Saturday, June 20, 2009

Book Review: The Greenspan Problem

by Calculated Risk on 6/20/2009 11:00:00 AM

CR Note: This is a guest post by Mathew Padilla of the Mortgage Insider blog. All opinions expressed are Matt's.

A book review by Mathew Padilla for Calculated Risk.

Count the following among the most accurate titles ever written: Nasdaq’s Peak was Greenspan’s. The title introduced a 2001 essay by James Grant, author of newsletter Grant’s Interest Rate Observer, in which the author addresses former Fed Chief Alan Greenspan’s approach to the ‘90s stock bubble: “He seeded it, accommodated it, celebrated it and defended it from those who believed they saw it turn into a bubble.”

The essay is an opening salvo against Greenspan to be followed by three other works that eviscerate the Maestro, the Federal Reserve and U.S. monetary policy in Grant’s late 2008 book Mr. Market Miscalculates: The Bubble Years and Beyond, which is a compilation of his essays celebrating the 25th anniversary of his newsletter. (I confess I submitted the review to Calculated Risk this month because I just finished reading the book.)

In the Nasdaq’s Peak essay Grant deconstructs Greenspan’s March 6, 2000 speech before the Boston College Conference on the New Economy. Greenspan praised the “revolution in information technology” including how managers formulated decisions with “real-time” information and that reduced uncertainty, allowing them to better control inventories. Grant delivers one of his many wry lines:

Thanks to clarity afforded by instantaneous communications, Cisco Systems had to write off only $2.25 billion in excess inventories during its third fiscal quarter, in addition to just $1.17 billion in restructuring and other special charges. … Lucent, Corning, Nortel and JDS Uniphase have been devastated by one of the greatest misallocations of investment capital outside the chronicles of the Soviet Gosplan. Who can conceive of the size of this waste had there been no e-mail?
It’s the misallocation of capital that gets at the heart of Grant’s criticism of both Greenspan and the Fed. Grant saw Greenspan as the Chairman of Perpetual Intervention, juicing the money supply 1. When a big hedge fund had a serious hiccup 2 When computers might go bonkers over two-digit dates. 3. After Nasdaq tanked. But the former chief saw no need to raise rates to stem speculative excesses. (Recall the 2001 essay is before the most pernicious bubble of all.) Greenspan practiced a lopsided monetary policy.

Compounding his folly, Greenspan was slow to react to the Nasdaq crash and start lowering rates when boom turned to bust in the second half of 2000, Grant writes, adding: “(B)ecause information technology was an absolute and unqualified good thing, it followed that it could not be held responsible for a bad thing – for instance, the bottom falling out of capital investment and, therefore, out of the GDP growth rate.”

That was Grant annoyed. Grant disgusted comes across in a September 13, 2002 essay, Monetary Regime Change, in which Grant’s prose oozes with repugnance as he picks apart Greenspan’s speech that year at the “monetary jamboree” of the Kansas City Federal Reserve Bank in Jackson Hole, Wyo. “Alan Greenspan washed his hands of responsibility for the bubble he said he could not have pricked even if he had noticed it floating above his desk on a string.” Again we are talking about the tech bubble – a warning that Greenspan was a deeply flawed policymaker. Grant goes on:
Following is a speculation on the outlines of a post-Greenspan monetary system. It is supported by some of the historical works that the chairman can read in the well-deserved retirement he should have taken starting in about 1996. We say “post-Greenspan” because, we believe, the Jackson Hole Speech will raise the odds against his reappointment (his current term expires in 2004), speed the day of his departure and reduce his policy-making influence for a long as he remains in office.
Grant was right about Greenspan not being reappointed, but wrong about his waning influence. In his final years, Greenspan fueled a pernicious explosion in credit, and he provided intellectual cover to politicians either ideologically opposed to regulation or too preoccupied with other matters to get to it. The essayist also was prescient but a little early with this in 2002: “Only one of the troubles with bubbles is that, after they pop, ultra-low interest rates and extraordinary rates of credit expansion lose their stimulative potency. The rate of creation of new yen by the Bank of Japan stands at 26.1% year-over-year, but this outpouring has yielded no appreciable reflationary results.” Grant was exactly right, but after a property bubble, not a stock-market bubble.

Greenspan is the lighting rod, but monetary policy is the storm. Grant writes since the late 19th century to their creators, each monetary system suited the ages. “But none lasted much longer than a generation. The system in place since 1971 is the worldwide paper-dollar system.” Grant takes this idea and runs with it in Mission Creeps, a November 7, 2003 essay that takes stock of the Federal Reserve on the eve of its 90th anniversary. “The Federal Reserve would be unrecognizable to the men who conceived it.” The law creating the Fed defined its purposes as follows, “to provide for the establishment of the Federal Reserve banks, to furnish and elastic currency, to afford means of rediscounting commercial paper and to establish a more effective supervision of banking in the United States, and for other purposes.”

