Hooked on “The Hand”:
Doug Noland
Alan Greenspan spoke (via satellite) yesterday to the Federal Reserve Bank of Chicago’s Conference on Bank Structure. His speech was titled “Risk Transfer and Financial Stability” and is available at the Federal Reserve’s website.
From the Q&A session:
Question: “Can more (hedge fund) transparency be required – should it be required?”
Chairman Greenspan: “You have to remember, that the one extraordinary important issue relating to the hedge funds is they act to increase liquidity in markets. And you have to be very careful to make sure that, on the one hand, that the hedge funds are completely transparent to their investors and that the investors are acutely aware of the nature of the risks and the level of the risk they are taking. But you also have to be careful about imposing regulation on these funds to the extent that you inhibit their actions. Remember, collecting data on hedge funds may appear to give you a degree of transparency, but most of the data you get – at best – will tell you about their strategy of last night. This morning they have a new one. Consequently, the type of data which is supposedly to be collected to create a degree of transparency and knowledge about how these funds are behaving is actually history. And it’s usually quiet unusable, because it’s their very nature to be innovative, changing and never actually to anticipate necessarily what they are going to find next in the marketplace which will suggest to them some imbalance – some potential exceptionally large profit arbitrage which they haven’t even anticipated would exist 48 hours earlier. So I think the question here is to be very careful to be sure that the people we want to protect are the counterparties to the hedge funds – meaning they have to get all the information that they need. And that will protect the marketplace and all their investors.”
Question: “Are there any financial crises brewing at the moment?”
Chairman Greenspan: “Well, not really. I mean, the problem that I have is that crises that you can see are probably already behind us. You have to remember, that the vast majority of imbalances that occur in markets are addressed very quickly by prices and we never hear of them. So, it strikes me that what we have to recall is the terrific insight of Adam Smith that there is something equivalent to an ‘invisible hand’ which continuously is readdressing market imbalances towards equilibrium is indeed what we are seeing virtually everyday – in fact, every hour and every minute – in the markets in which we deal. And I would suspect that the international context – looking at the increasing degree of globalization that we see almost on a day-by-day basis – that there is something attuned an international invisible hand that seems to be at work. Markets are always by their nature driving towards equilibrium. It looks as though it’s chaos- indeed it’s that chaos which was disposed of by Adam Smith in the great insights of more than 200 years ago – which in some respects hold up with very little revision to this day. In a certain sense that so called ‘creative destruction’ in markets which is what Schumpeter defined the process as many, many years later obviously, is a continuous train which is always creating a sense of nervousness about something going wrong. In fact, it’s normal. And it strikes me that crises are very difficult to forecast. Or, let me put it another way: the numbers of forecasts of crises that one gets day-by-day, week-by-week, is far in excess of the number of crises that actually occur. This is the reason why I’ve argued previously that since we really cannot know that we are about to get a crisis until we are right up against it, economic policy-making should be heavily focused on the issue of creating and sustaining the flexibility of markets so that when we get pressures of one form or another, the markets respond in a balanced manner and essentially remove the disruptions that are causing the difficulties.”
It is inadvisable to have one man singularly reign over monetary policy-making for 18 years. It is potentially disastrous when this individual is an ardent ideologue. And one of the painful lessons that will be ascertained from this experience is that the greatest risk with regard to discretionary monetary policy is the propensity for policy errors to engender only greater errors – along with a lot of rationalizations.
As chairman Greenspan’s views harden and become increasingly fanatical, identifying serious analytical errors is a less demanding endeavor. He has grown comfortable making grand economic declarations, ignoring the reality that many are valid only in an environment of sound and stable “money”/finance. Adam Smith’s wonderful “invisible hand” insight was made in the context of forces governing the mutually beneficial exchange of tradable goods. It is an Economic Sphere concept that certainly cannot be haphazardly projected to contemporary electronic markets for securities, derivatives and other financial instruments. As we have witnessed, an environment of Credit and liquidity excess will foster asset price distortions, speculation, and boom and bust cycles in the Financial and Economic Spheres. Unbounded finance nurtures self-reinforcing excess and distortions, the antitheses of the “invisible hand.”
Moreover, Mr. Greenspan’s assertion that “markets are always by their nature driving towards equilibrium” is categorically false. This is instead a holdover notion from Milton Friedman’s flawed belief that there is no such thing as “destabilizing speculation.” I have no qualms with the analysis that a well-anchored Financial Sphere and system pricing mechanisms will (generally) entice enterprising speculators to act when prices stray from normal bounds. In such an environment, capitalizing on speculative opportunities will tend to stabilize the system, pressuring markets back to the so-called “equilibrium” level.
