April 8 - Dow Jones (Charlene Lee): "Former Federal Reserve Chairman Alan Greenspan continued to defend his legacy Tuesday, saying he has 'no regrets' over Fed policy conducted during his tenure. He added that there was little the central bank or regulators could've done to avert the U.S. housing crisis. 'I have said to many questions of this nature that I have no regrets on any of the Federal Reserve policies that we initiated back then because I think they were very professionally done,' Greenspan said in an interview on CNBC."

Well, Alan Greenspan is not going to be of much help when it comes to the critical issue of exploring what went terribly wrong with monetary policy and the financial system. Interestingly, some are rallying to his defense. From the Financial Times' Martin Wolf: "Mr. Greenspan remains the most successful central banker of modern times. More important, blame distracts from the challenge, which is to understand what happened, why it happened and what we should do."

We do not want to get distracted. But "the most successful banker of modern times"? While the scope of the unfolding disaster has yet to be recognized by Mr. Wolf or others, Mr. Greenspan was the undisputed governor, architect - the promulgator of what will be recognized as an epic failure in central banking. After all, he was for almost 18 years the appointed guardian over a financial system that perpetrated the greatest Credit and speculative excess in history. He dominated monetary policy like no other central banker in history. Chairman Greenspan not only negligently failed to act to reign in dangerous excesses, he became a vocal proponent for virtually all aspects of "Wall Street finance."

Anyone that has read history related to central banking appreciates that Alan Greenspan conveniently made up new rules as he went along. He evolved into the absolute "maestro" at concocting sophisticated rationale for seemingly every troubling development that took root in contemporary ("wildcat") finance. Greenspan was an outspoken proponent of securities-based finance; of models-based risk management; of the great benefits provided by derivatives markets; of the liquidity benefits of leveraged speculation; of "telegraphed baby-step" monetary management; and a proponent of "risk management"-based monetary management (i.e. ease aggressively to forestall even a low probability of "deflation"). He trumpeted the profound benefits emanating from the capacity for contemporary finance to better quantify, manage and disburse risk - in the process creating a more stable financial sector. Most importantly, he championed the notion that it was preferable for the system to let Credit booms and asset Bubbles run their course - and then to treat their busts aggressively with monetary stimulus to ensure little negative impact the real economy. He claimed Bubbles were only recognizable after the fact.

He evolved into the ultimate activist and micromanaging central banker, wrapped bizarrely in the cloth of a free market ideologue. It was a most precarious amalgamation. On his watch transpired historic ballooning of the government-sponsored enterprises, of Wall Street balance sheets, and of the size, power and influence of the leveraged speculating community. Worse yet, it's my view that he used these sectors as key inflationary mechanisms. The Greenspan Episode will be seen from a historical perspective as central banking lunacy. It was the exact intoxicant for market participants and politicians to wallow in during a spectacular boom.

The inherent instability of money and Credit was the dominant focus from the earliest thinking on matters of monetary management and central banking. The U.S. Federal Reserve was (belatedly) created specifically to reign in the recurring boom and bust cycles, of which it failed spectacularly during the 1920s. Even today, the ECB and other central banks (read pronouncements from the Reserve Bank of New Zealand!) remain steadfast in their focus on money and Credit analysis as a fundamental pillar in their mandate to maintaining system stability. Somehow, the Greenspan 'New Age" doctrine was to completely disregard Credit - and disregard it they did during a period of unprecedented innovation, experimentation, and gross issuance of contemporary electronic and market-based "money" and Credit. In their distorted view, monetary instability is a dynamic of the bust and not the preceding boom.

It was a policymaking regime destined for failure. Go back and read some of the speeches by ECB officials - Bundesbank and ECB executive Otmar Issing, in particular. It has been for awhile somewhat a battle of central banking philosophies- the well-grounded and traditionalist ECB vs. the "New Age" Greenspan Fed. The ECB is clearly the victor, and "euroland" citizens (with their valuable euros) are winning in the process.

