There has not been a chairman of the Federal Reserve Board with sound monetary instincts since Paul Volcker resigned in 1987. It was Volcker who brought the dollar back from the brink of hyperinflation in 1987.

On May 14, Volcker testified before Congress. Scattered around the monetary world, and particularly influential in Europe, there is a group of central bankers who admire Volcker, as I do myself, and share his analysis of the present situation. The Volcker analysis is very similar to that of the European Central Bank, and to that of Mervyn King, the governor of the Bank of England.

Volcker testified that the Fed ought now tackle the threat of inflation more forcefully. He is particularly concerned about the danger of a return to the conditions of “stagflation” of the 1970s. The Bank of England also expects that the next two years will see the pressure of rising inflation combined with low rates of growth. In the 1970s, this unpleasant combination of economic trends resulted from the loose monetary conditions of the early 1970s and the oil shocks of the mid-1970s.

Those who experienced the 1970s were taught a painful lesson about the negative effects of inflation. In standard monetary theory, some emphasis is given to the initial phases of inflation, in which an increasing money supply funds economic expansion and tends to cause booms, bubbles, and speculation.

Less attention is usually given to the second stage of inflation, in which prices rise; interest rates are increased; and economic growth rates, after an acceleration, begin to slow down. There is an illusion that inflation is good for growth; that is true of the first stage, but only of the first stage. Staglation, in which rising prices are accompanied by reduced growth, comes as a second stage.

Volcker warned Congress that he saw a “resemblance” between present monetary conditions today and those of the early 1970s, when the economy had an overall tendency toward rising prices, including big increases in energy and agricultural prices. He observed, “If we lose confidence in the ability and the willingness of the Federal Reserve to deal with inflationary presses and to sustain confidence in the dollar, we’ll be in real trouble.”

On the same day, the Bank of England published its latest quarterly forecasts and came to much the same conclusions. The bank’s inflation projections will not return to the 2% target figure until early 2010, which suggest that it will have no room for rate cuts until then.

Britain and the United States have different political cycles. The next presidential election in the United States will come nearly two years earlier than the next British general election; the latest date for a British general election will be June 2010. The Bank of England’s economic forecast suggests that there is little chance of interest rate cuts much before that time. The government’s reluctant tax cut on the lowest income tax band will strengthen the bank’s hand in keeping interest rates at their present level.

Mervyn King observed that “The consequences of price increases would be a squeeze on real take-home pay that will slow consumer spending and output growth, perhaps sharply.”

There exists what might be termed the Volcker consensus that inflation has returned as the real threat to world economic conditions. This consensus includes Paul Volcker himself, the Bank of England, and the European Central Bank. It does not include Ben Bernanke, the Fed, or the current president of the United States. After November, we may find out whether it includes the next president of the U.S.

Regards,
Lord William Rees-Mogg
May 15, 2008

The Danger of Stagflation was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

On February 21, 2008, the Financial Times published the confession of Han de Jong, Chief Economist, ABN Amro Bank: “I am obviously biased, but I find it sad to conclude that the role of serious economists in financial institutions is very limited today. We are little more than clowns, whose purpose is to entertain clients…”

The substitution of image for substance, the promotion of sensational or simply idiotic ideas that destroy reality, are central to our time. Economic thought is a sad example of this deterioration, personified by a charlatan of little substance. This is not to deny the man credit for understanding how times were changing. Alan Greenspan was one of the first to climb the greasy poll of superficiality. He knew this path to the top did not include the study of economics.

Having earned a master’s degree in economics from NYU, Greenspan transferred to Columbia University in 1951. He pursued his doctorate studies under Arthur Burns. Burns had co-authored an influential book, Measuring Business Cycles. His academic achievements were substantial as were his political instincts. Burns would head President Eisenhower’s Counsel of Economic Advisers (CEA) and be named Federal Reserve chairman under President Nixon. Greenspan would also serve in both positions.

Greenspan did not finish his coursework at Columbia, but demonstrated his own political aptitude under Burns: He took up the pipe — Burns’ trademark. Picasso might explain that Greenspan was Rene Magritte’s subject in the surrealist’s famous painting of a pipe. Under the pipe, Magritte painted: “Ceci n’est pas une pipe.” (“This is not a pipe.”) Greenspan understood he was not smoking a pipe. He knew the forgone parchment from Columbia was insubstantial compared to worshiping at Burns’s doorstep.

Greenspan may have observed an economist (aside from Burns) who shuffled seamlessly between academia and policymaking; one who generated the media attention necessary to an economist-politician. Harvard University professor Sumner Slichter told Washington that the Federal Reserve must accept inflation. This would achieve extended prosperity. (The Russians were catching up. Growth at any cost was gaining traction.) For such advice, which could only warm a politician’s heart, Fortune magazine dubbed him the “father of inflation.”

By the late-1950s, Greenspan was proprietor of Townsend-Greenspan, an economic consulting firm. He headed President Ford’s Council of Economic Advisers in the mid-1970s. His economic forecasts were abysmal. (Senator Proxmire: “…I hope…when you get to the Federal Reserve Board everything will come up roses. You can’t always be wrong.”) This was of secondary importance.

He received adulation where no other CEA director had gone before: The front cover of Newsweek, in the same year Jimmy Hoffa, Patty Hurst, and Liv Ullmann were likewise honored. The CEA was flooded with autograph requests. The clientele was not interested in the CEA director. They wanted Greenspan’s autograph because he was famous.

In August 1977, Elvis died. The nation mourned. This was not due to his presumed talent: singing. Elvis himself had said: “I don’t know anything about music. In my line you don’t have to.” In 1977, Alan Greenspan received his Ph.D. in economics from N.Y.U. It can be said of Alan Greenspan, with some exaggeration that “He doesn’t know anything about economics. In his line you don’t have to.”

His line was fame. Greenspan followed the most direct route: He dated the press. First Barbara Walters, then Susan Mills (a producer for the MacNeil-Lehrer Newshour), then he married a television personality, Andrea Mitchell. He gained entrée to the celebrity circuit. At the home of Oscar and Francoise de la Renta, Norman Mailer asked Giovanni Agnelli if he “was indeed Alan Greenspan ‘the famous economist.’”

Greenspan became Federal Reserve chairman in 1987 and served until January 2006. He continued his fame game. Fewer than 10% of Americans knew the name of the Federal Reserve chairman in 1979. In 2001, 90% knew Greenspan’s name, though zero percent knew what he was talking about. This was to his benefit. It was believed he spoke on an elevated but indecipherable level. To the dedicated student of Federal Open Market Committee transcripts, Greenspan’s contributions read like a screwball comedy. Few were in on the joke, so he was recast. He was the greatest testament of Magritte’s warning to the twentieth century: “This is not a Federal Reserve chairman.” He played a deity, an icon, — Zeus, Moses, God — descriptions from an adoring or befuddled press. Greenspan lived in his own bulletproof bubble. As has happened in different countries at regrettable moments, the skeptic could only dismiss the transcendental gifts of this very common man at the risk of ridicule and loss of job.

As readers of Greenspan’s Bubbles know, he left a remarkable record of back-sightedness. His odes to technology drew a delirious public under the big top. On March 6, 2000, he told a star-struck audience: “[T]he essential contribution of information technology is the expansion of knowledge and its obverse, the reduction of uncertainty. Before the quantum jump in information availability, most business decisions were made in a fog of uncertainty.” The Federal Reserve chairman received a standing ovation. Less than two years later, after befogged technology investors had lost a few trillion dollars, he told a different audience: “[A]las, technology has not allowed us to see into the future any more clearly than we could previously.”

His dialogue alone might resurrect screwball comedy, if only it wasn’t real. Alan Greenspan is still famous, but the adoration has waned. His clown act worked when he threw candy and fireworks above the crowd. The masses have eaten the candy and are suffering shellfire. He is no longer an icon. Deities do not scramble for approval. Gods do not attract such headlines as: “Don’t Blame Me!” (Sunday Times of London). Alan Greenspan wants respect. We do not respect gods; we worship them.

In 2004, John Kenneth Galbraith described the Federal Reserve’s painless decisions made “in a pleasant, unobtrusive building in the nation’s capital” as not of “the real world but to that of hope and imagination. Here our most implausible and most cherished escape from reality” is led by “an informed, confident and respected figure of no slight theatrical talent.” When we are prepared to assess the end of this age honestly, here rests a truthful epitaph for Alan Greenspan and the Federal Reserve System.