Importantly, however, the financial backdrop plays a decisive role with regard to the character of - and ramifications for - speculative market dynamics. As much as a culture of sound finance tends to cultivate stabilizing speculation, profligate and unhinged finance promotes the opposite. Speculative profits become more easily captured betting that prices will continue to inflate away from normal bounds. Moreover, as Credit and speculative excesses fuel rising prices, myriad inflationary manifestations promote additional Credit and liquidity excesses. Financial Sphere excesses tend to stimulate the Economic Sphere, seductively validating the financial claims and asset inflation. Over time, as a system falls deeper into Credit Bubble dynamics, there will be an overwhelming propensity for destabilizing speculative dynamics and consequent asset price Bubbles. Left to its own devices, the Credit system will eventually succumb to dangerous speculative blow-offs. And if this Macro Credit Analysis is less than persuasive, there are hundreds of years of market history and scores of spectacular Bubbles (several over the past two decades) that are inconsistent with Mr. Greenspan’s market claims.
I am sticking again this week with Financial and Economic Sphere analysis, hoping this framework helps to clarify an especially unclear environment. I will this evening assume that today’s strong employment data will only soften the bond market’s “softpatch” fixation and the contention of many that the Fed has about completed its rate normalization project. Still, it does support my view that the Economic Sphere weakness is not the key dynamic driving markets. I take the general view that news and analysis follow the markets and not vice versa, and we have experienced an extreme example of this dynamic over the past two months. While a spate of softer data certainly didn’t hurt, I suspect that internal Treasury (and interest-rate, GM and CDS) market dynamics have played the key role in the recent rate decline and overall interest-rate volatility.
Ten-year Treasury yields traded at 3.99% on February 9th, surged to 4.64% by March 22nd, before sinking back to 4.15% yesterday (jumping 11bps today). And, let me confess, it is one thing suggesting readers be prepared to endure “manic-depressive” market behavior and quite another actually witnessing it firsthand. March’s perception of overheating morphed into April’s fears of a rapidly decelerating U.S. and global economy. Increasingly, data suggests that March’s softness did not carry into April. Perhaps the confluence of March’s surge in market yields, the media’s preoccupation with much higher rates to come, the public obsessing over daily mortgage rates as they did NASDAQ prices during 1999/2000, the spike in crude and gas prices, and general financial market tumult provided a temporary drag on U.S. activity – possibly compounded by the quarter-end timing of various negative factors. The financial horse continues to pull (and jounce) the economic cart.
There is a prevailing view that economic vulnerability precludes the Fed from significant further tightening. The unfolding issues with auto and auto-related debt and derivatives only add to the litany of financial sector fragilities. Even the discerning Stephen Roach made an abrupt u-turn after two weeks back arguing that a 5.5% Fed funds rate might be required. This week he suggested the Fed may be done. Sticking to their guns, the gentlemen at Pimco argue the Fed must soon end its tightening campaign or risk recession for the overleveraged, finance-based U.S. economy. I will dig in my heels and disagree. The Fed still has much work to do, acute financial fragility notwithstanding.
First of all, there is at this point absolutely no way around financial crisis and recession. And while there is the understandable preference to delay one’s comeuppance, when it comes to monetary and economic management it is of utmost importance to accept responsibility and take the pain early. The Financial Sphere has inflated dangerously and sustaining this Bubble is a precarious losing proposition. The wildly maladjusted and unbalanced U.S. economy must suffer through a wrenching adjustment period. Historic excess throughout mortgage finance must be reined in. The U.S. Current Account Deficit must be brought under control. The vulnerable dollar must be supported with significant yield differentials. The global economy must be weaned from the massive destabilizing pool of largely dollar-denominated liquidity.
The bottom line is that the Fed faces an enormously arduous task dealing with these now intransigent imbalances. The wildly inflated and dysfunctional Financial Sphere is not about to magically transform itself into a mechanism soundly financing a stable and well-balanced Economic Sphere. Powerful Monetary Processes must be contained (and eventually eradicated) and the adjustment process commenced. Three percent Fed funds is not up to the task, and fear of the unavoidable adjustment process is not pardonable analysis.
I find recent “neutral rate” discussions interesting, although generally misplaced. There is a decided Economic Sphere focus: what Fed funds target rate would today put the economy “on a trajectory of sustainable non-inflationary growth?” Well, with real GDP growth supposedly moderating and narrow aggregate measures of consumer price inflation still rather tame, most analysts feel today’s rate is just fine and see little justification for tighter monetary policy. And I would not take such strong exception with this analysis in a stable Financial Sphere environment. But today the paramount issue with regard to interest-rate “neutrality” is stabilizing the Financial Sphere Bubble. And, importantly, it is not a case of whether or not the financial Bubble bursts. The stakes include outright financial collapse.
