To many market watchers, Alan Greenspan leaves his post as chairman of America's Federal Reserve acclaimed as a hero. But is that really the case?
When Alan Greenspan was nominated by President Reagan for the chairmanship of the Federal Reserve Board on 2 June 1987 to succeed Paul Volcker, bond markets recorded their largest one-day fall in five years.
Within three months of him taking up the reins of the Fed, the US stockmarket saw its largest one-day fall since 1914. These experiences of market dislocation seem to have weighed heavily on him throughout his long tenure as Fed chairman (18 years and six months); his main aim since seems to have been to avoid such events happening again.
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It is a measure of the complexity of the outgoing chairman that assessments of his legacy will range from glowing to grotesque. To some, he is still the Maestro', but to others he has become the Maelstrom'. His reign has been littered with contradictions: has he been diligent or negligent? Has he promoted continuity or chaos? To the ideal of unfettered capitalism, is he apostle or apostate? Does he stand for prudence or profligacy?
For me, Greenspan is the savings saboteur, par excellence. There are two sorry tales of savings. On his watch, first we have seen the steady erosion of personal saving as a percentage of disposable income; and second, the eventual devastation of net national saving after the bursting of the equity-market bubble in technology, media and telecommunications shares in 2000. In 2005, after a spring and summer of wild credit excess, both the personal saving rate and the net national saving rate turned negative.
After building a well-deserved reputation as a safe pair of hands in his early years, Greenspan used his growing authority to dispense with policy rules and structures such as monetary targets and to conduct instead an entirely discretionary policy. Why?
That was never entirely explained, but a succession of presidents have been happy to endorse his methods on the basis that he has been getting what look like favourable results: low consumer price inflation and a brisk pace of economic growth ever since the 1990-1992 recession.
Most of the credit for vanquishing US inflation belongs to Greenspan's predecessor, Paul Volcker, but it was during the Greenspan years that people dared to believe that low inflation could really be sustained and inflationary expectations settled down. The result has been an impressive fall in government and corporate bond yields, something that in turn paved the way for a revaluation of all financial assets in the 1990s (the lower interest rates are, the higher asset prices tend to go).
There was a bump in the path in early 1994 when after government bond yields around the world had fallen much further than expected in the previous year a small interest rate increase in February initiated a sharp reversal in bond prices, which erased in ten months most of the gains investors had made over the previous two years. But this was to be Greenspan's last negative policy shock.
On all future occasions, he was careful to prepare the markets for bad news in advance. By degrees, the Fed has pursued a path of increasing transparency in its interest-rate announcements, beginning with cryptic clues in speeches and culminating in explicit language, such as to hold the funds rate at 1% "for a considerable period" and remove monetary accommodation "at a measured pace". This unprecedented clarity seems to have been born of an increasing fearfulness of a repeat of the February 1994 bond-market event.
This same fearfulness has been in evidence at frequent intervals and particularly since the near-miss of August-September 1998 (when there was a Russian bond default and the hedge fund LTCM collapsed). One of the Fed's favourite tricks is the "limited special offer" on the overnight funds rate. The rate set at successive Fed Open Market Committee meetings is the target Fed funds rate, but on a given day, the Fed is willing to force the actual rate lower in order to forestall a problem in the financial markets. The most recent instance of this was on 12 October in the context of the Refco scandal.
But there's been a price to pay for Greenspan's aversion to negative shock therapy, traditionally the Fed's responsibility. The price has not yet been paid in terms of economic growth, nor in the volatility of economic growth. Nor has it been paid (until recently) in terms of a higher or more erratic inflation rate. Instead, the price has been met through a progressive increase in uninsured risk and vulnerability to shocks thanks to a rise in debt.
Greenspan, deliberately or otherwise, has, with his low interest rates, engineered a massive domestic-credit experiment that has had global ramifications. In total, the US private sector raised its debt to GDP ratio from 164% to 251% between 1987 and 2005. Households have increased their debt to disposable income ratio from 79% to 122%.
Since January 1993, the average Fed funds rate has been 4%, implying that savers get deposit rates of perhaps 2.5%. This low level of return has played a key role in the near-abandonment of household cash accumulation, embodied in the popular slogan, cash is trash'.