Regards,
Fred Sheehan
May 14, 2008

Greenspan’s Fame was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

Financial upheaval owes homage to derivatives that shrouded the massive growth in debt and leverage. This murky world inflated the incentives of those who ran the machinery over the cliff — bankers, mortgage brokers, law firms, appraisers, rating agencies, politicians, and on it goes. This is well known. Despite protestations, the parties knew they were behaving either recklessly or criminally at the time. The Federal Reserve encouraged them.

With a straight face, Hank Paulson proposes that the Fed quash future imbroglios. Yet the terracotta soldiers of Xian would bring more initiative to the assignment.

In September 1998, the Federal Reserve didn’t have the slightest idea of how the banking system functioned; it hadn’t the slightest idea of the banks’ exposure to hedge funds; nor had it the slightest idea of the leverage within the financial system. Maybe these deficiencies are excusable, although the Federal Reserve was responsible for regulating bank holding companies (the holding companies being where much of the risk was housed). It is unpardonable in the aftermath, having learned of its own deficiencies, that the Federal Reserve made no effort to improve its oversight or to warn of the dangers it had recently discovered. Instead, the Fed encouraged devious practices.

In the first three weeks of September 1998, Long-Term Capital Management (LTCM), a Greenwich, Conn., hedge fund, lost half a billion dollars per week and everyone knew it. Except, possibly, Alan Greenspan. In mid-September, the Federal Reserve chairman told the House Banking Committee that “Hedge funds [are] strongly regulated by those who lend the money.” On Sept. 21, LTCM lost $550 million. In a virtuoso rejection of every financial institution’s model, all security prices went down. This is normal. In a panic, everyone sells.

The Fed’s lackluster oversight was partly to blame. On May 2, 1998, Alan Greenspan gave a speech in which he emphasized the advantages of “private market regulation.” Greenspan explained, “Rapidly changing technology has begun to render obsolete much of the bank examination regime established in earlier decades. Bank regulators are perforce now being pressed to depend increasingly on ever more complex and sophisticated private market regulation… One of the key lessons from U.S. banking history [is] that counterparty supervision is still the first line of regulatory defense.” He also noted the Federal Reserve’s decision to supervise “risk management procedures, rather than actual portfolios.” The Fed now evaluated how banks monitored their own risks (e.g., their modeling techniques, the process used to monitor counterparties) in lieu of examining specific securities.

The Federal Open Market Committee (FOMC) held a conference call on Sept. 29, 1998. The staff and Federal Reserve governors briefed Greenspan on Long-Term Capital Management’s counterparties — the banks that lent to LTCM. He was told that none of the banks, with the exception of Bankers Trust, had an up-to-date balance sheet for LTCM. Even this was “only a small piece of [Bankers’] whole action because so much of the latter is off balance sheet.” When assets are off balance sheet, the bank’s motivation to “strongly regulate” is diminished.

The Federal Reserve chairman was at a loss: “The question is why it happened in the first place. Is it just that the lenders were dazzled by the people at LTCM and did not take a close look?” Vice Chairman William McDonough replied there “was in place a credit system that made a great deal of sense.” In the next sentence — which simply cannot have been an explanation of this sensible system — McDonough told the FOMC: “For at least some of the lenders, there was no initial margin requirement.” McDonough went on to suggest the Federal Reserve might have taken more initiative: “We do not regulate the firm. But given the number of institutions they dealt with around the world, was there a way that should have enabled us to be more aware of their overall position? One is inclined to say, ‘You bet.’ But exactly how we could have done that I am not so sure.”

This was not the time for the FOMC to design a regulatory apparatus, but the Greenspan Fed never did attempt to fill this gap. In retirement, Greenspan reminds his audiences that the Fed does not regulate hedge funds. True, but the Fed could have worked backward from the foundation that McDonough had suggested. (The SEC is responsible for monitoring broker-dealers. It, too, has failed miserably.) The need for adult supervision of banks was obvious when a staffer commented on the conference call, “It is something of a signature for [LTCM] to insist that if a counterparty wanted to deal with them, there would be no initial margin. Not many other firms have gotten away with that.” For this reason alone, the Fed should have geared up its watchdogs to better monitor the suicidal banking system it regulated.

Another staff member enlightened the FOMC with a frightful prospect: “The counterparties…get comfortable with zero percent margin. But from the [financial] system’s point of view, zero initial margin permits an essentially unlimited amount of leverage. There is no constraint other than the exhaustion on the part of the counterparties.” Greenspan and Bernanke fiddled with their slide rules as financial derivatives grew to 10 times the world’s GDP. In 2007, Bernanke should have known that banks, in a desperate attempt keep dancing, were borrowing at five percent to lend at four percent.

Greenspan was vexed: “It is one thing for one bank to have failed to appreciate what was happening to [LTCM], but this list of [banks without knowledge of LTCM’s positions] is just mind-boggling.” So boggled was the man that the Greenspan (and Bernanke) Fed allowed the banks to lever as never before and write $400 trillion worth of derivatives between then and 2008 — without so much as a dollar bill of reserves: Nor a peep that maybe these off-balance-sheet liabilities might bear closer attention.

A staff member described what he had learned on his field trip to LTCM. On Aug. 31, the hedge fund had a $125 billion balance sheet. It also had $1.4 trillion of off-balance-sheet assets. On Sept. 21, when it appears (from the transcript) the Fed first saw LTCM’s balance sheet, its leverage was 55-to-1 and the “off-balance-sheet leverage was 100-to-1 or 200-to-1 — I don’t know how to calculate it.” He wasn’t alone. Greenspan’s “first line of regulatory defense” didn’t know if LTCM was trading interest rate swaps or stolen cars. The models of LTCM’s “counterparty supervision” were so “complex and sophisticated” that the hedge fund’s portfolio had been translated into a Greek salad — gammas, thetas, and epsilons.

For practical purposes, LTCM had no capital by Sept. 29. It was not able to meet margin calls. The hedge fund had not been required to post margin, but was required to post collateral worth 100 percent of the assets it borrowed. Even this looked amateurish. Greenspan, a former director of J.P. Morgan, shared his view: “If I am a bank lender and I lend $200 million to a hedge find, ordinarily, I would be overcollateralized. I would hold more than $200 billion in, say, U.S. Treasury bills.” Greenspan asked if the collateral was U.S. Treasuries. A staffer replied: “U.S. Treasuries, Danish government bonds, BBB credits — you name it.” Beanie Babies were next on the list. The value of LTCM’s collateral was falling. The balance sheets of the banks LTCM traded with were sinking.

A staffer explained the risk: “I’m going to say this in plain English. If markets keep moving away from [LTCM] in the wrong direction, their future exposure could be large and they might not have the collateral at that point in time to cover the exposure.” McDonough had described the house of cards earlier: “The firm’s position in a variety of instruments was very large. What my contacts were talking about was the effect that the failure of the firm would have on world markets if all these positions had to be dumped on the markets. People who thought they had an offsetting position with [LTCM] would suddenly find that they did not have one. They would suddenly find themselves with big open positions…” Globalization might end in a financial meltdown.

A Fed staffer thought the banks “were saying the right things in terms of the kinds of risk management processes they had in place” but “the question is how effectively the banks were actually implementing them…” The Fed staff had not taken the initiative to check. Greenspan was told the Federal Reserve had not examined the banks since December 1997. In Greenspan’s remaining decade at the helm, his bureaucrats produced masterful studies on counterparty risk, but permitted the banks’ risk models to optimize executive bonus compensation.

This is interesting, but not of great utility in 2008. The 1998 Fed weaknesses are important because the molehill grew into a mountain. Greenspan and Bernanke chaired the most egregious administrative failure in financial history. Paulson’s proposal is on a par with Caligula’s decision to name his horse consul.

In March 1999, Greenspan gave a speech on derivatives. He might have wandered onto the podium from Mars. Derivatives “are an increasingly important vehicle for unbundling risk.” He doused the post-LTCM movement toward a better form of regulation: “Some may now argue that the periodic emergence of financial panics implies a need to abandon models-based approaches to regulatory capital and to return to traditional approaches based on regulatory risk schemes. In my view, this would be a major mistake.” The regulators’ risk models “are much less accurate than banks’ risk measurement models.” The Federal Reserve is not the institution to lead the much-needed bank regulation.

The nominal value of derivative contracts held by U.S. commercial banks (those over which the Fed has direct regulatory authority) leapt from $33 trillion at the end of 1998 to $101 trillion at the end of 2005, about the time Greenspan left office. We mustn’t ignore Greenspan’s successor: By the second quarter of 2007, 18 months later, these banks held $153 trillion in derivatives. The collapsing financial system is in the early stage of unwinding. Ben Bernanke has had time as Fed chairman to do something — anything — to slow the production of bad debt. Instead, the rate of financial claims in the economy accelerated.