Excerpting from Dr. Issing's February 2004 Wall Street Journal op-ed piece (highlighted in the 2/19/2004 CBB, "Issing v. Greenspan"): "Huge swings in asset valuations can imply significant misallocations of resources in the economy and furthermore create problems for monetary policy. Not every strong decline in asset prices causes deflation, but all major deflations in the world were related to a sudden, continuing and substantial fall in values of assets. The consequences for banks, companies and households can be tremendous... Prevention is the best way to minimize costs for society from a longer-term perspective. Central banks are confronted with this responsibility, but there is no easy answer to this challenge. So far, only some tentative conclusions can be drawn. First, in their communication, central banks should certainly avoid contributing to unsustainable collective euphoria and might even signal concerns about developments in the valuation of assets. Second, the argument that monetary policy should consider a rather long horizon is strengthened by the need to take into account movements of asset prices. Finally, it should not be overlooked that most exceptional increases in prices for stocks and real estate in history were accompanied by strong expansions of money and/or credit. Just as consumer-price inflation is often described as a situation of 'too much money chasing too few goods,' asset-price inflation could similarly be characterized as 'too much money chasing too few assets.'"

This was the focal point of an historic debate. Dr. Issing and the ECB had history and sound analysis firmly on their side. The Fed had hope. And I do believe that as runaway Credit excess and asset Bubbles gained only further momentum - and as the consequences of dealing with these Bubbles became increasingly more problematic for our central bankers, the financial sector, and real economy - the Greenspan Fed became only more intransigent with respect to their flawed doctrine. They would not act; Wall Street knew they would not take the punch bowl away; and the Credit Bubble's "terminal phase" was let to run its own fateful course. While decisions at the Fed may have been made "professionally," they were nonetheless made from a deeply flawed analytical framework with predictable results.

Even today, Greenspan chooses to avoid a meaningful discussion about Credit. From his op-ed piece in Monday's Financial Times ("The Fed is blameless on the property Bubble"): "I am puzzled why the remarkably similar housing bubbles that emerged in more than two dozen countries between 2001 and 2006 are not seen to have a common cause. The dramatic fall in real long-term interest rates statistically explains, and is the most likely major cause..." He goes on refute those that place blame on the Fed for the housing Bubble, including arguing against the claim that the Fed's 1% funds rate triggered "a massive Credit...expansion." Greenspan wrote: "Both the monetary base and the M2 indicator rose less than 5 per cent in the subsequent year, scarcely tinder for a massive Credit expansion."

Tinder or no tinder, what transpired was unprecedented Credit expansion. The Greenspan Fed cut rates aggressively in 2001, and Total Mortgage Debt (TMD) growth accelerated to a rate of 10.4%. With rates dropping to as low as 1.25% in 2002, TMD expanded 12.1%. With rates dropping to 1.0% in 2003, TMD increased another 11.9%. Despite TMD increasing by a stunning 38% in three years, Fed funds remained at 1% through the first half of 2004. TMD growth surged to 13.5% in 2004, followed by 13.4% in 2005, and 11.6% in 2006. The Greenspan Fed sat idly as mortgage Credit doubled in just six years.

Meanwhile, "massive Credit expansion" led, characteristically, to ballooning Current Account Deficits. After averaging a large $122bn annually during the nineties, the Deficit swelled to more than one-half Trillion during 2003. It then jumped to $640bn in 2004, $755bn in 2005, $811bn in 2006, and $739bn in 2007. As a consequence (and in combination with speculative dollar outflows to play attendant dollar devaluation), Rest of World (ROW) holdings of U.S. Financial Assets - after increasing on average $374bn annually during the nineties - expanded $788bn (10.6% growth) in 2003, $1.518 TN (18.5%) in 2004, $2.263 TN (23.3%) in 2005, $1.868 TN (15.6%) in 2006, and $1.573 TN (11.4%) in 2007. ROW holdings surged $8.0 TN, doubling in just five years.

