absolutely classic piece by noland
prudentbear.com
The Greenspan Legacy and Issues 2004:
Alan Greenspan’s speech Saturday at the American Economic Association’s annual meeting in San Diego – Risk and Uncertainly in Monetary Policy – has not received the attention it deserves. Our Fed chairman forges ahead with painstaking efforts to fabricate an analytical perspective that places his reign at the Fed (as well as the current environment) in a most positive light. To read his carefully crafted reasoning, one would believe that U.S. monetary policy has been almost flawless for the past sixteen years. Moreover, central bankers have made monumental progress in advancing economic thought and monetary management.
Listening to Greenspan, one would also be left with the sanguine sense that contemporary economic and financial systems have evolved to a status superior to anything previously experienced. After decades of toil, we can now celebrate the achievement of the “price stability” holy grail. The economy? It has evolved to unprecedented flexibility and stability, with market forces readily capable of resolving imbalances like never before. Contemporary financial systems? It goes without saying that today’s risk management systems are unparalleled to anything from the past. Once again, Mr. Greenspan’s cheerleading has proved music to the ears of hyper-speculative global markets.
Yet “obfuscation” is too kind for Dr. Greenspan’s latest brainchild. For years, I have often pondered: “Greenspan: Inept or Fraud?” Something is just not right. As for his latest, I don’t believe “fraudulent” is either an inaccurate or excessive characterization. “Dishonorable” doesn’t seem strong enough; dangerous "historical revisionism", certainly. After all, truly monumental policy errors have been committed and negligently perpetuated. Back in 1999, at our Credit Bubble Symposium, Dr. Henry Kaufman stated, “The Fed missed its timing,” and there would be a heavy price to pay. More than 4 years later, Greenspan (“The Nick Leeson of central banking”) not only refuses to cut his escalating losses, but insolently claims he has brilliantly orchestrated a winning trade. For the public interest and for the benefit of future generations, a statesman – or any person with a sense of honor, for that matter – would come clean. He refuses, choosing instead to succumb to revisionism and deceit.
But his speech does provide the most comprehensive framework of current Fed “thinking.” It’s Greenspan’s interpretation of history and the present. It’s his “story” and we should expect that our central bank will be “sticking to it.” So it is definitely worth reading carefully and contemplating.
I will somewhat cut to the chase and begin with one of his concluding paragraphs:
“As we confront the many unspecifiable dangers that lie ahead, the marked improvement in the degree of flexibility and resilience exhibited by our economy in recent years should afford us considerable comfort. Assuming that it will persist, the trend toward increased flexibility implies that an ever-greater part of the resolution of economic imbalances will occur through the actions of business firms and households. Less will be required from the risk-laden initiatives of monetary policymakers.”
“…we at the Fed, to our credit, did gradually come to recognize the structural economic changes that we were living through and accordingly altered our understanding of the key parameters of the economic system and our policy stance.”
I expect future students of economics and history to find Dr. Greenspan’s reasoning hard to fathom: economic structural change created an environment where “less will be required from the risk-laden initiatives of monetary policymakers”? Clearly, there have been some crucial flaws in analysis of the U.S. economy and contemporary finance. First, consumer price inflation is no longer an effective gauge of the appropriateness of monetary policy. One must look first to Credit growth, the current account, financial speculation, asset inflation, and the nature of consumer and business borrowing and spending. A single index will not suffice. And in spite of Greenspan’s (and Milton Friedman’s) claims, inflation is no longer “everywhere and always a monetary phenomenon.”
Inflation is today a Credit phenomenon with myriad and complex manifestations. With unconstrained global electronic Credit/financial systems (including government issued fiat currencies, but largely non-government liability creation), never has financial stability been as reliant on central banker diligence and restraint. And the most significant economic structural changes include a massive global (but predominantly Asian) investment in manufacturing capacity coupled with a momentous change in the character of U.S. “output.” This combination has created economic systems where truly massive Credit and destabilizing asset inflations now have minimal effect on the traditional aggregate consumer price level.
The global Credit inflationary manifestation of endemic over/mal-investment in consumer goods production capacity ensures at least adequate supplies. And, most importantly, the nature of the contemporary U.S. economy has evolved fundamentally, although not as Dr. Greenspan professes. The crucial issue is the character of “output,” having “evolved” from predominantly manufactured goods to today’s multifarious intangible “services.” We will save for another day the debate over services’ (as compared to manufacturing) capacity to create true economic wealth. But it is simply sloppy - and it seems to me disingenuous - to herald a “productivity revolution,” while disregarding the fundamental change to predominantely contemporary services “output.”
