Greenspan: still blowing bubbles

Alan Greenspan: Greenspan still blowing bubbles - at - the best of the week's international financial media.

When Alan Greenspan took over from Paul Volker as chairman of the Federal Reserve, America's central bank, in 1987, it was a baptism of fire. Just 72 days after he started, on Monday 19 October 1987, Wall Street fell more than 20% in one day, its worst one-day fall in history. Then, just as he was recovering from that shock, along came the Savings and Loans financial crisis of 1989. This was a huge threat to the banking system and eventually saw 747 thrift institutions close, as well as landing the US taxpayer with a $140bn bill.

But without Greenspan, it could have been much worse. He stepped up to the plate and lowered short-term interest rates from over 9% to 3% over the next three years. Then he kept them there throughout all of 1993. It did the trick, and taught Greenspan a lesson he learnt rather too well: that an easy way to deal with every problem was to ease over to the punchbowl and give it another couple of shots of that high-proof gin.

Thwarted by Asia and Russia

Back then, he still had a sense of traditional monetary management and soon started to slide rates back up to non-inflationary levels (low rates in strong economies tend to cause inflation), only to be thwarted by the Asian currency crisis of 1997. Greenspan may have already thought that a stockmarket bubble was underway (in September 1996 he said, "I recognise there is a stockmarket bubble at this point"), but his solution to the Asian crisis was still to put a hold on rates. Then he was stuck. The very next year, Russia defaulted on its debt and the heavily geared LTCM looked like it could cause a systemic shock.

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Breaking the rules

Greenspan's reaction was to break every rule in the central banking book. He lowered interest rates three times (although they were already arguably lower than pure economic conditions justified) to 4.6%. That may not sound very low to us today, but at the time (apart from briefly during the S&L crisis) this was the lowest rates had been for over 20 years. The result? Everyone could borrow freely and at much lower rates than they should have been able to.

The Greenspan Put

It was the beginning of a debt explosion and a huge stockmarket bubble as the US population suddenly realised that they had their very own investment insurance. Every time things were good, you made money; if things then went bad, Greenspan cut rates until things were good again. You couldn't lose.This became known as the "Greenspan put" (defined on page 38).

Trying to stop a crash

Having created a euphoric bubble in the stockmarket - and one on which the average American had a great deal riding - Greenspan was again loath to take the punchbowl away. So he didn't. The Fed tried to raise rates again into late 1999, but only in January 2000 when the savings rates had turned negative (the bubble sparked a huge consumption boom) and unemployment all but disappeared did rates finally go above 5.5%. By mid 2000, they had clawed their way back up to over 6.5%, though this was still probably way too low, given economic conditions. Still, the Fed needn't have worried about causing the bursting of the bubble it had made: fantastical valuations did this for them. The dotcom crash started in March 2000, over three years after the Fed chairman had publicly worried that something should be done about its inflated prices.

The only way he knew how

The disaster Greenspan had feared for years had hit, so he acted in the only way he knew how. The interest rate was cut again. For most of 2002, it was then held at the low level of 1.75%. But this time, it didn't work immediately. The S&P 500 was 1,175 in March 2002, but soon dived again, hitting a new low in October. Out came the gin again: Greenspan cut rates again, to 1.25%. And when the 2003 recovery in shares looked to be faltering, he slashed them to 1% - the lowest rate since 1958.

Where we are today

Greenspan has dealt with the problems at hand, but he has also created massive distortions within the rest of the economy. The household sector was blissfully unaffected by Asian currency volatility and Russian defaults, and only marginally hit by the dotcom bubble. However, over the last three years artificially cheap debt has encouraged households to borrow using cheap debt to buy up houses and then use higher house values to refinance their mortgages to finance consumption (this is referred to as refi'). Now Greenspan's bubble are affecting everyone: by incessantly cutting rates, he has passed the bubble from bonds and equities to the widest possible number of people via the housing market.

What next?

This leaves Greenspan trapped. He doesn't want to raise rates, as that will mean the debt bubble bursts and consumer recession will hit. But he can't lower rates either: there's no room left. So he's doing nothing - for now. Poor Greenspan: each crisis he dealt with by cutting rates looked critical at the time, but by avoiding taking pain on the spot, he just created new bubbles for later. Back in 2001, he was saying "the brevity of the downturn [is] a testament to the notable improvement in the resilience and the flexibility of the economy". But what if Greenspan's irresponsible use of the lower interest rate has meant that the downturn hasn't actually happened yet? Instead, each time it started he put it off by cutting rates again, thus simply extending the cycle. The legacy is a massive housing and consumption bubble that will at some point burst, leaving the US (and by implication the rest of us) with a post-party hangover of unprecedented size to look forward to.

Where is the pin?

The answer to this starts with the consumer. One estimate claims that over the last decade, 90% of the world's growth came from the US consumer. Recently, Greenspan's been shouldering this responsibility with debt. But this can't last for ever, and as rates rise and refi falls off, so will the consumer's ability to keep shopping. The effect cannot be anything other than extremely recessionary. And not just in the US: all those areas that make finished goods for the black hole that has been America's import market can expect to see a dramatic drop in demand. So expect trouble all over Asia and Latin America too. Instead of a dangerous bubble for equity investors, Greenspan now has a debt-fuelled bubble in the household sector that will affect nearly everyone when it bursts. And burst it will.

Consider this: core US consumer prices are officially rising at 2.9% annualised, but if you add back in the food and energy components (which are excluded from the numbers), they're really rising at more than 5% annualised. This means that real interest rates are an extraordinary minus 4% - which means rates have to rise. Indeed, they could rise by a multiple of five times and still be too low. The fact is that the party is now going to have to wind down. It has gone on for longer than it should have and guests have had far too much liquidity refreshment. When they finally go home, there are bound to be some accidents.

What investors need to do

It's hard to know where to hide when rates are rising, because it hasn't happened for so long - we're out of practice. But the answer isn't stocks, bonds or property (rising rates are going to hit all of them); nor is it Asian export-led economies, or indeed, from a UK investor's point of view, the dollar. The only safe place to be with rising rates is in cash. Then you'll benefit not just from rising rates themselves, but you'll also be in a position to leap onto the bargains thrown up by the turmoil to come.