The virtues of derivatives (their ability to diversify risk away from the banking system) received full approval from Greenspan and, more to the point, from his audiences. Bernanke is considered a monetary genius. Will we ever learn? Someday, we might ridicule, rather than praise, the Fed. On that day, it should be disbanded.

Regards,
Fred Sheehan
April 14, 2008

Mistakes at the Federal Reserve was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

“After more than a half century observing numerous price bubbles evolve and deflate, I have reluctantly concluded that bubbles cannot be safely defused by monetary policy or other policy initiatives before the speculative fever breaks on its own. There was clearly little the world’s central banks could do to temper this most recent surge in human euphoria, in some ways reminiscent of the Dutch tulip craze of the 17th century and South Sea Bubble of the 18th century.”

When he was chairman, Greenspan testified before Congress as the voice of the central bank (“We at the Federal Reserve…”). Yet several members of the Federal Open Market Committee (FOMC) would have acted aggressively to attack asset inflation and prick the stock market bubble in 1998. The chairman dismissed both activities as beyond the mandate of central bank policy. Transcripts of the Federal Open Market Committee tell the story of committee members with an understanding of the terrors to come. (Since FOMC transcripts after 2001 have not been released to the public, Greenspan’s behind-the-curtain discussion of the housing bubble has yet to be revealed.)

By late 1997, the chairman was convinced stock market prices simply reflected improved productivity. Given this, there was no stock market bubble. Thus, the markets did not need to be considered when surveying inflation. (As background, the NASDAQ rose 21.6% in 1997, 39.6% in 1998 and 85.6% in 1999.)

At the Dec. 16, 1997, FOMC meeting, Jerry Jordan, president of the Cleveland Fed, had a different opinion: “Some board members referred earlier to the dichotomy between the prices of services and the price of goods. That clearly is the case, but the notion of dichotomy also has to be applied in the case of asset prices… I was reading some material about the operations of the FOMC in the early 1930s.”

Jordan then draws a conclusion from the Fed’s myopic concentration on the steady price level of goods and services during the 1920s: “I think it’s a useful reminder of what can go wrong if we are too narrow in thinking about the words ‘inflation’ and ‘deflation’…  What do we mean by the word ‘inflation’? Clearly, it cannot refer simply to the current price of goods…”

Greenspan, speaking a few minutes after Jordan, thought, “Something very different is happening.” The “something” Jordan identified was never addressed by the chairman: “[W]e keep getting reams of ever-lower CPI readings that seem outrageous in the context of clearly accelerating wages and an ever-tighter labor market… I was startled by this morning’s CPI report. We cannot keep getting such numbers and continue to say that inflation is about to rise.” Jordan had just told Greenspan that inflation was out of control: It was Microsoft, rather than mayonnaise, that was inflating.

At the March 31, 1998, FOMC meeting, Michael Prell, a Federal Reserve staff economist, reviewed current conditions:

“The gravitational pull of valuation may no longer be operating. The P/E ratio for the S&P 500 recently reached 27, based on trailing 12-month earnings, even as companies were issuing warnings and analysts were lowering their 1998 profit forecasts. In the prevailing psychological environment…the market can keep going appreciably higher on its own momentum.”

Jerry Jordan reminded the chairman: “I also continue to be concerned that we may never see the effects of monetary excesses in output prices, but rather we will see them in asset prices.”

Cathy Minehan, president of the Boston Fed, was also worried: “This speculation is fed by financial markets, which are extremely accommodative. From every perspective that we can see in our region and nationally, monetary policy is not tight; it is not even neutral. It is accommodative to an increasingly speculative environment.”

Nor was board member Susan Phillips attuned to the productivity miracle: “The situation is starting to feel a bit surreal, perhaps even unbelievable… The stock market may be too good to be true, and I must say this is the first time I have felt really uncomfortable about the market.”

The chairman’s response was mixed. He seemed to understand the economy was now driven by the stock market: “We have an economic policy that is essentially unsustainable… There is no credible model of which I am aware that embodies all of this.” Then he decided to sit on the fence: “I do not think it is appropriate to move, at this stage. Were we to do so, I believe we would create too large a shock for the system, which it would not be able to absorb quickly.” (“To move” meaning to reduce the speculative money flows by raising the fed funds rate.)

This to-and-fro continued from meeting to meeting. In March 1999, board member Alice Rivlin warned, “There is the risk that the stock market’s apparently unwarranted continued upward price march may accelerate again to even more bubbly heights, leading to a devastating crash when the bubble bursts.”

Greenspan’s reference in the Journal to the Dutch tulip craze and South Sea Bubble is interesting. Michael Prell warned the FOMC of exactly that when the stock market bubble was still inflating. At the Dec. 21, 1999, meeting, the Fed economist read from a recent prospectus in which VA Linux stated it lost $14.5 million in 1999 and expected to continue incurring significant expenses. Yet it rose 700% on the first day of trading. Prell went on: “The warning language I’ve just read is at least an improvement in disclosure, compared with the classic prospectus of the South Sea Bubble era, in which someone offered shares in ‘A company for carrying on an undertaking of great advantage, but nobody to know what it is.’”

Prell wondered “whether the spirit of the times isn’t becoming similar to that of the earlier period.” He then described how impervious speculators were to the Fed’s rate hikes:

“Earlier this year, those stocks supposedly were damaged when rates rose, because people said, quite logically, that the present values of their distant earnings were greatly affected by the rising discount factor. At this point, those same people are abandoning all efforts at fundamental analysis and talking about momentum as the only thing that matters.”

Prell might as well have read a laundry list. The enlightened members of the FOMC had lost their spark by now. Greenspan had hopped off his fence a year earlier, claiming, at the Dec. 22, 1998, meeting: “I do know that the presumption we have discussed in the last year or so that we can effectively manage a bubble is probably based on a lack of humility. As I’ve said before, a bubble is perceivable only in retrospect.”

If he had said this before, it is unrecorded. A reading of the FOMC transcripts shows this was an entirely new theory. Perhaps the FOMC meeting was his off-Broadway rehearsal. On June 17, 1999, he took his claim public, this time before Congress: “Bubbles generally are perceptible only after the fact. To spot a bubble in advance requires a judgment that hundreds of thousands of informed investors have it all wrong. Betting against markets is usually precarious at best.”

There was only scattered resistance. A New York Times editorial expressed concern: “The new Greenspan is brimming with self-assurance. Let us hope the market does not test his new confidence.” The Maestro could do no wrong. Whatever he said must be. The stock market bubble, probably the greatest in the history of such bubbles, would burst in early 2000. It was negligible, compared with the brewing mortgage bubble. But Greenspan had learned nothing from VA Linux and was just as blind to the speculative fury engendered by negative-amortizing mortgages. He can keep writing, but nothing will stop the popping of credit bubbles blown so large by Greenspan’s Fed.

Regards,
Fred Sheehan

December 20, 2007

While Humpty Dumpty Sat on a Fence was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

In February 2000, the last year of the Clinton administration, Greenspan appeared before the Senate Banking Committee. He recommended the government use the federal budget surplus to pay down the national debt. The chairman amplified: “The growth potential of our economy under current circumstances is best served by allowing the unified budget surpluses…to materialize, thereby reduce Treasury debt held by the public.” Meaning: We should direct budget surplus dollars to reduce the federal debt. (This is accomplished by government-initiated purchases of U.S. Treasury securities.) The salient circumstance was that Clinton was not proposing a tax cut.

One year later, Greenspan worked for new management — the Bush administration. President Bush wanted a tax cut to kick off his tenure. Greenspan marketed the tax cut as fiscally responsible, given recent surpluses. His advice was rendered on Jan. 25, 2001, to the U.S. Senate Committee on the Budget. The Wall Street Journal reported the next day: “Giving a big boost to President Bush, Chairman Alan Greenspan reversed his long-held view and said he now sees room for significant tax cuts in the federal government’s financial future…. [O]ver the coming decade, the latest budget surplus numbers show not only room for reductions, but even a need.” The New York Times on the same day: “Alan Greenspan, the Federal Reserve chairman, gave his blessing today to a substantial tax cut…. In a clear shift from his previous position that reducing the national debt should be the focus of fiscal policy, Mr. Greenspan said improvements in the economy’s long-term potential and the swelling surplus projections had ‘reshaped the choices and opportunities before us.’”

