Alan Greenspan Tries to Rewrite History

One of my least favorite things about the mortgage business is how everytime something goes wrong each party blames another party. Almost never does someone take responsibility and fix the error. Instead, they try to blame someone else and act as though fixing the error is someone else's responsibility.

I bring this up because Alan Greenspan wrote a column in today's Wall Street Journal. Greenspan laid out a very interesting and detailed version of the events that lead up to the crisis...

The root of the current crisis, as I see it, lies back in the aftermath of the Cold War, when the economic ruin of the Soviet Bloc was exposed with the fall of the Berlin Wall. Following these world-shaking events, market capitalism quietly, but rapidly, displaced much of the discredited central planning that was so prevalent in the Third World.

A large segment of the erstwhile Third World, especially China, replicated the successful economic export-oriented model of the so-called Asian Tigers: Fairly well educated, low-cost workforces were joined with developed-world technology and protected by an increasing rule of law, to unleash explosive economic growth. Since 2000, the real GDP growth of the developing world has been more than double that of the developed world.

The surge in competitive, low-priced exports from developing countries, especially those to Europe and the U.S., flattened labor compensation in developed countries, and reduced the rate of inflation expectations throughout the world, including those inflation expectations embedded in global long-term interest rates.

Now, this might be the height of my own hubris, however I find his entire narrative to be nothing more than intelligent sounding nonsense. The reason is that he is trying desperately to avoid his own responsibility in the mess. I pointed out his responsibility in this piece. While Greenspan would like us to take the roots back twenty years, I think we can find something more important much closer to the present.

This is a chart of the Federal Funds Rate which as Head of the Federal Reserve Greenspan controlled until recently. As you can see between the middle of 2001 and the middle of 2003, the rate was absurdly low. It reached below one percent for a period of time. Greenspan can try and re write history however by lowering the rate that much he created loose and easy money. While he may not have predicted the mortgage mess per se, he should have anticipated the law of unintended consequences. He should have known that it was irresponsible to leave rates that low for that long. He should have known that if banks could borrow from the Fed (which is the purpose of the Federal Funds) for so little, that they were bound to act irresponsibly with the money.

He can pin this on some sort of a complicated alter universe in which a sophisticated network of globalization combined with asleep at the wheel credit agencies, arbitrage players, and poor savings. He can do this, but it still isn't going to tell the whole story. To add insult to injury, Greenspan actually tries to justify his irresponsibility while paying nothing more than passing lip service to what it actually caused.

and my colleagues at the Fed believed that the potential threat of corrosive deflation in 2003 was real, even though deflation was not thought to be the most likely projection. We will never know whether the temporary 1% federal-funds rate fended off a deflationary crisis, potentially much more daunting than the current one. But I did fret that maintaining rates too low for too long was problematic. The failure of either the growth of the monetary base, or of M2, to exceed 5% while the fed-funds rate was 1% assuaged my concern that we had added inflationary tinder to the economy.

The entire piece is full of technical language and it is told in a manner only fit for an expert. I don't know if Greenspan hoped to impress anyone or if he merely actually believes the load of bull that he is selling. I do know that China, credit ratings, and poor savings rates played a much smaller role in the crisis than the irresponsible and precipitous drop that the Fed took on the Fed Funds Rate.

The root of the crisis as I see it was loans that were created for irresponsible borrowers. These loans were created because banks suddenly had an infusion of loose money that they were able to borrow from the Fed. Because the rate was so outrageously low, banks felt more room to take risks. They did and that started the ball rolling. While Greenspan painstakingly tried to explain the root cause going back to right after the Cold War, he conveniently overlooked his own responsibility in the crisis. Unfortunately for Greenspan, I don't think that history will have such oversight.

Should We Be Worried About Bernanke?

Those are the ominous words of Andrew Busch in his newsletter yesterday afternoon.

