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August 27, 2005

The Greenspan Era: Lessons to be Learned
by Doug Noland

Equities are trading unimpressively. For the week, the Dow dropped 1.5% and the S&P500 fell 1.0%. Economically sensitive issues were on the defensive. The Transports declined 1.4%, and the Morgan Stanley Cyclical index fell 1.5%. The Utilities gained 1.5%, while the Morgan Stanley Consumer index declined 1.2%. The broader market held together better than the major averages. The small cap Russell 2000 dipped 0.6%, and the S&P400 Mid-cap index declined 0.7%. Technology stocks were generally lower. The NASDAQ100 declined 0.9% and the Morgan Stanley Technology index fell 1.2%. The Semiconductors, however, rose 0.4%. The Street.com Internet Index dropped 1.6% and the NASDAQ Telecommunications index dipped 0.7%. Financial stocks lagged. The Broker/Dealers declined 1.6%, and the Banks were hit for 2.5%. Although bullion gained $1.40, the HUI gold index fell almost 3%.

The yield curve is getting quite flat. For the week, two-year Treasury yields rose 5 basis points to 4.06%, and five-year government yields added one basis point to 4.08%. At the same time, ten-year Treasury yields fell 3 basis points for the week, to 4.18%. Long-bond yields also declined 3 basis points, to 4.38%. The spread between 2 and 10-year government yields sank 8 to a mere 12. Benchmark Fannie Mae MBS yields were unchanged, again underperforming the hot 10-year Treasury note. The spread (to 10-year Treasuries) on Fannie's 4 5/8% 2014 note widened 0.5 basis points to 30.5, and the spread on Freddie's 5% 2014 note widened one basis point to 31. The 10-year dollar swap spread declined 0.5 to 44.25. Corporate bond spreads were largely unchanged. Junk bond spreads were also little changed. The implied yield on 3-month December Eurodollars rose 3 basis points to 4.315%, while December '06 Eurodollar yields jumped 4.5 basis points to 4.495%.

Corporate issuance fell to summer doldrums $5.4 billion. This week's investment grade issuers included Wal-Mart $2.5 billion, MBIA $900 million, Sovereign Bancorp $500 million, John Deere $300 million, and Idaho Power $60 million.

Junk bond funds reported inflows of $9 million (from AMG). Junk issuers included National Power Corp $400 million, MGM $375 million, and Station Casinos $150 million.

Convert issuers included WebMD $300 million.

Japanese 10-year JGB yields slipped one basis point this week to 1.40%. Emerging debt markets generally performed well. Brazil's benchmark dollar bond yields declined 2 basis points to 8.03%. Mexican govt. yields fell 5 basis points to 5.38%. Russian 10-year dollar Eurobond yields declined 2 basis points to 6.18%.

Freddie Mac posted 30-year fixed mortgage rates slipped 3 basis points to 5.80%, with a two-week decline of 12 basis points (down 5 bps from one year ago). Fifteen-year fixed mortgage rates fell 5 basis points to 5.35%, a four-week low. One-year adjustable rates dipped 2 basis points to 4.56%, up 51 basis points from the year ago level. The Mortgage Bankers Association Purchase Applications Index dipped 2.2%. Purchase applications were about 11% ahead of the year ago level, with dollar volume up almost 26%. Refi applications added 1.2%. The average new Purchase mortgage was unchanged at $243,000, while the average ARM slipped to $356,200. The percentage of ARMs dipped to 28.1% of total applications.

Broad money supply (M3) surged $33.4 billion to a record $9.812 Trillion (week of August 15). Year-to-date, M3 has expanded at a 5.5% rate, with M3-less Money Funds expanding at a 7.0% pace. M3 has expanded $186.9 billon over the past 13 weeks, or 7.8% annualized. For the week, Currency added $1.6 billion. Demand & Checkable Deposits rose $6.7 billion. Savings Deposits declined $5.0 billion, while Small Denominated Deposits gained $3.6 billion. Retail Money Fund deposits dipped $2.1 billion, and Institutional Money Fund deposits fell $4.7 billion. Large Denominated Deposits surged $28.2 billion, with a y-t-d gain of $175.6 billion (25.6% annualized). For the week, Repurchase Agreements added $0.3 billion, and Eurodollar deposits expanded $5.0 billion.

Bank Credit added $1.4 billion last week. Year-to-date, Bank Credit has expanded $552 billion, or 12.9% annualized. Securities Credit rose $8.1 billion during the week, with a year-to-date gain of $142.3 billion (11.7% ann.). Loans & Leases have expanded at a 13.7% pace so far during 2005, with Commercial & Industrial (C&I) Loans up an annualized 18.6%. For the week, C&I loans gained $7.4 billion, while Real Estate loans declined $4.3 billion. Real Estate loans have expanded at a 15.8% rate during the first 33 weeks of 2005 to $2.80 Trillion. Real Estate loans were up $378 billion, or 15.6%, over the past 52 weeks. For the week, Consumer loans added $1.0 billion, while Securities loans dropped $5.8 billion. Other loans fell $5.0 billion.

