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October 28, 2005

From Greenspan Put To Bernanke Straddle
by Brady Willett

Having studied at Harvard, earned a Ph.D. at MIT, and taught at Princeton, it is obvious that Ben Bernanke has forgotten more about economic theory than most of us will ever learn. But while academic excellence is what got Bernanke the job as Fed Chairman, [Wall] Street smarts will determine whether or not he proves effective. To be sure, deciphering the future direction of the US economy and inflation today has more to do with trying to understand the capricious psychological symbiosis between asset prices and foreign investment than with traditional economic models and stress tests. In other words, Bernanke has the theoretical solution to the problems that have plagued the Fed in the past, but tomorrow's challenges are sure to be unique.

Seemingly aware that the US is headed down a road not traveled, Bernanke has already taken steps to prove that he is a creative thinker. Specifically, Bernanke delved into the untraditional options available to the Fed to combat deflation (in an often quoted speech wherein Bernanke flippantly uses the term 'printing press'). Outside of the box thinking could be a quality that makes Bernanke better prepared than most for unique monetary challenges.

At the risk of painting too rosy a picture, it should also be noted that the hand Greenspan has left Bernanke to play could not be more infested with thorns. Accordingly, while Mr. Bernanke may indeed be the smartest Fed Chief ever, you nonetheless have to question his acumen for taking the job.

Bubbles Everywhere But Nary A Chairman Can See The Hot Air?

After being appointed by Bush as Fed Don, Bernanke's first order of business was to assure investors that his novel ideas would be shelved in favor of policy 'continuity'. Given that Greenspan is regarded by many investors as a legend this was a smart, albeit obvious position for Bernanke to take. Less obvious is exactly when Bernanke will acquire enough confidence to abandon continuity and adopt change.

Judging by what we know, change could mean inflation targeting, more blatant long-term interest rate manipulation and/or a proclivity to drop money out of a 'helicopter' at the first sign of deflation. As for Mr. Bernanke's position on asset prices, unfortunately it is similar to that of Greenspans:

"I think it's extraordinarily difficult for the central bank to know in advance or even after the fact whether or not there's been a bubble in an asset price." Bernanke Q&A, June 2004.

"Changes in asset prices should affect monetary policy only to the extent that they affect the central bank's forecast of inflation." Should Central Banks Respond to Movements in Asset Prices?

"A closer look reveals that the economic repercussions of a stock market crash depend less on the severity of the crash itself than on the response of economic policymakers, particularly central bankers." A Crash Course for Central Bankers, September/October 2000.

To summarize, the mention of asset bubbles makes Bernanke's vision go blurry, but after a crash in asset price(s) he quickly regains clarity and favors easier money policies. This position is akin to saying that Bernanke's Fed condones asset bubbles but does not condone them bursting.

Blowing bubbles worked like magic during Greenspan's 18-year tenure but is unlikely to work as well over the next 18-years. Bernanke recently stated that there is no housing bubble in the US, not even acknowledging the likelihood of 'froth'. Greenspan's position on bubbles is clear: "don't blame me!" Volcker seems to be the only honest Chairman around.

Bernanke's Poor Hand

When Greenspan took over as Fed boss the federal funds rate was 7%, the US savings rate was 7.5%, and foreign and international investors held 17% of outstanding US Treasury Securities. Today the federal funds rate is 3.75%, the savings rate is negative, and foreign and international interests hold nearly 50% of Treasury Securities. These three statistics - along with other well covered 'imbalance' related statistics (unsustainable debt and double deficits trends) - highlight why Bernanke is starting his tenure out at a disadvantage compared to Greenspan:

1) Another rate increase or two notwithstanding, Bernanke will begin his tenure with significantly less rate cut ammo than Greenspan. This is potentially ominous news given that the US economy has not been in a serious consumer driven recession in a long time (consumers spend the short lived 2001 recession borrowing and spending). One recession may be all that is required for Bernanke's zero bound interest rate policies to be put to the test.

2) The US consumer is not saving a dime and is more reliant on rising asset prices to fund spending today than in 1987. Greenspan benefited from the stock market becoming a savings account, and, more recently, homes becoming ATM machines. Bernanke will take over for Greenspan just as asset price increases are threatening to stall, and he will be greeted by a consumer that is, by some accounts, more stretched than at anytime since the 1930s. As consumers save less they can spend more. As consumers save more...

3) The US is more reliant on foreign investment than it has ever been. If Bretton Woods II can be sustained a little while longer this point means nothing. On the other hand, Bernanke will need to be more conscientious of foreign fund flows than Greenspan was early on in his tenure. This will take away some policy flexibility and/or force Bernanke's Fed to be respectful of the US dollar/interest rate situation.

Unwilling and Able?

With the US economy and financial markets performing strongly during Greenspan's tenure, and no one keen on returning to the 'tough love' days of Volcker, in order to be deemed a success Bernanke must preside over long economic expansions and short lived recessions. It is important to remember this myopic definition of 'success'.

Given the boom/bust characteristics easy money policies engender, one of the main challenges Bernanke faces is selling the next economic recession as a necessary ingredient to sustainable economic growth (i.e. creative destruction). If Bernanke is not adroit at selling the idea of recession to asset dependent US consumers he could spark a stock [savings] market slide that feeds on itself. Similarly, if during a period of slowing growth and financial market uncertainty Bernanke does not convince foreign investors that US dollar hegemony will not be allowed to wilt on his watch, he runs the risk of pushing the US towards an Argentina style collapse. Remembering the symbiotic relationship between domestic asset prices and foreign investment: How does Bernanke promote a strong dollar stance and monetary policy 'continuity' when Greenspan's pro-asset/leverage policies have deteriorated the moorings that support the US dollar? He doesn't.

The real challenge Bernanke faces isn't adopting the oxymoron that is 'sound monetary policy', but not trying to live up to the unattainable standard that Greenspan set. If Bernanke buys headlong into the theory that his management capabilities will be measured solely upon the US economy's expansion/contraction record his eagerness to be well liked will be his undoing. In short, while certainly able, it is uncertain whether or not Bernanke is willing to be bad guy to save the dollar. Being the bad guy means selling the idea of a imbalance remedying recession to investors that do not wish to buy.

Conclusions

The term 'Greenspan put' refers to investor faith that the Fed will always combat market declines. No need to buy put options to protect your portfolio, Greenspan is on the job.

A 'straddle' is a strategy option players use when they are uncertain of the markets direction but believe the next move in price will be large. With volatility having declined in recent years partially because of an overtly transparent Fed, and that the Fed's 'measured' tightening campaign is nearing an end just as an unproven commodity takes over for the legend of Sir Alan, the 'Greenspan put' era looks destined to quickly evolve into the 'Bernanke straddle'. In other words, expect financial market volatility as investors become more risk adverse; at least until Mr. Bernanke proves or disproves that his policy wand has some magic in it.

What direction will the markets break? Notwithstanding the flexibility that comes from being able to excessively print the reserve currency of the world, over valuation and unsustainable economic imbalances strongly suggest that the next big move in the stock markets will be lower. Bernanke, an outside the box thinker, risks being boxed in quickly if US asset prices stall. With the threat of becoming the fall guy, you have to wonder why the supposedly astute Bernanke accepted the job...

Brady Willett
FallStreet.com

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