Furthermore, and most importantly, today’s service sector economy has an unprecedented capacity to absorb Credit excess. First, a “digital” (technology) economy – including microchips, computers, the Internet, telecommunications services, entertainment and the general media – today has the capacity to expand (and absorb Credit creation) to a degree unlike a manufacturing-based economy. But we must be mindful that, while such Credit excess may not manifest into rising prices per se, there is nonetheless a residual of debt/financial claims with attendant issues (potentially weak debt structures, heightened speculation, destabilizing asset inflation, financial fragility, fraud and corruption, spending distortions, etc.).
Second, the evolution to an asset price-centric economy – financial, real estate, sports franchises, media, etc. – also creates an economy with an unparalleled capacity to create and absorb Credit inflation with minimal impact to the aggregate consumer price level. And, third, the “services” sector – government, financial, medical, attorneys, accountants, consultants, real estate agents, insurance salesmen, etc. – can thrive (and generate “output”) on the Credit excess emanating from booming asset inflation. It is an especially deceptive and seductive inflationary environment.
And contemporary finance and the modern structure of the U.S. economy simply could not have a stronger proclivity and capacity for dangerous Credit excess that manifests into asset inflation and economic maladjustment. With unconstrained Credit and an economy that can appear to accommodate even extreme excess, I strongly argue that the marketplace is incapable of self-regulation. It is simply too prone to self-reinforcing and ultimately uncontrollable Bubbles. Besides, there is the reality that Credit and speculative excess inherently distort the market pricing mechanism.
There is great irony: with Dr. Greenspan’s fallacious focus on stable consumer prices and “productivity” advances, he proclaims an environment where the Fed can gleefully allow the marketplace to correct imbalances. Wow… This is one - if not the greatest - blunder in the history of central banking.
From Dr. Greenspan:
“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.”
“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.”
“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.’”
“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…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.”
First of all, asset inflation and the propensity for destabilizing Bubbles should be recognized as a paramount risk to financial and economic stability, hence a fundamental focus/fixation of contemporary central banking. And as we have witnessed over the past decade (going back at least to what were at the time extreme speculative excess in the U.S. bond/interest rate markets back in 1993), once speculative forces are unleashed they are quite difficult to control. If they are not dealt with early – and only a disciplined central bank has such capacity – then they will inflate to the point of posing significant risk to the economy and financial system. Greenspan addressed the issue of stock and bond market Bubbles as early as 1994, but these Bubbles some years ago grew to unmanageable (at least not without considerable pain and dislocation) proportions. Held hostage to financial and economic Bubbles, the current environment is only an illusion of stability.
Conveniently, Dr. Greenspan today avoids the issue of a massive Bubble throughout the U.S. Credit system (leveraged speculation/the GSEs/derivatives/Credit insurance), choosing instead to trumpet his postulate and celebrate his strategy for dealing with the aftermath of the late-nineties stock market Bubble. But the harsh reality of the situation is that the stock market remains but one aspect of a monumental Credit/financial Bubble that I argue is in the midst of historic “blow-off” excess. Greenspan’s approach for “addressing” the aftermath of the bursting of the late nineties stock market Bubble was to further invigorate the bond/mortgage finance/real estate Bubbles. Credit Bubble excess has of late taken a decided turn for the worst with the direst consequences, yet Dr. Greenspan glorifies his accomplishments.
From Greenspan: “As this episode illustrates (the Fed’s aggressive response last year to ward off deflation risk), 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.”
I found it fascinating the Robert Rubin annunciated a similar philosophy in his book: Policymaking should weigh a potentially high-risk outcome heavily, even if a negative outcome is a relatively low probability. But what about a trader mitigating losses and closing out losing positions? There must be recognition that the risk associated with inflating financial and economic Bubbles grows exponentially over time. With Greenspan professing that Bubbles are not recognizable early, aren’t they thus signaling that the government and Fed is in the Bubble perpetuating business? At the minimum, such an approach incites speculation and excessive risk-taking.
It is today, as we contemplate Issues 2004, useful to appreciate the great paradox of the failed “Greenspan Doctrine.” Uncontrolled finance (“money,” Credit, and leveraged speculation) has nurtured an acutely vulnerable Bubble economy and unprecedented financial fragility (asset Bubbles, weak debt structures) and economic vulnerability (maladjusted economy). Negligent monetary policy has created an environment of exceedingly high risk. Accordingly, the Greenspan Fed now explicitly promises the massive and expanding Global Leveraged Speculating Community that the Fed will not only avoid moving to rein in excess, it will be quick to stimulate and flood the system with liquidity at any sign of trouble. Well, Dr. Greenspan may fabricate a cheery story, but we have witnessed the worst case scenario unfold before our eyes: The Fed Condoning Runaway Credit and Speculative Excess. The Fox has taken complete control of the henhouse.
