The Word with Brady Willet >
Blame The Fed - Then Pray They Don’t Fail Again
October 11, 2002
Greenspan has admitted that he did nothing to stop the stock market bubble from inflating, and the record clearly shows that he has done everything possible to fight economic recession. Perhaps he should have done the exact opposite?
First Greenspan (on Monday), then McDonough (on Tuesday), and then Hoenig (Wednesday) -- apparently the purpose of the closed door Fed meeting on Monday was to round up the troops and send them into a rhetorical ‘everything is alright’ campaign. However, and despite claims from numerous Fed members that the U.S. economy is smoothly riding through a bumpy recovery, everything is not alright.
Part I: The Fed did it
Greenspan took his share of criticism following his ‘don’t blame me for the bubble speech’. In fact, if it were not for the fact that Mr. G helped soothe investor fears following the crash of 1987 and helped keep the economy humming during the 1990s people would certainly be calling for Greenspan’s head today.
Even so, what is often overlooked when people criticize Greenspan is simple mathematics. To be sure, if an economy is growing at say 4% and the money supply is growing at say 15%, you don’t need a calculator to figure out that something is amiss. The simple truth, and one that Austrian economists often point out, is that expanding the money supply beyond the rate of economic growth creates inflation. Whether this inflation occurs as price inflation or asset inflation is irrelevant.
Question: did Greenspan and the Fed ever aim to expand the money supply beyond the anticipated growth rate? Yes. Did doing so help stoke the equity bubble and/or the housing bubble? Yes.
Deflationary Monster Has Many Tentacles
Put simply, deflation occurs when new money is no longer able to inflate either prices or assets. However, if allowed to linger deflation can represent a far more ominous threat – that being complete lack of central bank control.
For an example of this ‘loss of control’ consider what IMF Chief economist Kenneth Rogoff has this to say about Japan:
“I think that an aggressive move . . . including quantitative easing and a communication strategy (which clarifies) that the object is to end deflation . . . is warranted at this point.
He said BOJ should make clear to the markets that its policy is to end deflation and "to achieve a positive rate of inflation within a reasonably short time frame.””
Notice how Mr. Rogoff’s recommendations are not really recommendations at all, but simply vague and meaningless words. Think about it: how does a central bank achieve a ‘positive rate of inflation’ when a zero bound interest rate policy no longer stimulates economic activity? Furthermore, what does a ‘communication strategy’ mean? Does any investor on the planet actually believe that the BOJ has not been attempting to stymie deflation for much of the last decade? As for ‘easing’ – what a novel idea. In the case of Japan, what monetary constrictions are left to ‘ease’?
Point being, and as the Japan example aptly demonstrates, deflation can rendered a central bank helpless.
Fooled By the Maestro
With this in mind, we have all been tricked by Greenspan. For certain, as the Fed was recklessly expanding the money supply to help combat the Asian crisis and Y2K Greenspan would frequently herald that productivity growth had slain the inflation beast. Little did Greenspan know, or was willing to admit, that inflation was running amuck in equity markets, corporate debt markets, derivatives markets, etc.
Exactly why the Fed did not fear this asset inflation is unknown. After all, is not the Fed concerned about asset deflation today?
Part II Big Changes & Big Blow Ups
In a bear market characterized by seemingly never ending losses the one thing missing has been a memorable bankruptcy and/or bailout. Be it the demise of water stock issuance in the 1860s, the blow-up of railroad stocks in the 1890s, the failure of trust companies in the early 1900s (1907 Knickerbocker), or the collapse of investment trusts that began in October 1929, each ‘crash’ period is remembered for both the unprecedented amount of capital destroyed and the startling regulatory changes and/or bailouts that followed.
By contrast, all that can be said about the current period thus far is that the Fed gave LTCM some money. End of story.
Change Comes Slowly
Some would argue that internet blow ups and the demise of the stock markets in general rival any destructive period in history. And while this belief on the surface very true, after all nearly $8 Trillion in stock market wealth has been erased, the fact remains that is the thud has not yet been heard.
During every previous destructive phase mentioned above either JP Morgan (Fed) tried to bail out the markets (companies) and/or swooping regulatory changes where required to bring confidence back to stocks. The end of water stock issuance, the closing of NYSE for 10 days following a Jay Cooke & Company induced panic, the end of JP Morgan as the lender of the last resort following the panic 1907, the formation of the SEC – these are real and memorable events in the history of the U.S. financial markets.
By contrast, absolutely nothing tangible and/or memorable has changed since the current destruction phase began (it is debatable whether or not Goodwill impairment rather than amortization has been a significant change). Yes, CEOs and CFOs have re-signed their financial statements and new laws have been created with the hope of sending criminals to jail. However, while the regulators have been busy tackling blatant fraud what they have not been doing is changing what are undoubtedly the loosest sets of accounting standards since the SEC was formed. What this suggests is that more changes are coming: special purpose entities and off balance sheet financing must be consolidated to balance sheets, stock options must be expensed against reported earnings, the OTC derivatives markets must be regulated, and a universal standard for operational EPS calculations must be crafted (the trend appears to be towards S&P’s ‘core earnings’ numbers).
Conclusions
As the Dow scratches 5-year lows and the Nasdaq spends the next 20-50 years trying to recapture 5,000, the Fed is beginning to learn that expanding the money supply beyond the expected rate of economic growth can be a dangerous practice. Furthermore, as merchant energy traders who were once ‘perfectly hedged’ go broke and rumors of an OTC derivatives default abound (first Commertzbank bank (Germany), then J.P. Morgan), what is becoming painfully clear is that the financial markets may not escape their current doldrums without a memorable blow-up. Suffice it to say, with such a blow-up what will be even more memorable are the swooping regulatory changes that follow.
As the SEC and FASB work to counteract falling investor confidence by creating new reporting standards, the Fed will endeavor to adopt new ‘unconventional’ anti-deflation policies. Furthermore, the current stock market rally notwithstanding, rising corporate spreads to that of Treasurys and slumping global stock prices suggest that a ‘100 year flood’ is near – that a selective (perhaps also secretive) bailout by the Fed lurks…
Blame Greenspan and the Fed for helping to create then completely ignoring asset price inflation. Furthermore, and as the Fed’s printing press loses its power, blame the Fed for failing to accept the much needed cooling off period (recession) as a welcomed inevitability. However, and after criticism of Greenspan and the Fed has been exhausted, pray the Fed does not fail in the future. After all, Mr. Rogoff suggests the BOJ needs an ‘aggressive move’…Greenspan and company, save bailing out the next LTCM, may have already used up all of their ‘aggressive moves’...
BWillett@fallstreet.com
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