This data is from the Federal Reserve's Z.1 "flow of funds," a report I can only assume Dr. Greenspan is intimately familiar with (yet never addresses). That he can today cite moderate growth in the monetary base and M2 and imply the Fed was not culpable for the Credit Bubble is beyond me. Greenspan blames the worldwide "dramatic fall in real long-term rates." Even the FT's Martin Wolf concurs: "So what might explain these bubbles? I would point to four causes: very low long-term real interest rates, because of the global savings glut; low nominal interest rates, because of both low real rates and the benign inflationary environment; the lengthy experience of economic stability; and, above all, the liberalisation of mortgage finance in many countries."

First, I am surprised the "global savings glut" thesis is still being bandied about. This was a notion of Greenspan/Bernanke "New Age" central banking that was happily adopted by Wall Street. And Greenspan still refers to the interest-rate "conundrum." There was none, but instead a Global Liquidity Glut that was foremost a product of the massive Credit Bubble-induced dollar outflows (represented well enough by the Rest of World accumulation of our financial claims). Not only did this massive dollar "recycling" exercise put significant pressure on our long-term rates and currency, the unrelenting accumulation of dollar reserves globally proved a major impetus for overheated domestic Credit systems the world over - creating even more liquidity in the process. I find it repulsive today that Mr. Greenspan claims global forces were at work. In reality, the Federal Reserves disregard for Credit excess, Current Account Deficits, and the dollar's role as the "world's reserve currency" rest at the heart of what remains today escalating Global Monetary Disorder.

Not surprisingly, Greenspan is content to frame the debate in an "academic" context - ensuring no clear resolution (proof) is possible. The Wall Street Journal article (Greg Ip's) highlighted a disagreement between Greenspan and John Taylor on the "global savings glut thesis." Taylor says his data show the global investment equaled savings, thus there's no "glut." Greenspan counters that Taylor uses actual investment when it should be "expected" - that is anyway unquantifiable. Please note the clear language used by Otmar Issing above to communicate clear thinking to the interested laymen.

Fundamentally, the Federal Reserve "pegged" short-term interest rates, inviting leveraged speculation. I am not of the view that there is a specific interest-rate that is "right" for the system. But exceptionally low rates telegraphed to the leveraged speculating for the purposes of stimulating the acquisition of risk assets and reinflating asset markets is nefarious central banking. And never combine telegraphed "pegged" low interest rates with assurances that the Fed will always be there to sustain marketplace liquidity (underwrite securities prices), while cutting rates aggressively to mitigate bursting Bubbles. Once that path is taken there is no turning back; the central bank is held hostage by the fragility associated with escalating system leverage, speculative excess, and an increasingly maladjusted and vulnerable real economy.

Greenspan now warns against over-zealous regulation and the intrusion of governments into the competitive marketplace. Well, he should have considered these inevitable consequences when he disregarded Credit and asset Bubbles. And to admit to such mistakes to ensure a sounder monetary policy regime going forward would be statesmanlike - which he apparently is not. And while the focus these days is on government programs and regulatory reform, it is my hope that meaningful discussion emerges with regard to a sound "analytical framework" for our central bank. Unfortunately, he was lionized. It now becomes difficult to separate the cult of Greenspan - an individual I view as single-handedly more responsible for Credit and asset Bubbles than anyone else in history - from the Federal Reserve policymaking "analytical framework." Chairman Bernanke has referred to the understanding of the Great Depression as the "holy grail" of economics. The pursuit of the "grail" will now be assessing and interpreting the Greenspan Episode.

Doug Noland
The Credit Bubble Bulletin
PrudentBear.com

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© 2008 Doug Noland

ABOUT THE AUTHOR

Doug Noland is a market strategist at Prudent Bear Funds. Their website is www.prudentbear.com.

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The Greenspan Episode by Doug Noland

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