In his testimony, Greenspan expressed concern “that continuing to run surpluses beyond the point at which we reach zero or near-zero federal debt brings to center stage the critical longer-term fiscal policy issue of whether the federal government should accumulate large quantities of private (more technically nonfederal) assets.” Of the 10,000 most likely problems the government should consider, this was not one of them. Over $5 trillion in the hole, the possibility of eliminating the federal debt ranked behind that of Venus crashing into Mars. (In January 2001, the Congressional Budget Office had projected the federal budget surplus would reduce the government debt by $5.6 trillion over the next 10 years. This gem of infinite interpolation gave Greenspan the cover he needed. In 2002, the CBO reduced its surplus estimate by $5.3 billion.)

Whether his audience scratched their heads at Greenspan’s flight of fancy, another statement should have awakened their curiosity. Greenspan prefaced his tale of woeful surpluses by discussing “recent projections… [which] make clear that the highly desirable goal of paying off the federal debt is in reach before the end of the decade. This is in marked contrast to the perspective of a year ago, when the elimination of the debt did not appear likely until the next decade.” The Nasdaq had fallen 43% from its March 10, 2000, peak. Tax revenue had risen from 12.5% of personal income to 15.4% during the boom years. In 2000, this 2.5% increase equaled $237 billion — precisely the same as the total 2000 budget surplus. It suited Greenspan’s purposes to express mystification during testimony: “We still do not have a full understanding of the exceptional strength in individual income tax receipts during the latter 1990s.”

Greenspan could not have been blind to the source of the budget surpluses: capital gains, exercised stock options, and bonuses. These tributaries had dried up. Without these flows, his fear of paying down the national debt, or even running a balanced budget, made no sense. And while Alan Greenspan could claim that paying down the debt was a bad thing, it is a tribute to the man that his audience accepted such a silly pretense approvingly.

The Greenspan campaign for renomination in 2004 kicked off its media blitz on Feb. 11, 2003. The Boston Globe reported that Greenspan viewed Bush’s (new) tax cut plan with a chilly reception: “Greenspan… used the opportunity to admonish the federal government for losing its ‘fiscal discipline.’” In the chairman’s words, a “return to fiscal discipline should be instituted without delay.” That was the stick; on Feb. 12, Greenspan offered Bush the carrot. The Wall Street Journal reported: “Federal Reserve Chairman Alan Greenspan muted his initially chilly reception of President Bush’s tax cut plan, offering more praise for eliminating taxes on dividends and playing down the near-term consequences for the federal deficit.” (Emphasis added.) President Bush announced that he would reappoint Greenspan for a fifth term on Feb. 22.

On April 30, mission accomplished and Bush now bound by the reconfirmation, the chairman slithered back: “Alan Greenspan…told Congress today that the economy was poised to grow without further large tax cuts, and that budget deficits resulting from lower taxes without offsetting reductions in spending could be damaging to the economy. Opponents of the large tax cut favored by President Bush took Mr. Greenspan’s testimony as support of their position.” (Emphasis added.) The dissembling was obvious; yet no one questioned Greenspan’s motives.

On April 21, 2005, the chairman’s bewildering tax and federal budget advice came full circle. At a Senate Budget Committee meeting, Democratic Sen. Paul Sarbanes of Maryland pursued a ragged thread in the Greenspan tapestry. The senator contended that Greenspan’s endorsement of the president’s 2001 tax cut was the “green light” that George Bush needed. Greenspan replied that he had not “specifically” endorsed the tax cut plan. The chairman claimed: “You will not find anywhere in the public record that I supported the [2001] tax cut.”

Reading the Jan. 25, 2001 speech today (available for anyone to judge on the Federal Reserve Board of Governors Web site), his support is obvious. He was rooting for a tax cut.

This civil servant had made false assertions to the people’s elected representatives before. When a vote to balance the budget loomed early in Clinton’s presidency, Greenspan said a Fed study showed a balanced budget would reduce interest rates. The Fed had conducted no such study. Greenspan testified to Congress in 1993 that tapes of Federal Open Market Committee meetings were destroyed after summaries were written. Thus, no transcripts existed. He later admitted to Banking Committee Chairman Henry Gonzales that he had known for years transcripts were kept, but only remembered when a “senior staff member jogged my memory in the last few days.”

Back to Sarbanes, Greenspan deflected the criticism with a tried-and-true tactic: flattery. Greenspan revealed “an alternative program of tax cuts and spending increases then proposed by the Democratic Party’s leadership would have achieved the same desired reduction in surpluses.” Now we have it. He had not specifically endorsed the Bush tax cut. Yet he also told Sarbanes that he, “like many economists,” had been wrong about the surpluses he warned of in 2001. So why was he endorsing the Democrat’s program if he had been wrong about the motivation for promoting a tax cut? We will never know. Greenspan had triumphed once again using another tried-and-true tactic: confusion.

In The Age of Turbulence, Greenspan praises Bill Clinton and criticizes George Bush. This has been good publicity for his book, but misdirected. He is not turning his back on the Republican Party; Greenspan’s only allegiance is, as it has always been, to himself.

Regards,
Fred Sheehan

October 5, 2007

Greenspan Was Never a Republican — He Was an Opportunist was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

“For someone who made headlines with his every utterance — even if no one could agree on what he had said — Alan Greenspan offers few newsmaking moments in his eagerly awaited memoir, The Age of Turbulence…

“Sure, his criticisms of the Bush administration (for its ‘out-of-control spending’), Republicans in Congress (they ‘lost their way,’ ‘swapped principle for power,’ and ‘ended up with neither’) and the Iraq War (‘largely about oil’) provided weekend fodder for the media…

“While Greenspan calls his book a detective story, there isn’t much in the way of suspense…

“Greenspan’s words are as measured as they were in his communications as Fed chairman. Now as then, they seem designed to create an effect, rather than to unveil the wizard behind the curtain…

“Greenspan, who reportedly received an advance of more than $8 million for this memoir, seems eager to stave off criticism for keeping short-term rates too low for too long in 2003 and 2004, stoking a housing bubble in the process. He was aware of reduced credit standards on subprime mortgage loans, he says, ‘but I believed then, as now, that the benefits of broadened home ownership are worth the risk.’”

For someone who supposedly believes in the free market, except, of course, when it comes to the Fed itself, that is quite a statement. The criticisms of Bush, the Republican budgets, the war over oil, and his belief in subprime loans all smack of attempts to lay the blame elsewhere for the credit debacle that is about to unfold.

More interesting than the book, however, is Greenspan’s whirlwind promotion tour of it. Reuters reports, “Greenspan Says U.S. Not Headed for Recession”:

“Former Federal Reserve Chairman Alan Greenspan said on Monday the United States appears set to weather the bursting of a housing bubble without falling into recession…

“But in a separate interview with CNBC Television, he warned that the Fed has to be careful to avoid stoking inflation with any future policy moves.

“‘It’s very clear that the trade-offs between inflation and growth have altered,’ he said. ‘The Fed has to be more careful about inflation now than it did when I was chairman.’

“Greenspan, in an interview in the Dutch newspaper NRC Handelsblad on Monday, warned inflation will rise to about 5% in Europe and the United States.

[Mish comment: Price inflation is a lagging phenomenon.]

“‘The normal inflation level is closer to 5% than the current 2%,’ Greenspan said, adding that the 5% level fitted an economy with a ‘paper’ standard, where the currency is not linked to gold…

[Mish comment: That is an incredible statement. There is absolutely no such thing as a "normal inflation rate." Inflation is an expansion of money and credit, and one reason money expands is the government spends hundreds of billions of dollars more than it collects in taxes. There is nothing "normal" about spending more money than you make for decades. When consumers do it, they eventually go bankrupt. When the government does it, the Fed willingly prints more money.]

“The memoir has already drawn attention for the comment the Iraq war is ‘largely about oil.’ He said on Monday his comments should not be seen as questioning President George W. Bush’s emphasis on Saddam Hussein’s arsenal as the justification for invading.

“‘I’m not saying that [the Bush administration] believed it was about oil. I’m saying it is about oil and that I believe it was necessary to get Saddam out,’ he said.”

[Mish comment: This is another incredible statement. How can the war be about oil if those who started the war did not do so over oil? The statement makes no sense. But yes, the war was about oil, revenge, and ideological stupidity.]

Greenspan Is a Contrary Indicator

After warning about irrational exuberance in 1996, Greenspan embraced the “productivity miracle” and “dot-com revolution” in 1999. Midsummer 2000, Greenspan fell in love with his own analysis and was worried about inflation risks. Shortly thereafter, the Greenspan Fed embarked on an incredible campaign of slashing interest rates to 1% in a panic over deflation.

Greenspan is now trumping up the idea that today’s credit conditions are like 1998. I talked about this in “No, Greenspan, Conditions Are NOT Like 1998.”

On May 21, 2006, Greenspan said housing prices won’t fall nationally. That prompted me to write “Greenspan Predicts Housing Bust.”