I can't recall a time ever when stock prices were at all time highs, GDP was near 4.0%, and the US dollar was making all time lows....and the Federal Reserve cutting interest rates. I think I've underestimated the inexperience of the Bernanke Fed. The FOMC stands on a Jim Cramer induced precipice and risks losing the hard won Greenspan credibility.

He raises some interesting points and frankly I have to agree with him. Ever since Alan Greenspan fixated himself with the internet bubble to disastrous results, I am weary of any Fed Chairman paying too much attention to one industry. It is clear that Bernanke is focused on resolving the credit crisis in the housing market. It appears that he is ignoring the health of the overall economy. The end result of this could be disastrous.

The treasuries have responded to this latest move the same way they responded before. They traded down initially though they have come back this morning. The reason is for this is that traders see all of this rate cutting as inflationary. Here is how the USA Today analyzed his previous rate drop.

Treasury bonds were mostly lower Monday, sending yields higher, as investors focused on the prospect that last week's sharp cut in U.S. interest rates will result in spiraling inflation.

...

The stock market has focused on the positive implication that less expensive money will stimulate growth, while the Treasury market has fretted over inflation. Cheapening the cost of money tends to tempt sellers to lift prices, setting off inflation, which the Treasury market detests.

The reality is that most likely the best move for the Fed Chair to make is no move at all. The economy is humming along nicely. The only thing that rate cuts may do is overheat it. Bernanke is fairly new in his position and this maybe where his inexperience comes into play. Sometimes the most difficult move to make is no move at all.

This brings me back to my original point. Whenever a Fed Chairman focuses on one industry while ignoring the economy as a whole it leads to disastrous results. First, the problems in the housing market are too broad and deep to be solved simply by easing credit. Right now, we have people in homes that they simply cannot afford. Furthermore, the amount they own on their homes is probably more, a lot more, than what it is worth. This phenomenon is not something that can be solved simply by extending more credit. These people are in over their heads and they can't get out. This is not something that extending credit will resolve.

So what does Bernanke do? He lowers rates, and thus eases access to money, at a time when our economy is not only heating but on the verge of over heating. As Busch pointed out, he lowered the Funds rate on the same day that the GDP numbers came out. The latest GDP figures have the economy growing at 3.9%.

The magic number for GDP growth is 3%. Anything more and we worry about inflation and anything less and we worry about recessions. With GDP growing at 3.9%, the last thing the Fed Chairman should be doing is lowering rates. Lowering rates pumps more money into the economy and expands it even further. This puts extra inflationary pressure on an economy that already has several pre cursors to high inflation: strong GDP, strong job growth, strong stock market, and weak dollar. The genius of Greenspan throughout the nineties was managing the entire economy so that it never got too hot or too cold.

This latest move by Bernanke says that he is clearly ignoring the numbers on the overall economy and is fixated on one industry. That, frankly, is not in his job description, and is exactly the sort of hubris that I believe got Greenspan in trouble at the end of the nineties. If Bernanke continues to fixate on the housing market while continuing to ignore the economy as a whole, our economy WILL get overheated, and we WILL be dealing with out of control inflation. All of it will happen totally unnecessarily.

The Terribly Mixed Record of Alan Greenspan

Up top is a historical graph of Prime Rate for much of the tenure of Alan Greenspan as head of the Federal Reserve. Alan Greenspan is nearly universally revered as a many of genius and strength, and his tenure is nearly universally lauded as a great one for the Federal Reserve.

I worked as both a stock broker and a mortgage broker during two pivotal periods of Federal Reserve action, and I firmly believe that once history is written on his tenure, it will be a lot more mixed than its current perception.

First, there is no question that Greenspan handled the Fed with great flexibility and adaptability and somehow managed to keep the economy moving along at a breathtakingly brisk pace without ever causing the sort of inflation that follows such growth. The nineties were an unbelievable time. When President Clinton got into office, the cell phone and the internet were rarities, and when he left, they were common place. Rarely does technology ever take such a short time to seep into the public consciousness. The television, the radio, and the automobile all took generations before they become commonplace.