Even those integrating the financial environment into their analysis argue that recent market turbulence should force the Fed to soon terminate rate increases. Yet a strong case can be made that the prominent effect of heightened market stress is, to this point, a decline in mortgage borrowing costs – exactly what the system does not need. Throwing GM and Ford on the junk heap only has MBS (and mortgage loans) glistening more radiantly. As such, liquidity and Credit Availability may be somewhat more restrained for fringe corporate borrowers. Meanwhile, the Mortgage Finance Bubble receives wanton stimulus. Weighing one against the other, there is today little systemic Credit restraint and only further evidence of Financial Sphere Dysfunctionality. The experiment to ease the Credit Bubble down softly is, not surprisingly, failing.
And I passionately argue that the focal point for any contemporary conceptualization of interest-rate neutrality must be the identification of the principal means of systemic Credit and liquidity creation. If, as in the past, financing capital investment provided the key source of system liquidity, a “neutral rate” would be expected to correspond to the “return on capital” and corporate profitability, more generally. Today, on the other hand, Federal Reserve policymakers and pundits should recognize and incorporate into their analysis the fact that mortgage Credit and speculative leveraging are today the overwhelming source of system liquidity. Gross excess emanating from the Mortgage Finance Bubble fuels Financial Sphere inflation and consequent Monetary Disorder. And I can certainly appreciate why the Fed and Wall Street pundits avoid this issue like the plague. But this does not change the reality that only significantly higher mortgage rates will, at this point, stem gross excesses. The cost of being so far for so long behind the curve.
Mr. Greenspan’s comment that hedge funds “act to increase liquidity in markets” must make central bankers in Malaysia, Thailand, South Korea, Argentina and elsewhere bristle. Even we experienced hints of what hedge fund liquidations can do to marketplace liquidity back in 1994 and again during 1998. Our Fed chairman would more accurately state that hedge funds increase marketplace liquidity when the industry is receiving inflows, increasing leverage, and expanding positions. Under Mr. Greenspan’s watch, The Community created incredible liquidity in an expanding array of markets globally as it mushroomed from a couple tens of millions to surpass $1 Trillion in investor assets (position sizes significantly larger).
Mr. Greenspan’s protracted chairmanship has provided an astonishing windfall (wealth transfer) to the leveraged speculating community. The Fed’s decision to peg short term rates, the assurances of continuous marketplace liquidity, and moving to extraordinary transparency, along with the more recent promises of helicopter money and unconventional measures as necessary, were all major factors in nurturing exceptional speculator profits. And during the early nineties and throughout the past four years the Fed stimulated the system with ultra-low borrowing costs. The speculators were right there to take full advantage – building leverage, positions, and marketplace liquidity all along the way. There was also the explosion of GSE debt and MBS with implied government guarantees, a god-send for the mushrooming spread trade and derivatives markets. Greenspan’s public advocacy of derivatives and structured finance played a pivotal role in their respective ballooning growth. And while Mr. Greenspan trumpets Adam Smith’s “invisible hand,” I have in the past labeled the government’s towering market presence and interest-rate manipulation as “The Hand.” The relative degree of Mr. Greenspan’s faith in the “invisible hand” of free markets versus “The Hand” commanding speculative pursuits and a runway Credit Bubble is an epochal open question.
Not unjustifiably, the marketplace perceives that the leveraged speculating community is much “too big to fail.” This perception is an important aspect of the powerful inflationary bias (proclivity for higher prices/lower rates) that perseveres throughout the bond market (and stokes the destabilizing Mortgage Finance Bubble). At the first sign of system stress – GM debt problems, for example – Treasury, agency and MBS yields head lower. This ushers in “The Conundrum” – or the necessity for the huge amount of hedges against higher interest rates to be unwound, while hedges for protection from lower rates are implemented. And let's not forget the speculators intent on buying ahead of the derivative traders. The entire process has worked swimmingly to sustain excesses and avoid commencing the necessary adjustment process (although it does seem to have taken on a wrecking ball effect of late).
The question I have revolves around the possibility that Fed and leveraged speculating community interests have diverged. Perhaps Mr. Greenspan really believes that the economy and financial system are resilient and that the Fed shouldn’t be all too concerned about the risk of crisis. Could the Fed really have one eye on conspicuous excesses in mortgage finance and the other on the Current Account Deficit and vulnerable dollar? Is the Greenspan Fed prepared to call the markets bluff - to raise rates and let the “invisible hand” work its magic? This would be one hell of a change for a marketplace having grown So Hooked on “The Hand.” And, while I am daydreaming, wouldn’t it be ironic if the Fed finally attempts to find a little central banker religion right as leveraged player vulnerability and systemic fragility really begin to manifest. |