History shows Greenspan was worried about Y2K problems (slashing interest rates and adding fuel to the dot-com bubble). Y2K went off without even minor glitches.

In 2001, Greenspan pleaded with Congress to adopt Bush’s $1.35 trillion tax cut. Greenspan’s rationale was the government would run huge $5.6 trillion surpluses over the subsequent decade after the cuts. It’s right here in the testimony of Chairman Alan Greenspan before the Committee on the Budget, U.S. Senate, Jan. 25, 2001:

“The key factor driving the cumulative upward revisions in the budget picture in recent years has been the extraordinary pickup in the growth of labor productivity experienced in this country since the mid-1990s…

“The most recent projections from the OMB indicate that, if current policies remain in place, the total unified surplus will reach $800 billion in fiscal year 2011, including an on-budget surplus of $500 billion. The CBO reportedly will be showing even larger surpluses…

“The sequence of upward revisions to the budget surplus projections for several years now has reshaped the choices and opportunities before us. Indeed, in almost any credible baseline scenario, short of a major and prolonged economic contraction, the full benefits of debt reduction are now achieved before the end of this decade — a prospect that did not seem likely only a year or even six months ago.”

Greenspan has been wrong at every critical juncture in his career. So now, when Greenspan is warning of inflation just as he did in summer 2000, fears should be of anything but inflation.

But if inflation is the fear, why is Bernanke on a shock-and-awe campaign, surprising the markets with half-point cuts first in the discount rate and, second, in the fed funds rate, during options expiration week, in consecutive months?

Greenspan on Comedy Central

Click here to see Greenspan and Jon Stewart.

Kevin Depew of Minyanville had this interesting take on the show:

“Alan Greenspan’s whirlwind book promotion tour finally landed him on Comedy Central’s The Daily Show last night. We particularly enjoyed this quote:

“Greenspan: ‘I’ve been dealing with these big mathematical models of forecasting the economy, and I’m looking at what’s going on in the last few weeks…If I could figure out a way to determine whether or not people are more fearful or changing to more euphoric, and have a third way of figuring out which of the two things are working, I don’t need any of this other stuff…Forecasting 50 years ago was as good or as bad as it is today. And the reason is that human nature hasn’t changed.’

• “Yes, if only there was a way to model transitions in social mood from euphoric to fearful and from fearful back to euphoric…if only…
• “Greenspan’s unwitting acknowledgment that if he could ‘figure out a way to determine whether or not people are more fearful or changing to more euphoric’ then he could throw away his other models is precisely why those models he, and other economists, rely on are powerless at predicting future outcomes
• “When social mood supports credit expansion, as it has for the better part of two decades, then the kind of central bank policy practiced by Alan Greenspan indeed looks ‘Maestro’-like
• “When social mood no longer supports credit expansion, however…well, just ask Japan.”

What Greenspan is admitting is the Fed has no idea what it’s doing. As a result, the Fed always seems to be chasing its own tail in a sequence that keeps creating bigger and bigger bubbles.

Here is another interesting exchange from The Daily Show:

Stewart: “When you lower the interest rate and drive money to the stocks, that lowers the return people get on savings in a bank.”

Greenspan: “Yes, indeed. Yes, indeed.”

Stewart: “So they’ve made a choice — we would like to favor those who invest in the stock market, and not those who invest in the bank; that helps us.”

Greenspan: “That’s the way it comes out, but that’s not the way to think about it.”

Stewart: “It seems to me that we favor investment, but we don’t favor work. The vast majority of people work and they pay payroll taxes and they use banks. And then there’s this whole other world of hedge funds and short betting and…it seems like craps. And they keep saying, ‘No, no, no, don’t worry about it, it’s a free market, that’s why we live in much bigger houses. But it really isn’t, it’s the Fed, or some other thing, no?’”

History Will Be the Judge

History will not be kind to Greenspan. He was wrong about every critical pronouncement for his entire career, and no amount of whitewashing can change that. So forget the book, just play the video. You won’t waste $20-35 bucks, and the video will be far more entertaining.

Regards,
Mish

September 21, 2007

Maestro Memoirs was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

And where are these trends going to take us? We ask that question a lot here at Agora Financial. And sometimes it helps me to clear my head and collect my thoughts if I listen to some music.

Let’s Go to the Opera

So let’s go to the opera. Consider for a moment the opus Treemonisha by the great American musician and composer Scott Joplin (1868-1917). Written in 1910 and never performed in its entirety during Joplin’s lifetime, Treemonisha is the only large-scale work to survive from the great ragtime master. Overlooked for many decades, and indeed almost lost to history, Treemonisha was not performed in its entirety until 1970, but thereafter, it went to Broadway, became a hit and won a Pulitzer Prize (posthumous) for composer Joplin in 1976. Thus Treemonisha is a classic that transcends time and space, and serves well to remind us of another era with a very different set of values. And the reminders inherent in those old, value-laden chestnuts from Joplin are presented in easily understood comparisons that are almost, if you will excuse the expression in this context, black and white.

A Bag of Luck

Treemonisha has a simple plot. The story takes place in September 1884, on a plantation in Arkansas. The namesake of the opera, a young girl named Treemonisha, encounters a group of local conjurers who deal in voodoo and mysticism. These conjurers are at root nothing but scam artists, trying to sell Treemonisha’s poor mother what they call a “bag of luck.” Treemonisha refuses to go along with this transparent rip-off and denounces the conjurers. The conjurers retaliate by kidnapping Treemonisha, who is, in turn, heroically rescued by her beau, Remus (this is opera, after all). Having exposed the conjurers as frauds, Treemonisha leads a campaign to educate and improve the lives of the members of her community. And this being opera, there is much delightful singing and dancing.

What prompts me to think of Treemonisha in light of the recent market volatility is the Joplin opera’s forceful emphasis on certain basic elements of living an honest and decent life. One song is entitled, “When Villains Ramble Far and Near.” The lyrics say it all: “When villains ramble far and near/With their hearts full of sin/They do much wrong without a fear/But someday right will win.”

Or try this operatic ditty, entitled “Wrong Is Never Right.” The lyrics are, “Wrong is never right/That is very true/Wrong is never right/And wrong you should not do.”

OK, I admit it. There may be a certain dramatic lightness to the work. The libretto can legitimately be viewed as juvenile, if not condescending toward the poor, ill-educated sharecroppers (mostly former slaves) who form the characters of the tale. So the story line of Treemonisha is not exactly The Brothers Karamazov by Dostoevsky. But Treemonisha is also something of an idyll, certainly an Americana musical marvel. It is downright sweet and a resourceful and multidimensional mixture of rags, dances, waltzes, sentimental ballads and full-scale arias. Treemonisha is filled with expressive ranges, syncopated rhythms, harmonies and instrumental sonorities of ragtime. Oh, would that much else in this life could imitate such art.

In Treemonisha, composer Joplin takes a simple folk message and uses complex ragtime musical elements to create set pieces that go far beyond the conventions of the style. Joplin takes you back to the basics, back to plain old right and wrong, and with his musical background drives home the key points like a lightning bolt hitting the tree outside your window. Yes, dear readers, you can go home again.

Back to the Stock Markets

So now that we have been to the opera, let’s get back to the financial markets. What has been happening? How can Treemonisha help us to understand our predicament? Well, we are now witnessing the end result of too many economic conjurers peddling too much of the equivalent of that “bag of luck” to gullible, if not greedy, borrowers and investors over the past decade or so.

Looking back, the biggest purveyor of superstition, voodoo and a “bag of luck” was the No. 1 macroeconomic witch doctor of our era, the so-called “maestro” Alan Greenspan. Between 2001-2004, Mr. Greenspan engineered the decline of what is called the fed funds target rate from 6% to 1%. In consequence, banks borrowed cheap money from the Fed and in due course searched high and low for ways to pump that liquidity into the economy. Much of the money wound up in risky mortgages, clinically enabled — like a bartender pouring more drinks for the inebriated sot on the adjacent stool — by a convenient decline in traditional lending protocols as the subprime mortgage market took off like a rocket.

Between 2001-2005, subprime mortgages grew from 2% to 14% of all mortgages issued in the U.S. In 2003, in fact, the Fed cut rates to only 1%, causing subprime lending to increase by 150%, from 4% of total lending to more than 10%. The money supply of not just the U.S. housing market, but of the entire U.S. economy and the related dollar-using world just went haywire. But then again, as is the case with cancer and petroleum dependency, there were and are more people living with the disease than dying from it. For now, at least.