We are now in the midst of history’s greatest global speculative Bubble, and it simply could not appear more appealing and enticing to the eager participants. A strong argument can be made that, here at home, stock market speculation is much broader than even (the technology centric Bubble) during 1999. Bond and interest-rate market speculation are unprecedented, encompassing Treasuries, agencies, mortgage-backs, corporates, converts, asset-backed securities, junk and “structured finance.” Leveraged speculation has engulfed the emerging markets, both in equities and debt. The currency and commodity markets are, as well as bastion of speculation. Seemingly no country or market is being overlooked.
History’s greatest Credit inflation (and increasing dollar revulsion) is spewing dollar liquidity throughout the global financial system. At the same time, the Bank of Japan balance sheet is ballooning unlike anything previously experienced. The Chinese and Asian economies are in the midst of an historic Credit inflation. The global financial system is over-liquefied like never before. A massive global Leveraged Speculating Community has become the “investment” vehicle of choice, with a virtual global buyers’ panic in search of yield and strong returns. The U.S.-based Credit and speculative Bubbles have engulfed the world.
Massive Credit inflation is, today, working its seductive wonders, much as it did for awhile during some of history’s infamous financial fiascos. As I have tried to explain many times, the problem is that inflation of this variety – ingrained asset inflation and gross financial speculation - is impossible to manage: It is impossible to turn down, let alone to shut off. Excess begets only greater excess, with only more problematic manifestations. Yes, prices of U.S. stocks, bonds, homes, and other assets prices are today inflating, and many have never perceived as much wealth. As fast as liabilities rise, perceived wealth inflates much more rapidly. It appears miraculous.
But with these rising prices comes only the greater requisite Credit inflation to keep asset values levitated and the increasingly maladjusted U.S. Bubble economy pumped up. The amount of Total Credit growth to keep these Bubbles afloat is enormous, but possible – for now. One can envisage for 2004 $1.2 Trillion of new household borrowings, $500 billion Federal debt growth, $200 billion State & Local government, and perhaps $500 billion of net new corporate borrowings.
This $2.4 Trillion of new non-financial debt would be about 10% growth on top of a massive debt mountain, in what would perpetuate the greatest ever expansion of non-productive debt. It would also perpetuate one of the great currency debasements in history. But such is the heavy price for central bank incompetence and futile Bubble preservation. One would typically expect the local central bank to move aggressively against gross excess to protect the value of its citizens’ currency. Greenspan has promised not to safeguard our dollar. One would typically then expect the marketplace to discipline a runaway Credit inflation. The Bank of Japan, Asian central banks, and central banks around the world (ex the ECB) are committed to circumventing market forces. Thus, reckless excess runs unabated. And, again, this massive inflation will appear miraculous until “the wheels come off.”
Yesterday the Bank of Japan reported that Official Foreign Reserves increased $29.1 billion during December to $652.8 billion. These largely dollar reserves were up an astonishing $201.3 billion, or 45%, for the year. There is market speculation that the Bank of Japan expended as much as $30 billion this week supporting the dollar. The size of these unrelenting interventions/liquidity injections is simply incredible, especially in the face of today’s wildly overheated global financial system. That unprecedented intervention barely stabilizing the dollar is indicative of an unfolding crisis.
Over-liquefied global financial markets are a key Issue for 2004. The Wall of Liquidity is poised to inundate economies and markets with inflationary biases (of which there are many). Virtually the entirety of greater Asia appears on the brink of problematic overheating. Expect myriad inflationary manifestations to take hold, especially in China, India, and SE Asia. Procuring sufficient future energy supplies will become an important concern and issue for the future. And, increasingly, the Wall of Liquidity has its sights on Latin America. With such a backdrop, economies could surprise on the upside. Inflation will not be far behind.
Here at home, markets are bringing new meaning to “financial fragility.” The Great Credit Bubble is in the midst of gross “blow-off” excess. The speculative stock market is in speculative blow-off excess. The bond market is at risk to melt-up dynamics -- at the cusp of another self-reinforcing and destabilizing yield collapse. One key consequence of the over-liquefied global financial system (stoked by dollar weakness and Fed accommodation) is that the U.S. bond market is nudged toward dislocation. The massive derivatives market – hedging ballooning MBS, GSE, and speculative positions – is prone to self-reinforcing dislocation, with the specter of another refi wave always looming. Furthermore, acute systemic risk to higher rates precludes rising yields. And if yields are not allowed to go up, the nature of market dynamics dictates that they could surprise on the downside. Artificially low yields would be destabilizing in many ways, including throwing gas on the mortgage finance fire. The bias will remain for “blow-off” excess throughout residential real estate, setting the stage for an inevitable crash.
