One phrase or word from the second most powerful man in America, Federal Reserve Board Chairman Alan Greenspan, can send the global financial markets into a hysterics. Such was the case on December 5, 1996 when Greenspan uttered 'irrational exuberance' and the global financial markets, albeit temporarily, shuttered.
But Greenspan doesn't waste many words trying to talk the financial markets down. Rather, with the traditional threat of price inflation seemingly under control in a post-Volcker world, Greenspan's voice has remained largely optimistic during his tenure. As for the untraditional challenges - including the S&L crisis, Mexican peso crisis, LTCM, Asian Crisis, the 2000-2002 stock crash, and the housing bubble - with the exception of the unresolved 'housing bubble' in America these threats have been handled in short order. Legend has it that Greenspan was, and still is, the magical cook.
Suffice to say, the Fed's bailout and pro-asset inflation policies while under Greenspan's control have awarded Sir Alan the nickname 'Easy Al', and brought to light the idea that a 'Greenspan Put' is in the marketplace. And while some - including Roach, Fleckenstein, Faber, Grant, North, Noland, and now Ravi Batra - have balked at laying roses around Greenspan's bubble-building-bailout legacy, one factoid is not open for debate: failing a complete meltdown before he retires next year the US economy and financial markets have performed exceptionally well during Greenspan's tenure. To be sure, if monetary policy was scored like a baseball game Greenspan's team would be a dynasty.
Unfortunately, with regime change at the Fed drawing near, cheerleading for team Greenspan on the ebb since the 1990s stock bubble went bust, and the Fed not sure of how many more 'measured' helpings it can doll out before something in the markets or economy cracks, an increasingly uncertain monetary policy outlook lurks. Add to this the fact that the US economy has grown even more reliant on rising asset prices (houses) and foreign investment than it was before the stock bubble peaked, and one ominous observation surfaces: Greenspan's policies have, at least for the foreseeable future, locked the Fed into a dangerous game of asset bubble management.
Go-Go Greenspan Takes Over From The Heavy
"I overstate it, but the traditional method of making small moves has in some sense, though not completely, run out of psychological gas. Every time the interest rate goes up by a small amount [bankers] say okay, we'll raise the prime rate. Whatever you do is inadequate -- you, the Federal Reserve -- and we'll go along. We have access to liquidity at a fairly fixed federal funds rate -- the rate isn't going to change all that abruptly -- and you're not having much impact on market thinking or on market confidence in your ability to keep the money supply under control." Volcker. October 6, 1979
Often times going against the Street, former Fed Chairman, Paul Volcker (1979-1987), was able to get a stranglehold on inflation by adopting tough policies designed to better control the money supply. The following joke told by Volcker was, in fact, the policy goal that Volcker was sculpting (or "managing Desk operations from week to week.")
"He [the discount officer) asked them why they were borrowing. And the bank official cautiously says: "What the hell, I hadn't borrowed in a while and your rate looked pretty low." And the discount officer replies: "Well, you can't borrow for that reason." Now, if a Reserve Bank really enforces that kind of discipline, it doesn't get many borrowings."
Weeks into Volcker's tenure he called a special meeting on a Saturday, raised the Federal funds rate by 1% to a record 12% Saturday night, and quickly went from Wall Street Fed favorite to the heavy. Continuing to play the heavy in the 1980s, Volcker ended up handing the keys to Greenspan after successfully slaying inflation.
"By 1979, the need for drastic measures had become painfully evident in the United States. The Federal Reserve, under the leadership of Paul Volcker, dramatically slowed the growth of money. Initially, the economy fell into recession and inflation receded. However, most important, when activity staged a vigorous recovery, the progress made in reducing inflation was largely preserved. By the end of the 1980s, the inflation climate was being altered dramatically." Greenspan. December 19, 2002
Mr. Greenspan Finds His Muse
Weeks after taking over for Volcker in August 1987, Alan Greenspan was confronted by a stock market crash. As if to set the tone for his 18-year tenure to follow, Greenspan's Fed released a simple one sentence statement aimed at reassuring a frazzled Street.
"The Federal Reserve, consistent with its responsibilities as the nation's central bank, affirmed today its readiness to serve as a source of liquidity to support the economic and financial system." Tuesday, Oct. 20, 1987. 8:41 AM.
After losing 22.6% on October 19, 1987 the Dow Jones Industrial Average logged a record (point) gain on October 20 and October 21, and by early 1989 the Dow had recouped all of its losses from October 19. While other explanations for the quick turnaround in the markets are certainly worth mention - namely that the crash may have simply been a temporary phenomenon caused by the portfolio insurance blowup/dollar scare, not a key turning point in the broader US economy - the above statement and actions from the Fed are nonetheless regarded as having saved the day.