Credit facilities have taken the place of precautionary deposits. Although most households now have two wage earners, they still have proportionately less discretionary income than 30 years ago, and they have found regular injections of new credit indispensable to maintaining their living standards. In a booming housing market, the mechanisms of mortgage refinancing and home-equity loans have provided abundant cheap credit over the past five years. Yet, remarkably, more than two million individuals filed for bankruptcy last year.
At the corporate level, where profitability has been wonderfully restored since 2000 by ultra-low borrowing costs and easy yield-curve profits, the assumption of increasing balance-sheet leverage has facilitated the over-distribution of profits as dividends and share buybacks. A golden opportunity for the rebuilding of corporate saving has been wasted. Consequently, the US as a whole has failed to make adequate provision to renew its capital stock.
Greenspan's legacy is this: the exhaustion of personal debt capacity, the erosion of the savings incentive and the resulting fragility of consumer finances. If the US housing market follows the fading path of the UK this year, as the chairman expects, then this major engine of credit provision will begin to shut down. If equity markets fail to sustain their upward track after three solid years, then employment in the financial and real-estate sectors will also begin to turn down. No matter how robust the US economy has seemed in the recent past, its momentum could easily be lost in the space of six months.
Greenspan's successor, Ben Bernanke, inherits a Fed that has become less of a monetary policy institution and much more of a risk-management operation. In his 18 years, Greenspan has failed to shake off the notion that his personal judgement and discretion are critical to market outcomes. Indeed, some would argue that he has come to enjoy his market-moving potential. If Bernanke chooses to operate in the same discretionary mode, it does not follow that the markets will trust his judgement to the same degree.
Peter Warburton is author of Debt and Delusion' (www.debtanddelusion.com) and managing director of Halkin Services Ltd
How the Fed plays pass the parcel
Last week we asked our Roundtable members to tell us what they think of Greenspan's legacy. Here are their answers.
Jim Mellon: Greenspan has created credit at a monstrously fast rate for the last few years, which has led to instability. His legacy will be a US recession.
Mike Lenhoff: I'm not sure I'd agree. Paul Volcker (chairman of the Fed before Greenspan) and Greenspan have both been good chairmen and presided over quite a successful period globally for growth. They've reduced inflation and helped reduce inflation expectations. That's helped lower interest rates, which has been good for asset markets, growth, jobs and corporate activity.
Now it's just a question of whether the legacy Greenspan is handing to Bernanke is something he can keep going. I feel he probably can the global economic imbalances we worry about have been around for a long time and the world has coped relatively well with them. Now if some accident comes along, we're vulnerable and could have a recession. But that's hard to call.
Merryn Somerset Webb: What do you mean by an accident'?
ML: Well, perhaps investors will decide they don't want to keep investing in America so they stop holding dollars and the currency crashes. That would push up rates and tip the US into recession.
MSW: Jim, would that be an accident or an inevitability?
JM: An inevitability. Apart from anything else, I take issue with the idea that Greenspan has controlled inflation in the US. I think it's disguised by the deflationary effect of Chinese imports plus the fact that the basket of goods and services used to measure inflation isn't representative of real life. I've just been in Vegas and it struck me how expensive everything from real estate to labour is.
And you talk about how good growth has been in the US. But it's been unbalanced growth. Most job creation has been of the Burger King type and the ratio between CEO earnings and those of the underclass is something absurd like 500-1, whereas it was 200-1 in the early 1990s.
John Walter: Inflation is a risk and it has affected services in the US, which has been offset by deflation in goods, but it can't continue. Things like T-shirts from China aren't going to get cheaper and once they tick up in price, trouble starts.
David Stevenson: The interesting thing is that the market isn't convinced all is well. Note that despite an enormously long period of double-digit profit growth in the US, the stockmarket didn't perform last year.
ML: I think the reason for that is simply that the Fed has been tightening raising interest rates. But the market now recognises that the end is near the Fed should stop when we get to 5% maximum. That's why the markets moved ahead early in January.