Mr. Greenspan’s revisionism also referred to the Savings & Loan “crisis” “that had its origins in a serious maturity mismatch as interest rates rose.” Well, the truth of the matter is that the S&L collapse was a massive fraud, with the Fed and government policymakers complicit for fostering a huge fiasco rather than dealing with early on. In this regard, the S&L debacle was a forerunner for the GSEs, leveraged speculation, derivatives, and other unfolding fiascos. The bottom line is that, as history has made so clear, “easy money” nurtures fraud and corruption and I am willing to prognosticate that the current runaway mortgage finance Bubble is cultivating fraud what will be shocking in its scale. And fraud and corruption will certainly be an increasingly problem down the road for financial markets at home and abroad.
But for now, there is certainly sufficient risk apparent in market dynamics. Extraordinary moves are now commonplace in global equity, fixed-income, currency, and commodity markets. It is an environment conducive to accidents in a marketplace dominated by highly leveraged speculators. And with the dollar in virtual free fall – albeit thus far managed by enormous foreign central bank buying – the possibility of a derivative-related dislocation is not insignificant. It does not take a wild imagination to envision a problem in the currency derivatives marketplace impinging other markets, especially the convoluted U.S. interest rate market. And a scenario of collapsing yields, a rekindled refi boom, overheated mortgage finance and the resulting massive Credit creation (dollar claims inflation) feeding a dollar collapse is not a remote possibility.
The sinking dollar will be an ongoing and increasingly problematic Issue for 2004. The U.S. is “exporting” inflation, this exportation is self-reinforcing, and the consequent manifestations will not indefinitely appear so benign (or darn right wonderful!). The Pandora’s Box of a Collapsing Dollar is now Agape.
As for the U.S. Bubble economy, its fate is in the hands of the Great Credit Bubble. At this point, there appears such an inflationary bias in the U.S. interest rate markets (certainly exacerbated by the over-liquefied global financial system) that any weak economic data will be met with exaggerated declines in market yields. Today’s reaction to the disappointing jobs data is a case in point. For now, this will tend to support real estate inflation – the key to the consumer borrowing and spending Bubble. The farm and manufacturing sectors appear poised to overheat. Ultra-easy money has, regrettably, rekindled the technology Bubble.
Yet, the bottom line is that years of Credit and speculation-induced maladjustment have severely distorted the U.S. economy, and these distortions are in “blow off” mode as well. And even massive stimulation – while creating incredible perceived wealth for some – is incapable of supporting broad-based employment gains. Importantly, the now highflying manufacturing sector has been so weakened and diminished to the point of being incapable of being a meaningful jobs creator for the general economy. Employment gains will be spotty and feeble relative to the degree of stimulation. Economic performance will be extraordinarily uneven, income growth extraordinarily uneven, and spending – as was demonstrated during the Christmas retail season – will be extraordinarily uneven (stagnant real wages for the majority, with inflating incomes for those fortunate enough to profit from asset markets and other inflations). Inflationary manifestations will broaden, with energy prices and supplies an ongoing concern.
To wrap this up, Issues 2004 will likely revolve around ongoing extreme financial and economic risk and uncertainty. And that the marketplace has lunged into such incautious optimism and gross speculative excess portend ominous developments. Importantly, participants are mistaking the terminal stage of (prolonged) “blow off” excess for the commencement of a new bull market. Moreover, confidence is running high that the powers that be will ensure strong markets through the election. Perhaps, but this is precisely the type of market psychology that sets the stage for disappointment.
Surely, the spectacular Russian debacle would not have been possible without the insouciant boom-time perceptions that “the West” would never allow Russia to collapse. Leveraged speculators flocked to Russia in droves. Today, the U.S. (and global) marketplace goes to truly unprecedented extremes with the comfort that the all-knowing, all-powerful, all-beneficent market administrator, Alan Greenspan (and global central bankers), would never allow collapse or even severely disappoint. He has certainly done everything imaginable (and then some) to nurture this dangerous mindset. Accordingly, I would strongly argue that 2004 is distinguished from any year since 1929 for the Great Divide Between Optimistic Perceptions and an Acutely Fragile Reality. Such circumstances dictate that the risk of spectacular financial tumult is today considerable and rising.
And when tumultuous times arrive, Mr. Greenspan will surely wish he had more than 100 basis points. He will also regret nurturing a massive Leveraged Speculating Community, as well as cajoling U.S. savers into risky assets and reckless mortgage borrowings. He will come to appreciate that there is a profound difference in kind between “output” that we can exchange with our trading partners and much of services “output” that only inflates GDP and productivity measures. He will come to appreciate the risk of using financial speculators as the key monetary transmission mechanism. And our Fed chairman will also bemoan his lack of friends at the ECB, while wishing for much larger foreign reserves and a large cache of gold bullion. There is surely a larger probability of this painful process commencing during 2004 than the markets appreciate today. |