In the Olden Days

Some of those tunes from Treemonisha are still humming in my head. In the olden days, and not even as far back as the pre-Fed gold standard era when Treemonisha was composed, first-time home buyers paid about 20% of the value of the houses upfront. Borrowers took out long-term, fixed rate mortgages, and not those bizarre “interest only” or “negative amortization” loans.

On the other side of the transaction, in the olden days, the lenders were usually local bankers, and not faceless Dilberts who worked in some cubicle of a national lending institution on the other side of the continent. And the lenders tended to be from the serious, skeptical faction of the human gene pool. That is, the lenders understood that they were loaning out the depositors’ money and that the depositors eventually wanted it back. When it came to mortgage lending, those uptight bankers knew generally that, in the words of Scott Joplin, “Wrong Is Never Right.”

So in the olden days, the lending system was tilted, if not rigged and structured, so that homeowners bought houses that they could actually afford, at prices and mortgage terms that they could pay over the long term. If one did not qualify under the bank’s lending protocols, then one remained a renter. It was not considered illegal or unpatriotic redlining to deny a mortgage to someone with little or no prospect of paying it back. When borrowers ran into financial trouble (and to be sure, on occasion they did), it was usually due to some unforeseen event in their lives like the loss of a job, an illness or a divorce. Yes, as former Defense Secretary Donald Rumsfeld once said, “Stuff happens.” But in the olden days, the mortgage was almost never the “stuff” of the main problem.

Villains Ramble Far and Near

Yet in a world of easy money from the Fed, and in the words of Scott Joplin, “Villains Ramble Far and Near.” Subprime mortgages have now become the financial culprit that is wrecking the national and international credit markets from the ground up, like Samson pulling down the Temple. And by extension, those subprime mortgages are bringing down the related financial markets and disrupting the predictability of interest rates. This subprime disaster is particularly toxic due to the so-called “zero-down,” ninja loans (“ninja,” as in no income, job or assets) issued with two- or three-year terms, followed by floating rates that are keyed to reset upward (right about now, sad to say, with much more due to hit the fan in the next year) in a higher interest rate environment.

These home-wrecking loans were arranged, for the most part, by those national mortgage brokers and bankers who earned lucrative fees (and permit me to add, purchased many a flashy automobile and tawdry 14-carat bling), peddling their own “bags of luck.” The selling point was that interest rates were low and real estate prices were rising, so the overstretched borrower could eventually refinance at a lower rate or sell his overpriced hacienda into that proverbial “rising market.” Yes, and children believe in Santa Claus, while some adults think they can get rich by gambling at casinos in Las Vegas.

Where Are We Headed?

So where are we headed in all of this? I seldom make guarantees, but in this case, I will pretty much guarantee you that all borrowers, in whatever sector of the economy you care to name, are now likely to face significantly higher borrowing costs for years to come. This will be the case whether the loan is personal or business, and even for those with stellar credit histories.

And according to Edward Chancellor, author of Devil Take the Hindmost: A History of Financial Speculation, there is another profound problem:

“The credit system is losing its, well, credibility. People no longer trust the triple-A ratings that many complex debt securities carry. The risk models used by rating agencies, hedge funds and banks have also come under suspicion. The effects of subprime losses are being felt in unexpected places, including supposedly impregnable money market funds. Hedge funds and other highly leveraged investment vehicles are being forced to unwind. After years of excess, credit is beginning to contract. There has been a run on Wall Street finance… but no one knows how long it will last, or where it will end.”

The companies that we recommend in Outstanding Investments do not own, make or sell the proverbial “bags of luck.” We screen for that. Still, any company may be whipsawed by the business cycle or by an economic contraction caused by a slowdown in consumer spending or deterioration of lending or capital spending. So if you have a gain on the books and are nervous about hanging onto it, you should sell some shares and take your money off the table to the point where you can sleep at night. As we said above, cash is good. Going forward, you should keep an eye on any decline in share prices and consider it a chance to acquire great energy or mining shares for the long haul, and at a discount.

Until we meet again…
Byron W. King

P.S.: Scott Joplin’s wonderful opera Treemonisha is rarely performed these days, so if you ever have the opportunity to see a performance, you should buy a ticket and go. The only recording that is still widely available is from Deutsche Grammophon, based on a performance by the Houston Grand Opera in 1975. Enjoy the show.

September 14, 2007

A Day at the Stock Market, A Night at the Opera was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

“Former Federal Reserve Chairman Alan Greenspan said the current market turmoil is in many ways ‘identical’ to that which occurred in 1987 and 1998, when the giant hedge fund Long Term Capital Management nearly collapsed.

“‘The behavior in what we are observing in the last seven weeks is identical in many respects to what we saw in 1998, what we saw in the stock market crash of 1987, I suspect what we saw in the land-boom collapse of 1837 and certainly [the bank panic of] 1907,’ Mr. Greenspan told a group of academic economists in Washington, D.C., [on Sept. 6] at an event organized by the Brookings Papers on Economic Activity, an academic journal…

“Bubbles can’t be defused through incremental adjustments in interest rates, Mr. Greenspan suggested. The Fed doubled interest rates in 1994-1995 and ‘stopped the nascent stock market boom,’ but when stopped, stocks took off again. ‘We tried to do it again in 1997,’ when the Fed raised rates a quarter of a percentage point, and ‘the same phenomenon occurred.’

“‘The human race has never found a way to confront bubbles,’ he said.”

The truth of the matter is the Fed (and, in particular, Greenspan) has embraced every bubble in history, adding fuel to every one of them. Let’s consider the last two bubbles.

The Fed’s Role in the Dot-com Bubble

Acting in misguided fear of a Y2K calamity, the Fed stepped on the gas with unnecessary liquidity, having previously stepped on the gas to bail out Long Term Capital Management in 1998.

And after warning about irrational exuberance in 1996, Greenspan embraced the “productivity miracle” and “dot-com revolution” in 1999. Midsummer 2000, Greenspan believed his own nonsense, and right as the dot-com bubble started to burst, he started to worry about inflation risks. The May 16, 2000, Federal Open Market Committee minutes prove this:

“The members saw substantial risks of rising pressures on labor and other resources and of higher inflation, and they agreed that the tightening action would help bring the growth of aggregate demand into better alignment with the sustainable expansion of aggregate supply. They also noted that even with this additional firming, the risks were still weighted mainly in the direction of rising inflation pressures and that more tightening might be needed…

“Looking ahead, further rapid growth was expected in spending for business equipment and software…Even after today’s tightening action, the members believed the risks would remain tilted toward rising inflation.”

How could Greenspan have possibly been more wrong? Over the next 18 months, CPI dropped from 3.1% to 1.1%, the U.S. went into a recession, and capex spending fell off the cliff.

The Fed’s Role in the Housing Bubble

In 2001, Greenspan went overboard in the other direction, embarking on a campaign that eventually slashed interest rates to 1%, while embracing the miracle of derivatives and encouraging consumers to get into ARMs along the way.

And right as the bubble was bursting, Greenspan dismissed the idea of a national housing bubble.

No National Housing Bubble

Flashback, May 21, 2006: Greenspan says housing prices won’t fall nationally.

History suggests that betting against Greenspan is the correct thing to do. Thus, I mockingly talked about his call on May 27, 2006, in “Greenspan Predicts Housing Bust.”

Confronting Bubbles

As for “confronting bubbles,” the Fed foolishly watches (takes action on) only consumer prices. Thus, the Fed ignores expansion of credit when that credit fuels asset bubbles, as opposed to the prices of consumer goods.

The Fed could easily target credit with higher interest rates if it cared to, but it does not.

This is not a matter of attempting to identify bubbles in advance — this is a matter of attempting to identify credit conditions that create bubbles. And the fact is runaway expansion of credit fuels one or both of two things in some combination: asset bubbles and/or consumer price increases.

Bernanke is equally as bad as Greenspan, if in fact not worse, by supporting positive inflation targets. (See “Inflation Targeting Is Flawed” and “Can the Fed Control Prices?” for more on the silliness of inflation targeting.)

Is It 1987 or 1998?

