thesis. Taylor claims his data show that global investment equaled
savings, hence there’s no "glut".
Clear thinking in Europe
Greenspan counters that Taylor uses actual investment when it should be
"expected" - that is anyway unquantifiable. As Mr Ip wrote, "vintage
Greenspan". Please note the clear language used by Otmar Issing above to
communicate clear thinking assessable to the interested laymen.
Fundamentally, the Federal Reserve "pegged" short-term interest rates, inviting
leveraged speculation. I am not of the view that there is a specific
interest-rate that is "right" for the system. But exceptionally low rates
telegraphed to the leveraged speculators for the purposes of stimulating the
acquisition of risk assets and reinflating asset markets is nefarious central
banking. And never combine telegraphed "pegged" low interest rates with
assurances that the Fed will always be there to sustain marketplace liquidity
(underwrite securities prices), while cutting rates aggressively to mitigate
bursting bubbles.
Once that path is taken there is no turning back; the central bank is held
hostage by the fragility associated with escalating system leverage,
speculative excess and an increasingly maladjusted and vulnerable real economy.
One monetary policy mistake ensures a series of compounding errors.
Greenspan now warns against over-zealous regulation and the intrusion of
governments into the competitive marketplace. Well, he should have considered
these inevitable consequences when he disregarded credit and asset bubbles. And
to admit to such mistakes to ensure a sounder monetary policy regime going
forward would be statesmanlike - which he apparently is not.
And while the focus these days is on myriad government stimulus programs,
creative liquidity arrangements for Wall Street and regulatory reform, it is my
hope that meaningful discussion emerges with regard to a sound "money" and
credit-based "analytical framework" for our central bank.
Unfortunately, Greenspan was lionized. It now becomes difficult to separate the
cult of Greenspan - an individual I view as single-handedly more responsible
for credit and asset bubbles than anyone else in history - from Federal Reserve
policymaking philosophy and "analytical framework". Greenspan's successor,
chairman Ben Bernanke, has referred to the understanding of the Great
Depression as the "holy grail" of economics. The pursuit of the "grail" will
now be assessing, interpreting and drawing lessons from the Greenspan Episode.
WEEKLY WATCH
For the week, the Dow declined 2.3% (down 7.1% y-t-d) and the S&P500 fell
2.7% (down 9.2%). Economically-sensitive sectors were weak. The Transports (up
5.3%) and the Morgan Stanley Cyclicals (down 6.1%) both were hit for 3.3%. The
Utilities were unchanged (down 7.7%), and the Morgan Stanley Consumer index
declined 2.0% (down 6.7%). The small cap Russell 2000 fell 3.6% (down 10.2%),
and the S&P400 Mid-Cap index declined 1.9% (down 6.9%). The NASDAQ100 was
hit for 3.6% (down 13.7%) and the Morgan Stanley High Tech index 3.4% (down
13.8%). The Semiconductors fell 2.8% (down 12.1%), the Street.com Internet
Index 3.5% (down 11.9%), and the NASDAQ Telecommunications index 3.8% (down
11.8%). The Biotechs slipped 0.5% (down 2.3%). Financial stocks again found
themselves under heavy selling pressure. The Broker/Dealers were hit for 7.4%
(down 26%), and the Banks dropped 4.2% (down 10.9%). Although Bullion rose
$11.50, the HUI Gold index declined 1.6% (up 8.3%).
One-month Treasury bill rates sank 58 bps this past week to 0.90%, and 3-month
yields fell 19 bps to 1.19%. Two-year government yields declined 7 bps to
1.74%. Five-year T-note yields dipped 4 bps to 2.57%, while ten-year yields
were little changed at 3.47%. Long-bond yields dipped one basis point to 4.30%.
The 2yr/10yr spread ended the week at 170 bps. The implied yield on 3-month
December ’08 Eurodollars increased 3 bps to 2.345%. Benchmark Fannie MBS yields
rose 3 bps to 5.20%. The spread between benchmark MBS and 10-year Treasuries
widened 3 to 173 bps. The spread on Fannie’s 5% 2017 note widened 3 to 67 bps
and the spread on Freddie’s 5% 2017 note widened 4 to 67 bps. The 10-year
dollar swap spread increased 1.75 to 64.5. Corporate bond spreads were wider.
An index of investment grade bond spreads widened 18 to 129 bps. An index of
junk bond spreads widened 8 to 639 bps.
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