This sort of growth of technology and by extension the economic growth that follows is frankly unprecedented. It is not to be understated what a wonderful job Greenspan did in navigating such a hot economy so that the heat never turned against it. By deftly cutting and raising interest rates at just the right time, in just the right amounts, he never let the economy get too hot, and also never let interest rates cool it too much. For this he will forever be lauded.

My problems with his tenure start at the end of Clinton's time in office. By the end of the nineties, internet stocks were frankly out of control. Paper thin companies which barely registered any profits and were deep in red were worth more than well established brick and mortars like Sears, GM, and KMart, as a common place.

There were rumors among so called well placed sources that this was very troubling to the Chairman. It was more troubling than the normal bit of troubling economic date or trend. There were more rumors among more so called high placed sources that this was so troubling that the Chairman felt it was his duty to pop the so called internet bubble. Only the Chairman knows the truth, however this much is true. What he did starting at the end of 1999 and ending in 2001, was in and of itself very troubling, and its motivations are besides the point.

Starting at the end of 1999, when he unexpectedly first starting raising, the so called internet bubble burst. By the end of 2000, roughly three trillion dollars was lost in paper profits in the stock market. No one should argue that the popping of the internet bubble was also the pre cursor of the recession that followed, which officially started in mid 2000. What is very troubling is that in two years, Greenspan first raised rates dramatically and then immediately dropped the very same rate just as dramatically. In other words, whatever problem he thought he was fixing by raising the Prime Rate, he created an equally big problem that he then had to fix by lowering it.

The official explanation for the reasoning behind the initial increase in the Prime Rate was that he feared inflation on the horizon. This maybe so though the numbers at the time didn't seem that frightening. According to this chart, inflation was on the rise though, at least in my opinio, hardly at a level that warranted a rate increase. It matters not at this point. Whatever Greenspan did or didn't see, he rushed to head off inflation and caused a recession.

There are only two explanations for his motives. The first explanation is that he misread the tea leaves and was to aggressive in heading off inflation and caused the opposite, a recession. In that case, he was incompetent. The other more nefarious reason is that inflation worries were just a trojan horse for his real fear, the internet bubble. In that case, he showed unprecedented hubris since popping internet bubbles is not among the many lists of responsibilities of the Federal Reserve Chairman.

Either way, if the Chairman raises rates furiously for over a year and as a result then needs to drop the rates just as furiously, it is safe to say they didn't act appropriately in managing rates.

By the end of 2001, the recession was perpetuated not only by 9/11, but by the plethora of accounting scandals headed up by Enron. Chairman Greenspan continued to lower rates to absolutely no avail all the way deep into 2002. He lowered rates so much that eventually the Federal Funds Rate (three points below prime) dropped below one percent. At that point, he could lower it no longer since it really couldn't go any lower.

As we shake out the current mortgage crisis, I below the ridiculously low Federal Funds rate will wind up being a not so insignificant factor in triggering the mess we are in now. By having this rate at such a ridiculous low level, it was too much of a stimulant for banks not to borrow, and borrow, and borrow, and borrow. At the time, the only sector that was performing was the housing sector, and so a large majority of the borrowed funds wound up in the housing sector, much of which by way of mortgages. That said, the borrowed money didn't have enough of an audience in the traditional mortgage market, and so these banks created new loans that would attract borrowers who traditionally wouldn't qualify. This fed on itself and just as the internet bubble burst so came along the housing bubble, and the rest is history.

Obviously, there was no way that Greenspan could possibly foresee how irresponsibly the banks would lend in the mortgage market, however what he could foresee was the law of unintended consequences. It was simply irresponsible to drive interest rates so low because at those levels there was simply too much money available. He may not have predicted that banks would lend irresponsibly in the mortgage market, but he should have predicted that at those levels the money would be used irresponsibly in some capacity.

So, while we laud Greenspan for the oracle and savior that he was, we should all remember his not so insignificant role in the two most important financial situations of our time as well. For, if we do, we will see that his record is not the shining beacon that some make it out to be.