• In 1987, we had the Internet revolution to look forward to. Yes, that was a productivity miracle, but it also allowed the Greenspan Fed to open the credit spigots wide open because rapidly increasing productivity is highly disinflationary
• In 1998, as the Internet boom was starting to peak, there was still one more bubble up the Bubblemeister’s sleeve: the housing bubble
• In both years, the ability of consumers to take on (and afford) debt was vastly different than it is today
• In both years, there were numerous new credit products to exploit coming up on the horizon: CDSs, CDOs, SIVs, ABSs, LBOs, conduits, MBSes, “swaptions,” etc., etc., etc. See “Swaptions and Financial Turmoil” for more on swaptions and off-balance sheet conduits at Citigroup, as well as leveraged buyout turmoil at Citigroup, JPMorgan Chase, Lehman, and Bear Stearns
• Massive junk bond-financed share buybacks, LBOs, and speculation in mergers and swaps, etc. were on the horizon in 1998. Those are now history
• Credit standards were poised to fall to insanely low levels, but are now swinging back in the other direction. In fact, loose credit standards made a secular low that will not be seen again for decades, if ever
• Off-balance sheet garbage not marked to market was never as high as it is today
• Various carry trades fueled all sorts of speculative investments. Those carry trades have yet to be unwound, but they will be. And they are orders of magnitude bigger than anything we saw in either 1987 or 1998
• The China factor is vastly different today than it was even as late as 1998. The resultant deflation in wages as a result of outsourcing and manufacturing moving to China and service jobs to India is still being felt
• There is now $300-500 trillion (yes, trillion with a “T”) in derivatives floating around, depending on whom you believe. But even the smaller number is many orders of magnitude greater that either 1987 or 1998.

By suggesting that conditions are “identical” to either 1987 or 1998, Greenspan is one or more of the following:

• A misguided fool
• Lying
• Blinded by his own arrogance
• Attempting to rewrite history
• Attempting to lay the blame on Bernanke
• Some combination of the above.

Whatever it is, Greenspan is above all…wrong. Furthermore, Greenspan has been consistently wrong at every major turn in his entire history as Fed chair. The only thing he has been correct on is his unwavering support for free trade. And on that issue, ironically enough, hardly anyone listens to him.

With that in mind, I have to wonder just what Pimco thinks it can get out of hiring Greenspan as an adviser. All I can figure out is: 1) Pimco is hoping somehow to cash in on Greenspan’s list of contacts, or 2) Pimco is asking for Greenspan’s advice and betting the other way.

Regards,
Mish
September 11, 2007

No, Greenspan, Conditions Are NOT Like 1998 was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

When the nomination was announced, Greenspan’s face was on the front cover of Time, with the caption “The New Mr. Dollar.” This was prophetic for both the omnipresent Greenspan image and the man who printed more dollars than all of his predecessors combined.

Greenspan was quick to demonstrate how he would shift his opinions to satisfy an audience. In early June, he told a Chicago audience that “over the long run,” the value of the dollar would go “significantly lower.” A week later, at the press conference announcing his nomination, he discussed “evidence” that the dollar’s fall had “bottomed out.” In July, before the Senate Banking Committee, he announced the dollar had entered a “period of stability.” The last forecast missed by a mile, but this was not his prediction at all. His true position was expressed to the Chicago audience the month before.

Greenspan testified before the Committee on Banking, Housing, and Urban Development. It was headed by Sen. William Proxmire of Wisconsin. The most compelling testimony appeared in the May 21, 2007, edition of Whiskey & Gunpowder (see “Help Wanted: A Leading Contrarian Indicator”). Some of it is worth recalling, since it cuts to the heart of the public’s 20-year-long miscalculation: He is a man of modest ability. The revelations of his inadequacy for the job were obvious. Yet, the media did not pursue what a Pulitzer Prize-chasing editor could have turned into front-page news. Two decades later, this is still true.

Sen. Proxmire chided the candidate for a “dismal forecasting record” when he was chairman of the Council of Economic Advisers. (Greenspan was CEA chairman during the Ford administration.) In Proxmire’s words, the forecasts made by the candidate were “way off.” Of the interest rate forecasts made by the CEA, Greenspan’s were “wrong by the biggest margin of any of the [CEA chairmen].” Proxmire went on: “There you broke all records for the entire period in error.” Of inflation: “There again, you broke all records.” The only CEA chairman to adorn the front cover of Newsweek estimated the consumer price index would rise 4.5% in 1978. It soared 9.2%.

Greenspan would control such quibbles in later years, but not this day. He replied: “That is not my recollection of the way the forecasts went.” Proxmire, forecasts in his hand, read the dates to Greenspan. The candidate admitted: “Well, if they’re written down, those are the numbers.”

Greenspan then embarked on the gobbledygook so familiar in later years. Proxmire waited patiently, and then responded:

PROXMIRE: “Every one of the chairmen of the Council of Economic Advisers had the same problem, and they didn’t miss by as much as you did, not nearly as much…”

GREENSPAN: “I feel sorry for me and happy for them.”

Proxmire pursued Greenspan’s competence as a private forecaster. “As you know, you put your forecasting to a direct test in the private sector.” Proxmire then quoted a recent issue of Forbes magazine. “Greenspan and O’Neil turned in one of the least impressive records of all pension fund advisers.”

Greenspan did not throw out an illusory defense this time: “All I can say is I acknowledge that did not work out very well, and I take my share of the responsibility.”

PROXMIRE: “I hope…when you get to the Federal Reserve Board everything will come up roses. You can’t always be wrong.”

GREENSPAN: “All I can suggest to you, Senator, is that the rest of my career has been somewhat more successful.”

As a taste of what was to come, this was an introduction to Greenspan’s ever-present qualifiers: “Suggest” and “somewhat” giving the candidate room to maneuver, should Proxmire pursue this course of interrogation. The senator did.

Proxmire quoted a forecast Greenspan sent to clients on March 20, 1987. “The recession we had not expected until 1990 now appears more likely to emerge in the last quarter of 1989…A stock market-led expansion of capital equipment in late 1987 is projected to lead to a final surge for the business credit cycle. This surge is expected to precipitate a recession shortly thereafter…[and the] recession is also expected to be somewhat more severe than we had projected in October [1986].”

Proxmire asked Greenspan if he still stood by that forecast:

GREENSPAN: “I don’t know how to answer that…”

After not knowing how to answer that, he launched into an answer that was not an answer, but a response full of qualifications that qualified the qualifiers. Proxmire waited patiently before responding: “You were so specific in the dates of this forecast.” To this, Greenspan went on to qualify more qualifications. Proxmire, his time up, responded “yes.”

Note the turn of the tide. Proxmire was in charge, but Greenspan’s furtive nondisclosures had prevented a deeper inquiry into his contestable past.

His most deliberate nondisclosure passed without much notice. Greenspan had submitted a written statement of relationships that might cause conflicts of interest. Sen. Proxmire questioned Greenspan on two relationships Greenspan had not listed: Sears, Roebuck & Co. and Lincoln Savings & Loan of Irvine, Calif. Greenspan had distinguished the two by slipping them in the side pocket of “advocacy projects.” Cutting through the euphemism, he was paid by each to lobby for banking deregulation. As Fed chairman, he would become the nation’s banking regulator. He had good reason to leave both off the full-disclosure list. Besides the conflict of interest, Greenspan’s relationship with Lincoln Savings & Loan was more discreditable than is commonly believed. That story deserves wider circulation.

The other senators had different concerns. This is not to disparage their interrogation. Their questions and statements were intelligent. A consistent theme was the senators’ concern that the growing indebtedness of the United States to foreigners was creating a dependency on foreign charity. This has come to pass. It is also lost on today’s politicians.

Sen. Shelby from Alabama asked Greenspan if he was troubled that, as a nation “the U.S. had added $1.5 trillion to the national debt over the previous five years when it took the first 195 years to accumulate $1 trillion.” Greenspan responded, “It bothers me a great deal.” He then attempted to pacify the senator: “We’re starting to deal with it.” Shelby was having none of this: “We haven’t even started to deal with it.” The nominee thought he might soothe Shelby by claiming he did not think “it would be necessary to actually reduce the national debt.” Greenspan then launched into some equivocations, that, if read five or 10 times (not a luxury available to the senators), essentially meant: “We can’t reduce it because we won’t reduce it.” This, of course, was true, and it was diplomatic of Greenspan not to call the kettle black to the very men who had let the kettle rot.

In an Abbot and Costello routine so common in later years, Shelby worried about America’s status as the largest debtor nation in the world. Greenspan replied, it “isn’t clear” which is the largest debtor nation in the world:

SHELBY: “If we are not first, who is?”

GREENSPAN: “Oh, there are a lot of others.”

End of discussion. Shelby did not have time to clarify questions and answers for a Trivial Pursuit contest. The senators were allotted a given amount of time to quiz the nominee. There may be a good reason for this (the filibustering of politicians comes to mind), but Greenspan knew — if not on this day, soon enough — he could run out the clock with his own form of filibustering.

Shelby warned that the national debt was “a ticking time bomb.” He worried that the U.S. was vulnerable to foreign influence on the dollar. He asked the nominee: Since the Germans, French, and several others held an abundance of dollar claims, could they, in unison, decide to peg the U.S. dollar at a specific rate convenient to their own policies? Greenspan’s answer was ambiguous but concerned the senators enough that he was asked if the Federal Reserve could intervene in the foreign currency markets to set the price of the dollar.