Total Commercial Paper dipped $1.6 billion last week to $1.586 Trillion. Total CP has expanded $172.6 billion y-t-d, a rate of 18.7% (up 16.6% over the past 52 weeks). Financial CP slipped $0.9 billion last week to $1.445 Trillion, with a y-t-d gain of $161 billion (19.2% ann.). Non-financial CP declined $0.7 billion to $141.1 billion (up 13.7% ann. y-t-d and 9.0% over 52 wks).

ABS issuance this week slowed to $13 billion (from JPMorgan). Year-to-date issuance of $485 billion is 21% ahead of comparable 2004. Home Equity Loan ABS issuance of $313 billion is 25% above comparable 2004.

Fed Foreign Holdings of Treasury, Agency Debt declined $2.5 billion to $1.466 Trillion for the week ended August 24. "Custody" holdings are up $130 billion y-t-d, or 14.9% annualized (up $188bn, or 14.7%, over 52 weeks). Federal Reserve Credit fell $2.3 billion to $791.4 billion. Fed Credit has expanded 0.2% annualized y-t-d (up $36.2bn, or 4.8%, over 52 weeks).

International reserve assets (excluding gold) - as accumulated by Bloomberg's Alex Tanzi - were up $602 billion, or 18.2%, over the past 12 months to $3.906 Trillion. "Eurosystem" reserve assets declined 1.4% over the past year to $173.8 billion.

Currency Watch:

August 25 - Bloomberg (Christina Soon and Yumi Kuramitsu): "Indonesia's rupiah fell to the lowest level in 3 1/2 years after oil prices surged to a record, adding to concern the government of Southeast Asia's largest economy is losing investors' confidence. President Susilo Bambang Yudhoyono yesterday said he will work with the central bank to curb the slide after the currency had its biggest drop in 15 months."

The dollar index declined 0.75% this week. On the upside, the Brazil real gained 1.9%, the Norwegian krone 1.7%, the Swedish krona 1.5%, the Iceland krona 1.4%, and the Swiss franc 1.3%%. On the downside, the Indonesian rupiah sank 3.8%, the Jamaican dollar 1.0%, the Israeli shekel 0.9%, and the Mexican peso 0.7%.

Commodities Watch:

October crude oil rose 34 cents to $66.13. For the week, the CRB index added 0.6%, increasing y-t-d gains to 11.7%. The Goldman Sachs Commodities index jumped 2.2%, with 2005 gains rising to 40.7%. Sugar rose yesterday to a 7-year high.

August 26 - Financial Times (Haig Simonian): "Before reaching for that chocolate bar for comfort from the prospect of ever higher oil prices, spare a thought for the ingredients. The price of many commodities used by leading confectionery and snacks groups, such as Nestle, Kraft and PepsiCo, have been soaring through an unusual mixture of poor harvests and politics. Almonds, particularly popular in US snacks and confectioneries, have more than doubled in price to $8,400 a tonne in the past two years. Cocoa beans have soared from £600 a tonne to £1,647. But nothing matches the humble hazelnut. 'I visit growers many times each year. But in all my career I've never seen anything like what's happened to hazelnuts,' says Rosanno Barbieri, a buyer for Nestle, the world's biggest foods group. Prices have risen more than fivefold from about $2,150 a tonne two years ago to a peak of $11,120 earlier this year... 'Nobody expected this. Prices were already at a record level because of a bad harvest in 2003,' says Peter Etter, a trader at Barry Callebaut, the world's biggest chocolate maker.'"

China Watch:

August 22 - XFN: "China's industrial firms' profits rose 20.6% to 743.7 bln yuan in the first seven months, the National Bureau of Statistics said...That compares with an increase of 19.1% in the first six months of this year and 39.7% for the same period last year."

August 26 - Bloomberg (Yanping Li): "The Chinese government's revenue rose 15 percent year on year to 1.94 trillion yuan ($239 billion) in the first seven months of this year, state-run Xinhua News Agency reported. Expenditures increased by 15 percent during the same period..."

August 25 - Bloomberg (Koh Chin Ling): "China's cost of importing crude oil in July rose 61 percent to $4.2 billion... The country spent $25.8 billion on oil imports in the first seven months, 45 percent more than a year earlier... China's oil imports in July rose 15 percent to 11.1 million metric tons..."

August 24 - Merrill Lynch Research: "Hong Kong is headed for a multi-year trend of accelerating inflation, in our view. We expect inflation to hit 6.5% by end-2007. The main reason: rising factor costs (rent and wages), as well as a long-run depreciation of the Hong Kong dollar..."