The founders, including Sen. Carter Glass (D.Va.), feared bank runs and their potential to disrupt commerce. They envisioned a central bank that could keep the banking system liquid. But they lived in the era of the gold standard, and never, ever dreamed of an expanding money supply designed to boost employment. Balancing full employment and appropriate inflation came later – the Fed and Congress found uses for the original act’s “and for other purposes.” Grant’s strongest ammunition is fired at the very idea of a central bank’s power to steer an economy, and all the myriad actors in it, by comparing economics to the hard science of physics in 2003:
Both use quantitative methods to build predictive models, but physics deals with matter; economics confronts human beings. And because matter doesn’t talk back or change its mind in the middle of a controlled experiment or buy high with the hope of selling even higher, economists can never match the predictive success of the scientists who wear lab coats. … Gov. Ben S. Bernanke is one of those true believers, as he reiterated last month in a lecture at the London School of Economic. “If all goes as planned,” said Bernanke, getting off on the wrong foot, “the changes in financial asset prices and returns induced by the actions of monetary policymakers lead to changes in economic behavior that the policy was trying to achieve.” If all went according to plan, the LSE would be teaching case studies in the triumphs of the Soviet economy.
In yet another essay, There ought to be Deflation, in January 14, 2005, Grant builds on the idea of a monetary policy as a source of economic distortion. He quotes Friedrich von Hayek, who, while accepting the Nobel price for economics more than 20 years ago, said:
The continuous injection of additional amounts of money at points of the economic system where it creates a temporary demand which must cease when the increase of money stops or slows down, together with the expectation of a continuing rise in prices, draws labor and other resources into employment which can last only so long as the increase of the quantity of money continues at the same rate – or perhaps even only so long as it continues to accelerate at a given rate.
And that is exactly what happened when Greenspan cut rates in the 2000s. Workers flooded into subprime lenders, construction companies, Home Depots, and on and on.

Grant bemoans, in more than one essay, the death of the gold standard. In his view a fixed currency would constrain both the Fed and the federal government. It might even have prevented a war of choice in Iraq, since what cannot be funded cannot be done. But fixed currencies have their disadvantages, writes another Nobel laureate, Paul Krugman, in another book tackling our current woes, his updated The Return of Depression Economics and the Crisis of 2008. A currency that is allowed to fall benefits an economy in recession since its exports become cheaper, Krugman argues. He’s also a proponent of a flexible currency giving a central bank freedom to expand money and combat unemployment.

Curiously, Krugman has a chapter in his book dubbed Greenspan’s Bubbles, but he does not address the Greenspan conundrum: what to do about the risk a Fed chairman will over stimulate asset prices while doing nothing to stop credit abuses. Until that problem is addressed I side with Grant and Hayek – expansionary monetary policy is dangerous.

In all of Mr. Market Miscalculates, I have but one quibble with Grant’s views. He cites the “socialization of risk” as encouraging reckless corporate behavior. The problem began with FDIC insurance and culminated in Greenspan’s interventions, including the orderly dissolution of hedge fund Long Term Capital Management. Grant’s case is that banks are more willing to lend to corporate cowboys if they think government will bail them out, or the market overall.

An alternative view is that FDIC insurance has been a key element among government initiatives that maintained safety and soundness in banking for some 50 years. It wasn’t until President Reagan initiated the anti-regulation era that insured institutions went bonkers – S&Ls binged on junk bonds and commercial real estate. Even now, with all that has happened, consumers are not lining up at insured banks in an all out panic – before FDIC insurance some good banks failed on mere rumors of trouble.

And moral hazard did not fuel the excesses of the era just ended. As an example, noninsured, nonbank New Century Financial secured more than $15 billion in credit lines from bigger banks in housing’s heyday. No one thought the subprime generator was too big to fail. And as soon as it wobbled, New Century found its credit cut off, and it fell into the abyss. This is the real issue with the modern era -- capital flows quickly, at times too quickly, into and out of any venture anywhere in the world.

On the whole, there is much genius in Grant’s observations. And his book covers more than what I touched on here. He gives a modern take on value investing, illuminates Wall Street’s mortgage fantasies, and more. As for a solution to the Greenspan problem, it is not Grant’s style to offer one. He never explicitly says the country should return to the gold standard or hack some appendages off the Federal Reserve. Grant is subtler, and more general. He simply warns us: change is coming.

Mathew Padilla is co-author of Chain of Blame: How Wall Street Caused the Mortgage and Credit Crisis, a USA Today Business Book of the Year, and hosts the Mortgage Insider blog.