The senators agreed some questions were difficult to answer on the spot. He was asked to reply to these questions in writing. He wrote that the Federal Reserve should not intervene in currency markets. It could, however, set the currency rate, but only for a short period of time. This is a topic that would have made for a fascinating discussion later in his term. Interest seems to have faded after the hearing.

In another written response, Greenspan disavowed his former advocacy of the gold standard. His reasoning was specious: “Considering the huge amount of dollar claims in world markets, fixing the price of gold [by central bank intervention] seems out of reach.” It is safe to assume he pulled this response out of a hat. He wanted to be Federal Reserve chairman. The committee wanted to assure itself Greenspan was not one of those dreaded gold bugs. Each side got what it wanted.

Sen. Sasser from Tennessee was concerned with debt accumulation. He thought rising corporate debt associated with mergers and acquisitions was troubling, particularly the capacity of business to operate in the next downturn. Greenspan agreed. He was concerned with “debt charges…specifically, debt service, which obviously does not decline when gross operating incomes fall, and the so-called ‘coverage’ of the interest becomes insufficient…We are increasing debt at levels which should make us all uncomfortable. It certainly makes me uncomfortable.” Once he became Federal Reserve chairman, Greenspan steered clear of any discussion of leveraged buyouts, junk bonds, or bank solvency. This response to Sasser appears to be an answer the nominee knew would assuage his interrogators, after which he shied away from discussing such a delicate misappropriation of the banking system when he was in charge of it.

Proxmire closed the hearing, resigned to the result. The senator had greater concerns than Greenspan’s wayward forecasts. “It seems to me that banking in this country and finance in this country is moving very sharply…in a direction of concentration and in a direction, which, I think, most senators, if they thought about it very long, might be very concerned about.” This gives the sense of a man with a clear view of the future, but who did not think much of his fellow senators. (He also did not think much of the Federal Reserve Board: “[Y]ou will move in with a board of clones — not clowns — clones.”)

Greenspan lacked the mental vigor to ever imagine the future: Witness his consistent inability to discuss even present dangers. Greenspan’s trail of misapplied economics would be clear soon enough. One of many examples that would pass unnoticed: In January 1990, Greenspan prophesized, “Such imbalances and dislocations as we see in the economy today probably do not suggest that anything more than a temporary hesitation in the continuing expansion of the economy.” In the wake of this speech, Drexel Burnham Lambert failed. This fractured the junk bond market. The economy was in recession by midyear.

The economic consulting firm of Townsend-Greenspan died quietly on July 31. The White House asked Greenspan to remove his name from the firm. The furniture and computers were sold at the beginning of August. The White House request was fortuitous. Pierre Rinfret, a New York consulting economist (who served with Greenspan on Nixon’s 1968 economic advisory panel), refuted the common perception: “Everyone thinks that Greenspan gave up a lucrative consulting business to work in the public sector. In actuality, his business had been losing clients steadily to the point where he hardly had any left by the middle of the 1980s.” The new Fed chairman had spent the past few years lobbying for the Fed chairmanship. Townsend-Greenspan had been hollowed out. A hollow man would be the new Federal Reserve chairman.

Regards,
Fred Sheehan

July 20, 2007

Alan, We Hardly Knew Ye was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

“Like a highly contagious virus, fear that foreigners will dump all their U.S. Treasury securities spreads through the market at periodic intervals.

“The fear is not totally unfounded. Foreigners own a little more than half of publicly held U.S. government securities, according to the Treasury Department. So if these foreigners — both central banks and private investors — woke up on the wrong side of the bed one morning and decided to give the Treasury portfolio the old heave-ho … well, you can begin to understand the basis for the recurrent nightmare.

“‘When people say, What happens when foreigners dump U.S. securities, I say, Tell me why,’ says Jim Bianco, president of Bianco Research in Chicago. ‘It’s never happened before’ on a long-term basis…

“The latest bout of flu-like symptoms was triggered by news earlier this year that the People’s Bank of China was setting up an investment vehicle to diversify its $1.2 trillion of dollars…

“Real-World Example

“Last month, China announced it was investing $3 billion of its dollar reserves in Blackstone Group LP, manager of the second-largest buyout fund, to boost its returns. What if China were to shoot itself in the foot and dump its entire Treasury portfolio in one fell swoop?

“It just so happens we have a real-world example of what it would mean, according to Bianco. The Bank of Japan bought $244 billion of Treasuries in the 12 months ended August 2004. During that time, U.S. long-term interest rates rose and the dollar fell versus the yen.

“By April 2006, the BOJ was a net seller of U.S. Treasuries (on a 12-month basis) to the tune of $26 billion, a swing of $270 billion. U.S. interest rates fell during that period while the dollar rose.

“‘The BOJ bought a quarter-trillion dollars of Treasuries and then abruptly stopped and no one noticed,’ Bianco says.

“Never let the evidence stand in the way of a popular obsession.”

While I agree with Bianco that no one noticed when Japan stopped buying, that is not a valid model for what would happen if China (or Japan) were to dump its entire Treasury portfolio in one fell swoop. There is a big difference between stopping additional purchases (or selling them slowly over a period of time) and a massive dumping of everything at once.

Furthermore, given that Bianco states, "It’s never happened before," how can he (or anyone else) come up with a "real-world example"? Isn’t that an enormous contradiction? Nonetheless, I am sympathetic toward what I believe to be a key idea of the article: that China or Japan stopping additional purchases or divesting slowly over time does not necessarily spell disaster. There IS a real-world example of that, with falling Treasury yields to boot. On that score, it’s as Caroline suggests: "Never let the evidence stand in the way of a popular obsession."

Are Dumping Fears Overblown?

Greenspan says there is nothing to fear: “Former Federal Reserve chairman dismisses fear of China dumping U.S. Treasuries”:

“There is little reason to fear a wholesale pullout by China from U.S. government bonds, former Federal Reserve Chairman Alan Greenspan said Tuesday.

“While expressing concerns about China’s runaway growth rate and what he described as overvalued stocks, Greenspan played down the prospect that Chinese authorities would sell Treasuries in earnest, forcing a sharp spike in U.S. interest rates.

“Asked at a commercial real estate conference if investors should be worried about this oft-cited concern, Greenspan said: ‘I wouldn’t be, no.’

“Still, Greenspan said the reason such a withdrawal was unlikely was that China would not have anyone to sell the securities to…

“Greenspan said that a global liquidity boom, which he traced back to the end of the Cold War, would not go on forever.

“‘Enjoy it while it lasts,’ he told the audience.

“Now a private-sector consultant, following more than 18 years at the U.S. central bank, Greenspan reiterated his prediction that China’s latest growth spurt had come too far, too fast.

“‘We cannot continue this rate of growth in China and the Third World. This cannot continue indefinitely,’ Greenspan said in a speech. ‘Some of these price-earnings ratios are discounting nirvana.’”

Now, there’s a comfort… China won’t sell them because "China would not have anyone to sell the securities to." So instead of accumulating more Treasuries, China is plowing U.S. dollars into inflated U.S. stocks, agencies (tied to horrendous fundamentals in the U.S. housing market), junk bonds, and other garbage.

Why is it that foreigners always buy market tops (first Treasuries, now equities)? Regardless of the answer to that last question, there’s always a buyer at the right price. That holds true for housing, Treasuries, and even CDOs.

Let’s have a count of hands, please: Other than bond funds that deal in Treasuries, is there anyone anywhere that has anything positive to say about Treasuries? Has such pessimism at market bottoms ever in history been rewarded?

There’s no denying that China has cut back on Treasury purchases. In fact, avoidance of U.S. Treasuries in now approaching a near mania everywhere, even as funding can easily be found for the junkiest of junk offerings (not related to housing). But is there any reason for China to do a wholesale dump? I personally doubt it.

More to the point, is lack of foreign demand the reason for the recent bond sell-off? That’s what everyone seems to believe, but if that were the reason, then what was the explanation for falling yields as Japan was selling?

Greenspan has been wrong at every major turning point his entire career. The fact that Greenspan states there would be no buyers could be yet another of a long series of contrary indications suggesting that internal demand just might be ready to soar. If that’s the case, the real question, then, is: "How high do yields get in the meantime?" as opposed to these unlikely "what if?" scenarios. As an aside, the higher rates get in the meantime, the bigger the debacle in housing. It’s a no-win situation for the Fed.

Regards,
Mike Shedlock ~ “Mish”
June 18, 2007

Will China Dump U.S. Treasuries? was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.