Operating in post-crash-containment mode, Greenspan used the November 3, 1987 FOMC meeting to offer further verbal assistance to the financial markets: 'volatile conditions in financial markets and uncertainties in the economic outlook may continue to call for a special degree of flexibility in open market operations'. Still only months into his reign, it was the meticulous tinkering of important Fed statements in Oct/Nov 1987 that Greenspan seemed to most relish. Indeed, although the words changed from crisis to crisis, the phrase 'special degree of flexibility' best describes Greenspan's answer to any and every Fed challenge from 1987-2005.
"There is also the issue of how we portray ourselves to the public. And that's not only the issue of what we do but of how we say it -- how we write down the directive -- because this particular directive is going to be disaggregated in such detail that periods and misprints are going to be read as having great, great importance." Greenspan. November 3, 1987
While Greenspan's greatest trait (some would say downfall) is that he supposedly supervised countless bailouts, reality paints a different picture. To be sure, Greenspan was not the head maestro behind the Mexican peso bailout (Rubin was), and Alan played no role in overseeing the Long-Term Capital Management bailout meeting (McDonough did). In fact, on the LTCM issue Greenspan was (internal sources suggest) not pleased with the meeting that McDonough orchestrated. For that matter, Greenspan remained uninformed of the situation days before he was set to deliver a testimony on LTCM to Congress.
"It is one thing for one bank to have failed to appreciate what was happening to LTCP, but this list of institutions is just mind boggling.
What I think we are going to need for our testimony on Thursday is a general summary of what we do as examiners, how often we do it, and why banks with a huge amount of experience in lending got caught in this kind of thing. We need an answer...
All I care about is that we produce accurate testimony." Greenspan. September 29, 1998
That 2-days before Greenspan testified on LTCM he knew very little about the multi-billion hedge fund is telling not a calculating bailout master, but of a boss rushing to grasp what his underlings had accomplished. And while we may do not know to what extent Greenspan authored his speeches/testimonies, the issue is worth discussing. Why? Because on numerous occasions Greenspan's rehearsed words have contradicted some of his more improvised comments (made during Q&As and Fed minutes). In some case the contradictions are so fabulous that you get the impression that Greenspan rarely allows his own opinions to mix with 'how the Fed portrays itself to the public'.
As a quick example, consider some of the remarks Greenspan made on September 23, 1996, or more than two months before he uttered 'irrational exuberance'. Whereas the rehearsed (or edited/Fed approved) 'irrational exuberance' phrase was asked within a rhetorical question, Greenspan took a decidedly different tone when talking with Fed members months earlier:
"I recognize that there is a stock market bubble problem at this point, and I agree with Governor Lindsey that this is a problem that we should keep an eye on." Greenspan. September 23, 1996
Remember, when Greenspan said 'stock market bubble problem' in September 1996 he wasn't thinking about policy decisions or how the Fed was being portrayed to the public. Rather, he was simply telling it like it was. And yes, when cornered years later - even after the bubble grew to unthinkable heights - Greenspan argued that bubbles were only identifiable after they burst in rehearsed comments.
Another example of Greenspan telling it like it was appears in the same September 1996 FOMC transcripts. This time Greenspan was talking about the possibility of increasing margin requirements to combat the stock bubble:
"We do have the possibility of raising major concerns by increasing margin requirements. I guarantee that if you want to get rid of the bubble, whatever it is, that will do it."
Years later when under pressure to explain the Fed's neutral stance in the face of arguably the greatest stock market mania in US history, Greenspan squirmed and said 'There is no evidence to suggest margin requirements have an effect on stock prices (Jan 13, 2000 ~ Q&A)' No evidence? How about common sense: raising margin requirements could not possibly made the bubble any worse!
Suffice to say, while Greenspan's pre/post-bubble related words are rife with contradiction, the historian would be drawn into fits of confusion if they dare study Greenspan's record on to topic gold.
But alas, in an effort to make a long and confusing historical record short, Greenspan didn't practice what he preached because his sermons were disjointed. And while conflicting statements should be cause for concern, remember that stock prices rose during Greenspan's tenure! Glory, glory, hallelujah!
A Strategy without Fail?
According to Greenspan the Fed cannot 'definitively identify a bubble until it bursts', but the Fed is willing to try and 'mitigate the fallout when it occurs'. When translated this means that the Fed condones excessive asset price speculation, but only if prices are rising.
"The notion that a well-timed incremental tightening could have been calibrated to prevent the late 1990s bubble is almost surely illusion." Greenspan. August 30, 2002.