August 26 - Bloomberg (Philip Lagerkranser): "Hong Kong's exports reached a record in July as the city's sea and air ports shipped more Chinese-made toys, computers and clothing abroad. Overseas sales increased 8.1 percent from a year earlier to $25.5 billion..."

August 22 - Bloomberg (Joshua Fellman): "Hong Kong's real estate transactions will probably jump to 140,000 this year, the most since 1997 when about 180,000 units changed hands, the Standard said..."

Asia Boom Watch:

August 22 - Bloomberg (Theresa Tang): "Taiwan's unemployment rate fell to a four-year low in July as expansion by companies including Taiwan Semiconductor Manufacturing Corp. created jobs. The seasonally adjusted jobless rate fell to 4.15 percent..."

August 25 - Bloomberg (James Peng): "Taiwan's money supply grew in July at the fastest pace this year as foreign funds bought more local assets, the central bank... M2, the broadest measure of the island's money supply, rose 6.5 percent from a year earlier after increasing 6.3 percent in June..."

August 25 - Bloomberg (Stephanie Phang): "Malaysia's economy grew in the second quarter at its slowest pace in more than three years as factories cut production of semiconductors and building materials. Southeast Asia's third-largest economy grew 4.1 percent in the three months ended June, compared with a revised 5.8 percent expansion in the first quarter..."

Unbalanced Global Economy Watch:

August 23 - Bloomberg (Lindsay Whipp): "Japan's services industries expanded in June, as consumers spent more on Internet services and in shops, suggesting the world's second-biggest economy may sustain a recovery from last year's recession. The tertiary index, a gauge of demand for services that make up about 60 percent of the economy, increased 1 percent from a month earlier..."

August 26 - Bloomberg (Simone Meier): "Money supply growth in the dozen countries sharing the euro unexpectedly gained at the fastest pace since October 2003 in July, increasing pressure on the European Central Bank to raise borrowing costs from a six-decade low. M3, the ECB's measure of money supply, accelerated to a 7.9 percent increase from a year earlier after a revised 7.6 percent expansion in June..."

August 23 - Bloomberg (Matthew Brockett): "Germany's domestic economy expanded in the second quarter for the first time in nine months as company investment rose, adding to signs that growth may accelerate in the second half. Domestic demand, which combines consumer, government and corporate spending, rose 0.3 percent from the first quarter..."

August 24 - Bloomberg (Brian Swint and Matthew Brockett): "Import prices in Germany, Europe's largest economy, rose at the fastest pace in more than four years in July as oil prices surged. Import prices rose 4.7 percent from a year earlier, the fastest rate since January 2001..."

August 25 - Bloomberg (Victoria Batchelor): "Australian construction work completed in the second quarter unexpectedly increased, driven by the largest gain in commercial building work in eight years. Construction work done in the three months ended June 30 rose 4 percent from the previous quarter, the largest gain since the fourth quarter of 2003..."

Latin America Watch:

August 25 - Bloomberg (Patrick Harrington): "Mexican retail sales rose at a faster pace in June than in the previous month... Retail sales increased 6 percent from the year-earlier period after rising 3.7 percent in May..."

August 23 - Bloomberg (Matthew Walter): "Chile, the world's biggest copper producer, said economic growth picked up in the second quarter as the country benefited from record prices for the metal. Chile's gross domestic product grew 6.5 percent, after expanding a revised 6.1 percent in the first quarter..."

August 23 - Bloomberg (Alex Emery): "Peru's July exports rose to a record of $1.49 billion, spurred by U.S. and Chinese purchases of copper, gold and fishmeal. Exports rose 32.5 percent..."

Bubble Economy Watch:

August 23 - Bloomberg (Danny King): "U.S. retail sales for the back-to-school season may increase as much as 18 percent from a year earlier to $34 billion as students buy more denim items and electronic goods, the New York Times reported. "

August 22 - The Asian Wall Street Journal (Christine Haughney): "Australian pension funds are snapping up U.S. commercial real estate, adding heat to a steamy market. In the past 12 months, Australians have purchased $6.8 billion of American office buildings, shopping centers and other commercial properties, according to Real Capital Analytics. During that period, Australians accounted for 37% of the international capital that poured into U.S. real estate, the New York research firm says."

California Bubble Watch:

From the California Association of Realtors: "July's increase in the median price of a home followed the trend we've experienced for most of this year. Mortgage interest rates remain lower than a year ago and the inventory of homes for sale has improved slightly compared to the historic lows of 2004. Both the national and state economies are doing better than a year ago, and household incomes are improving. These are all contributing to the continued strength of the housing market in California."

