The single cause of all financial busts is excess credit and financial leverage, a crucial policy variable that falls under the responsibility of the central bank. Mr. Greenspan chooses to ignore this fact, as does Mr. Bernanke.
From this week’s Barrons:
Regrets? The Maestro Has None
By RANDALL W. FORSYTH
The former Federal Reserve chairman admits that he didn’t see the financial crisis coming.
Being Fed chairman apparently means never having to say you’re sorry.
In his media rounds plugging his new book, The Map and the Territory, former Federal Reserve chief Alan Greenspan admitted last week that he didn’t see the crisis of 2007-08 coming, but he refused to apologize for that. “I missed certain forecasts,” he admitted on Bloomberg TV. “You don’t apologize for that,” he said, adding that he isn’t omniscient and is a mere human being.
“To apologize for not being Superman, I refuse to do that, because that never entered my mind,” said the erstwhile maestro, who was awarded an honorary knighthood in the United Kingdom for putatively being the greatest central banker of all time.
So why did things go so wrong, leading to the worst financial and economic meltdown since the Great Depression? Greenspan traces this to what he admits was a misplaced faith that banks and financial institutions would be better stewards of their own capital and act as self-regulators in a largely deregulated world.
But, in perhaps the most revelatory interview—with Jon Stewart on Comedy Central’s Daily Show—he confessed that, nonetheless, on Wall Street people sometimes “do screwy things.” “You just learned this?” Stewart replied in mock amazement to the ex-Fed boss, 87.
The bouts of screwiness would wash out over time, and rational self-interest would protect institutions over the long run, Greenspan explained. It wasn’t the fault of deregulation, which he championed, along with Lawrence Summers (which probably contributed to the opposition to the latter becoming the new Fed chairman).
The problem began, Greenspan asserted, when investment firms were allowed to become corporations in 1970, after always having been partnerships on Wall Street. In the old days, the partners’ entire personal fortunes were on the line if their firm went bust. In a corporation, their exposure was limited to their stake in the firm. And in boom times, they wanted to take their bonus money and run, rather than having it tied up with their employer’s fortunes. [Blog Note: so what matters here is who bears the risk of the banks’ actions. It still falls to taxpayers.]
The solution is for banks to be better capitalized, Greenspan contended, adding even more capital than they have been forced to raise in the wake of a crisis in order to have fortress balance sheets that can withstand future hits. And, by implication, never need bailouts from taxpayers.
Had there not been so much leverage in the financial system, he argued, the damage to the economy from the 2007-08 crisis wouldn’t have been so severe. The October 1987 and the 2000 dot-com crashes had limited impact on gross domestic product, Greenspan noted. The difference this time was all of the debt that had been accumulated, the effects of which were magnified when asset prices went bust.
What was missing in these discussions was the role of the Fed in this, specifically what came to be popularly known as “the Greenspan put.” A put option offers the holder the right to sell an asset at a preset price. In other words, it’s a form of insurance.
In those crashes cited by the former Fed chief, the central bank provided insurance to investors in risky assets, such as stocks, through massive liquidity infusions, first after the 1987 crash and later following the failure of giant hedge fund Long-Term Capital Management in September 1998. After the dot-com bust, the Fed also eased aggressively, bringing short-term interest rates down to then-record lows.
Disasters were averted, which in turn boosted confidence that the Fed always had the backs of investors and speculators. And so the Fed’s 1987 easing eventually was followed by bubbles in commercial real estate and junk-bond-fueled leveraged buyouts. In reaction to the mild recession that followed, the Greenspan Fed took short-term interest rates down to levels not seen in generations: 3%. After the 1998 LTCM debacle, the Fed eased again, inflating the Internet bubble. And when that burst, the central bank took rates to still lower lows, 1% this time.
And when the Federal Reserve did begin to lift rates last decade, it did so in quarter-point baby steps. (That probably was a reaction to the market dislocations in 1994, when the Fed boosted rates in fairly short order, resulting in a crash in mortgage-backed securities, the bankruptcy of Orange County, Calif., and the Mexican peso crisis of that year.) With lots of money looking for yield in a superlow-rate environment in the middle of the past decade, the mother of all bubbles was inflated in housing and mortgage-related derivatives. And we know how that turned out.
Rather than an inadequacy of capital, the recent crisis was a result of complacency or hubris (take your pick), which arguably resulted from the exercise of the Greenspan put and, later, the Bernanke put. Until the near-meltdown of 2008, each market drop was met with a flood of liquidity that inflated the next bubble, until that one burst, which brought on the fresh infusion of cash. In other words, lather, rinse, repeat.
Greenspan has always contended that bubbles could only be identified in retrospect, which is consistent with the shibboleths of efficient-market theorists—such as Eugene Fama, one of the co-winners of this year’s Nobel Prize in economics—who contend that assets are always correctly priced by rational market players. So, better to let them inflate and burst, and deal with the aftermath later.
Another joint winner of this year’s Nobel in economics, Robert Shiller, argues the opposite, notably in his popular book Irrational Exuberance, whose title was taken from one of Greenspan’s most famous turns of phrase. Because people can do screwy things, as the former Fed chief observed, markets can get out of whack, Shiller says. Eventually, they correct, whether in the case of kooky dot-com stocks or McMansions.
Did the Greenspan put contribute to the screwy behavior that produced ever-larger bubbles and busts, figuring in the latest crisis? I didn’t hear the question asked, or an answer proffered.
THIS ISN’T JUST A matter of revisionist history. With the Fed continuing to pump liquidity into the financial system at a $1 trillion annual rate, signs of asset inflation (if not bubbles) are increasing. At least the regulators are taking note.
Last week, the Fed proposed rules to require big banks to have sufficient liquid assets to meet 30 days of expenses in order to deal with the 21st century equivalent of a bank run, last seen in 2008. The requirement, scheduled to take effect in 2017, would be a reversion to old-time banking—before banks would routinely fund themselves in the money market cheaply on a daily basis. That works until there’s a crisis, as after the Lehman failure in 2008. Having a piggy bank of low-yielding liquid assets is a drag on bank earnings but may insure ready buyers of Treasury securities to finance the federal deficit.
At the same time, regulators are recommending banks tighten standards for risky corporate loans, Bloomberg News reported. The Fed and the comptroller of the currency sent letters to some of the biggest banks to avoid making loans that regulators could deem as prone to a loss, loans that have reached levels not seen since the crisis, according to people knowledgeable about the matter.
The same is evident in the capital markets, where the kind of wild and wacky debt seen before the crisis is making a comeback. The Financial Times last week noted the revival of “payment-in-kind toggle” bonds, which let borrowers pay interest in more debt if they can’t come up with the cash. Which shows the lengths to which investors are going to generate yield.
That’s extending into the stock market, where the Standard & Poor’s 500 set another record last week, along with the S&P Mid-Cap 400 and the small-cap Russell 2000. In addition, the Nasdaq Composite moved closer to 4000, a 13-year high, but still 1,000 points light of the bubblicious peak of 5048 in early 2000, lifted by the continually rising tide of Fed liquidity.
The Federal Open Market Committee meets this week and is unlikely to taper its $85 billion-a-month in bond purchases, especially given the lousy September employment data delayed until last week (see Economic Beat, page 54).
March 2014 now looks like the earliest time for a cut in the central bank’s largess. Until then, there should be ample liquidity to fund all manner of screwy stuff.
Hang on for the ride!