Commenting on the above quote, what is surely just as much of an illusion is the overly simplistic premise that a 'well-timed incremental loosening' [to combat the bubble fallout] is somehow more effective at achieving its desired ends than a 'well-timed incremental tightening'. Quite frankly, the mechanics of the curve, the money supply, bank reserve/margin requirements are controlled by the Fed, and if Greenspan and company had wanted to they could have slowed down the ridiculous and dangerous events that were transpiring in the stock market in 1999. As for the Fed admitting to being unable to calibrate policy to prevent bubbles, if this is true how can the Fed take credit for calibrating policy that prevents the fallout of bubbles? In what is one of the most important quotes of Greenspan's tenure, he attempts to answer this conundrum:
"Instead of trying to contain a putative bubble by drastic actions with largely unpredictable consequences, we chose, as we noted in our mid-1999 congressional testimony, to focus on policies "to mitigate the fallout when it occurs and, hopefully, ease the transition to the next expansion...
There appears to be enough evidence, at least tentatively, to conclude that our strategy of addressing the bubble's consequences rather than the bubble itself has been successful." Greenspan. January 3, 2004
Without doubt Greenspan's rate cutting campaign was 'successful' if success is measured by the near term performance of the financial markets and economy. However, it is also possible that while aggressively trying to slow the stock bubble crash the Fed was responsible for spawning other bubbles. Greenspan continued his self-congratulatory words in the footnotes:
"Some have argued that, as a consequence of the 1995-2000 speculative episode, long-term imbalances remain...
Even if imbalances still persist in our current environment, the business decline that began in March 2001 came to an end in November of that year, according to the National Bureau of Economic Research. We experienced tepid recovery until the second half of last year, when GDP accelerated considerably. Hence, when the next recession arrives, as it inevitably will, it will be a stretch to attribute it to speculative imbalances of many years earlier."
Just so there is no misunderstanding, after recognizing a stock bubble existed Greenspan waited 5-years for it to burst before he did anything. Then, after aggressively cutting interest rates as stocks plunged, and with very little hope of ever reacquiring the ammo spent without hurting the increasingly curve reliant US economy, Greenspan now contends that the next recession will not be the result of late 1990s imbalances. Does Greenspan really believe that 1990s imbalances only impacted stock prices? (not say credit, consumer savings, the current account deficit, etc.?)
Suffice to say, Greenspan's master strategy of turning a blind eye to growing imbalances until the moment of ease arrives will fail miserably when the Fed is unable to avert the fallout from the next bubble or financial crisis because of lack of ammo.
Greenspan's greatest mistake, which has been covered before, was not doing anything on the regulatory front to help ensure the long-term stability of the US financial markets. That the largely unregulated OTC derivatives market continues to grow and hedge funds have amassed more than $1 Trillion is not cause for applause, but deep concern.
Greenspan's second mistake, which has been widely covered, is that his policy of ignoring asset bubbles as they form and 'aggressively easing' when these bubbles meet resistance has helped create a situation wherein people always expect the Fed to save the day. That the expectation of omnipotent Fed management engenders irrational investment decisions is not so much a question after 18-years of Greenspan, but a fact of investment life.
Finally, Greenspan's third mistake - which can only be validated at some point in the future - was/is his failure to recognize that the speculative forces allowed to fester in the late 1990s were not expunged by declining stock prices, but merely dispersed into other stock and assets classes. As Greenspan took the Federal Funds rate down to 1% and effectively taxed savers into riskier investment vehicles he did so under the assumption that post-bubble insurance was required to avert a Japanese style bust. What Greenspan did not consider was that his actions might create a larger and even more menacing credit bubble that will need to be reckoned with on a later date.
Despite all of his mistakes there is no mistaking the fact that Greenspan has been successful at achieving the mandates set out by the Fed, at least in the past and present. Perhaps also, Greenspan has been too successful:
"...it seems ironic that a monetary policy that is successful in inducing stability may inadvertently be sowing the seeds of instability associated with asset bubbles."Greenspan. December 19, 2002.
That Greenspan's success is largely the result of a lucky inflation draw (Kasriel) is without question. By contrast, the prospect of having to map out monetary policy in a post-Greenspan world is less than inviting for the next Fed Chairman.
In short, if monetary policy was scored like a baseball game Greenspan's team would be the dynasty. However, when grading Greenspan it may be more prudent to forget about baseball and instead think chess: time and time again Greenspan flaunted conventional wisdom and attacked with his queen early in the game with great success. One of these days this strategy will backfire.
By ignoring the formation of asset bubbles Greenspan has ensured that asset prices will remain the driving force in determining monetary policy in the future. Regardless of who is in control of the Fed's ever increasing role of asset management, uncertainty will remain. Queen to...?
McDonough: The problem with our convening the meeting and sitting there glowering at people to induce them to reach an agreement is that if they were not able to solve the problem, then it would be our deal. The Federal Reserve would be excessively, inappropriately, and unwisely involved.
Greenspan: ...did those in the room think that their own firms would benefit from an agreement, or were they looking solely at the macroeconomic effects of being good citizens?