THE TRUE GREENSPAN LEGACY

THE TRUE GREENSPAN LEGACY
by Dr. Kurt Richebächer

Reading so many ecstatic laudations on Fed Chairman Alan Greenspan, "the
greatest of all central bankers," two other names and occurrences came to
mind. The one was John Law and his tremendous wealth creation through
rigorously inflating the share prices of the Mississippi Company. And the
other was former Fed chief Paul Volcker and his recent article in the
Washington Post titled "An Economy On Thin Ice," wherein he expressed his
desperation about the economic and financial development in the United
States. Though he never mentioned his successor's name, it was all about
him and his policies.

Just a few samples from Paul Volcker's assessment:

Under the placid surface, there are disturbing trends: huge imbalances,
disequilibria, risks - call them what you will. Altogether, the
circumstances seem to me as dangerous and intractable as any I can
remember, and I can remember quite a lot. What really concerns me is that
there seems to be so little willingness or capacity to do much about
it...

I don't know whether change will come with a bang or a whimper, whether
sooner or later. But as things stand, it is more likely than not that it
will be financial crises rather than policy foresight that will force the
change.

What, after all, are the great merits of Mr. Greenspan, according to the
conventional laudations? They are, actually, seen in two different fields:
first, in the striking successes of his actual policies; and second, in
notable contributions to both the theory and practice of monetary policy.


His policy successes seem, indeed, all too conspicuous: lower inflation
rates than expected despite strong GDP growth; high gains in job growth;
and low rates of unemployment. And yet only two mild recessions, of which
the second one, in 2001, was so mild that it disappears when quarterly
data are aggregated to a year.

His extraordinary successes are generally attributed to radically new
practices in monetary policy. The Financial Times ran a full-page article
under the big headline "Greenspan's Record: An Activist Unafraid to Depart
From the Rule."

To quote the paper presented by Alan S. Blinder and Ricardo Reis of
Princeton University at the Federal Reserve Bank of Kansas City symposium
on this point: "Federal Reserve policy under his chairmanship has been
characterized by the exercise of pure, period-by-period discretion, with
minimal strategic constraints of any kind, maximal tactical flexibility at
all times and not much in the way of explanations."

It is true Maestro Greenspan disregarded any established rules in central
banking. To escape the consequences of the equity bubble that he created
in the late 1990s, he generated a whole variety of new bubbles that
radically changed the U.S. economy's growth pattern. What he achieved was
the greatest inflation in asset prices in history, which became the
economy's new engine of growth. What about its inevitable aftermath?

If Alan Greenspan jettisoned all inherited rules, he nevertheless chose
one predominant rule, actually, his only rule: a strictly asymmetric
policy pattern. Every central bank has two policy levers at its disposal.
The big lever is changing bank reserves, the banking system's liquidity
base. The little lever consists in altering its short-term interest rate.

Whenever monetary easing appeared opportune, Mr. Greenspan has acted
rigorously with both levers. When it seemed to require some tightening, he
always acted hesitantly and only with his little interest lever. He has
never seriously tightened bank reserves. Though hard to believe, he has
actually been easing the Fed's reserve stance since last May.

This is most probably occurring because the continuous rampant credit
expansion is increasing the banking system's reserve requirements.
Nevertheless, to keep the federal funds rate at its targeted level of 4%,
the Fed has to provide the higher reserves.

What this means should be clear: The Fed is anxious to avoid any true
monetary tightening in the apparent hope that the "measured" rate hikes
will softly do the job over time, causing less pain. Most probably,
though, this implies more rate hikes and more pain - later.

It was, as a matter of fact, precisely the same kind of experience that
induced Volcker to abandon such strict funds rate targeting in October
1979 in favor of targeting bank reserves. It marked the fundamental divide
in U.S. monetary policy from prior persistent monetary looseness and a
strong inflation bias to genuine credit tightening, ushering in a secular
decline in the inflation rates.

The Greenspan Fed has returned to dubious interest targeting, while
explicitly restricting itself to "measured" - in other words, very slow -
rate hikes. The true monetary ease shows in the continuance of the
relentless credit deluge.

When Alan Greenspan took over as Fed chairman in 1987, outstanding U.S.
debts totaled $10.57 trillion. According to the latest available data,
they stand at $37.35 trillion. This is definitely Mr. Greenspan's most
conspicuous achievement.

To escape the aftermath of the equity bubble, the Fed created the housing
and bond bubbles in 2001 and the following years. It is time, we think, to
ponder the aftermath of these two asset and credit bubbles. The inverting
yield curve is primarily threatening the huge existing carry-trade bubble
in bonds. But the big housing bubble and the smaller car bubble too have
plainly peaked. Rising interest rates and poor income growth are
relentlessly taking their toll.

It should be immediately clear that the potential economic and financial
aftermath of a bust of these bubbles will be many times worse than the
potential aftermath of the earlier equity bubble. Spending and debt
excesses have multiplied over the past four to five years to an extent
that threatens the stability of the whole U.S. financial system.

Lately, Mr. Greenspan's public speeches have insinuated that the high
asset prices in the United States in recent years may, ironically, be due
to the extraordinary success of his policies, by leading investors to
demand lower risk premiums. Eventually, however, this reverses and asset
prices fall reflecting "the all-too-evident alternation and infectious
bouts of human euphoria and distress and the instability they engender."

Yet he emphasized that it is "simply not realistic" to expect the Fed to
identify and safely deflate asset bubbles. The right response in his view
is for all policymakers to keep markets as flexible and unregulated as
possible. Flexible markets, he said, helped absorb recent shocks, such as
stock-bubble collapse and the Sept. 11, 2001, terrorist attack.
We are not sure what shocked us more, this senseless, arrogant remark or
the complete silence on the part of American economists. Exuberance, just
by itself, is unable to inflate asset price levels. The indispensable
primary condition is always credit excess, and Mr. Greenspan delivered
that in unprecedented profligacy. By the nature of things, loose money and
credit excess lead, and exuberance follows.

America's reported economic recovery since 2001 has been its weakest by
far in the whole postwar period. For the working population, there never
was a recovery. They speak euphemistically of a shortfall of employment
and income growth. It is better described as a fiasco for both.

Two acute dangers presently lurk in the U.S. economy and its financial
system. One is the inverting yield curve threatening to pull the rug out
from under the huge carry-trade bubble in bonds, and thereby from under
the housing bubble. The other is the slump in consumer spending. Consumer
borrowing is slowing, while employment and labor income growth are
weakening again.

It seems that the carry-trade community is betting on prompt rate cuts by
the Fed if something goes wrong in the economy or the financial system. We
suspect that the Fed, grossly underestimating the enormous vulnerabilities
in both sectors, will stick to its rate hikes. The interest "conundrum" is
pretty much the only thing holding up this house of cards.

"Super-liquid markets" has become the common bullish catchphrase. It
should be realized, however, that the existing liquidity deluge in the
United States and some other countries has its sole source in the
monstrous asset bubbles providing the collateral for virtually limitless
borrowing. It needs a sharp distinction between earned liquidity from
saving and borrowed liquidity accrued from asset bubbles. The latter kind
of liquidity can vanish overnight.

The sharp surge in inflation rates is forcing the Fed to continual rate
hikes. Doing so, it takes enormous risks with the existing bubbles.
Bluntly put, it has lost control.

Regards,

Dr. Kurt Richebächer
for The Daily Reckoning