Francis Brooke: But the end of tightening is going to present a pretty big challenge to the dollar. I don't think it matters who is head of the Fed: when interest rates start to look better outside the US than in, the dollar will be hit hard. The question is whether the Fed can manage the currency down without frightening global markets. A collapsing dollar wouldn't be helpful to anyone.
ML: No, but the weak dollar story based on America's balance of payments problem has been around for decades and the dollar hasn't collapsed. So you have to attach a low probability to it collapsing now. The fact is that Greenspan has steered the American economy, single-handedly, pretty well, through the difficult background that the global economy has faced recently and he has done it without the help of Europe and without the help of Japan. So he is to be applauded for that. Maybe there will be a price to pay later, but who knows when or how.
JW: But it will come. Yes, he has steered the economy very well, but he has also created bubble after bubble after bubble. So crisis is just delayed. There has to be a day of reckoning.
James Ferguson: I agree, but I don't think it is here yet. Don't forget that Greenspan is handing a fairly loaded gun to Bernanke. By the time trouble arrives growth looks like it is slowing or inflation rising interest rates in the US could be 5%. So Bernanke will have plenty of room to cut and keep the party going a bit longer. That will be his escape route. There is one last bite of the cherry to be had.
JM: It's a bit like a long game of pass the parcel with just a few more passes left.
Great Moderation' or big mess?
Alan Greenspan, the most famous public servant since Pontius Pilate, leaves his post next week. We stand back in wonder. Is it not to him that we owe this long stretch of prosperity, known as the Great Moderation'? Has he not served six different administrations? Did he not win a host of awards, including the prestigious Enron Prize for distinguished public service, awarded in 2001, just days after Enron collapsed in a heap of corruption charges?
So what of his legacy? If nothing else, the American empire has been a more entertaining place since Greenspan took over at the Fed 18 years ago. The Fed's role is to maintain financial discipline; to take away the punchbowl' before things get out of control.
Greenspan's approach has been different; he doesn't create discipline, instead he sneaks over and adds more gin. As he leaves the office, bonus-happy financiers are tap dancing on tables on Wall Street, and in California, realtors slap each other on the back after another year of double-digit house price gains, while Chinese manufacturers can't remember having it so good.
Greenspan's easy-money policies which have involved setting short-term lending rates even below the rate of consumer-price inflation stifled a much-needed recession in 2001, stirred up a real-estate bubble on both coasts and helped re-elect two presidents. But they've also coaxed a generation of Americans into debt.
Since 1987, outstanding mortgage debt has jumped from $1.8trn to $8.2trn. Total consumer debt has gone from $2.7trn to $11trn. And household debt has quadrupled. Worse, last year real wages (adjusted for inflation) went down for the second year in a row, leaving people with little choice: if they wanted to maintain their lifestyle, they had to borrow. The result? The savings rate went negative for the first time since the Great Depression.
Government debt, too, has exploded. The Fed owed less than $2trn in the second Reagan administration. Now it's over $7trn. During the two terms of George W Bush, the Fed borrowed more money from foreign governments and banks than all other US administrations put together from 1776 to 2000.
On Greenspan's watch, the trade deficit more than tripled from $150.7bn to $756.8.bn and will reach $830bn in 2006. When he took over, the US was still a creditor. Now, it is a debtor, with more than $11trn worth of US assets in foreign hands. The Great Moderation', indeed.
So what next? Greenspan's successor Ben Bernanke says that by targeting inflation he'll make the financial world more stable. And if the party ever starts to wind down, he has told economists he'll drop money out of helicopters, if necessary, to keep the spending going. Here is where the gods must start holding their sides. This is not the first time they've seen this movie, but they laugh harder every time.
Since 1971, the world has had an experimental' financial system, with currencies backed by nothing more than the full faith and credit of governments. And history shows that governments' faith and credit always run out, usually sooner than you expect. Even without being dumped from the sky, the dollar has lost 95% of its purchasing power since the Fed was set up to protect it in 1913; it's lost half its value since Greenspan joined the Fed. Expect it soon to lose the rest.
Bill Bonner is founder of The Daily Reckoning and author of the US bestseller, Empire of Debt