California Median Home Prices slipped slightly from June's record to $540,900. Median Prices were up 17.1% ($79,140) from one year ago, with an 18-month gain of 42% ($158,960). Median Prices are up 68% ($219,000) over three years and 145% ($320,370) in six years. California Condo Prices rose $1,000 during July to a record $426,320. Condo Prices have jumped 41% ($123,260) in 18 months, 71% ($177,430) over three years, and 152% ($257,150) over six years.

Mortgage Finance Bubble Watch:

Total July Home Sales were up 7.9% from July 2004 to an 8.57 million annualized pace, second only to June's record 8.674 million level. Annualized Calculated Transaction Value (CTV) was up 16.3% from July 2004. Year-to-date Total Home Sales are running 6.6% ahead of last year's record pace. July New Home Sales were up 28% from one year ago to a stronger-than-expected and record 1.41 million annualized pace. Average (mean) prices, however, dipped 1.5% from the year ago level to $275,000. Existing Home Sales were up 4.7% from one year ago to a robust 7.16 million annualized pace. Average Prices (mean) were up 9.5% to a record $266,100. Average Existing Home Prices were up 20% over two years, 28% over three years, and 55% over six years. The inventory of unsold Existing Homes was up 6.8% over the past year to 2.35 million, while the inventory of New Homes jumped 15% to 460,000.

August 23 - Florida Association of Realtors: "The frenzied pace of existing home sales in Florida eased in July, while the statewide median sales price rose 33 percent to $252,300.... A year ago, the statewide median price was $190,300; in July 2000, the statewide median price was $119,600... A total of 21,669 existing single-family homes changed hands...declining 8 percent compared to 23,646 homes sold in July 2004."

August 25 - The Wall Street Journal (Christine Haughney): "The growing popularity of interest-only loans has already raised eyebrows in the residential market -- it is seen as a sign that buyers may be stretching themselves too thin to purchase homes they otherwise couldn't afford. Now, an increasing number of commercial real-estate buyers are following that lead, using interest-only loans to snap up far-larger properties, from skyscrapers to shopping centers. According to a recent report from ratings agency Moody's...65% of the U.S. commercial loans that it rated in the second quarter were interest-only for part or all of the loan's term."

August 25 - The Wall Street Journal (Ruth Simon, James R. Hagerty and James T. Areddy): "Strong demand for mortgage-backed securities from investors world-wide is allowing American lenders to make more loans -- and riskier ones -- in a way that is helping prolong the boom in U.S. house prices. The cash pouring in -- not only from U.S. investors but increasingly from Europe and Asia -- keeps stoking the housing market even as the [Fed] continues to raise interest rates, normally something that damps home prices. The market has shown a few signs of slowing recently, and talk of a bubble has grown louder, but prices continue to rise or remain at lofty levels as investors continue to gobble up mortgage-backed securities and banks keep lending. 'As the Fed has tightened, lenders have eased' terms for borrowers, says Mark Zandi, chief economist at Economy.com..."

August 25 - New York Times (David Leonhardt): "Rents are rising again across the country, squeezing tenants who are already coping with high gasoline prices and improving returns to landlords after a deep five-year slump. The turnaround appears to be another sign that the boom in house prices and sales is finally slowing, as homes have become so expensive in many metropolitan areas that some people have decided to rent instead. ...Rents have clearly changed direction, even if the increases have been relatively small. With the economy growing and mortgage rates inching up, more people are looking to rent apartments and homes rather than buy them. At the same time, many buildings are being turned into condominiums, reducing the supply of rental property."

The Greenspan Era: Lessons to be Learned in the Future:

This weekend's global central banker powwow at Jackson Hole sets off what will surely be at least five months of Greenspan - "the greatest central banker of all-time" - pomp and adulation. I will anxiously await the public release of this weekend's papers from "The Greenspan Era: Lessons Learned." They will be worth storing away for later reflection. His legacy has already become favored pundit subject matter, although I find much of the commentary misplaced.

No discussion of Greenspan's possible legacy will stand the test of time without addressing the momentous financial sector developments nurtured under his watch. Ultimately, I expect that he will be judged most by the success or failure of the Financial Sphere he cultivated, sustained and endorsed. Curiously, I have yet to read or listen to any comments regarding the unprecedented buildup of debt under The Greenspan Regime. He has operated for too long as undisputed Master and Commander of what has evolved into today's massive and unwieldy global pool of speculative finance. Disconcertingly, his impending exit will coincide with increasingly vulnerable U.S. Mortgage Finance and Credit Bubbles.

Under Mr. Greenspan's watch, Total US Credit Market Debt (TCMD) ballooned from (using year-end 1986) $9.8 Trillion to $37.3 Trillion (380%). As a percentage of GDP, TCMD expanded from 220% to 318%. Rest of World (ROW) holdings of US Financial Assets increased from $1.18 Trillion to $9.72 Trillion, or 826%. ROW holdings of US Credit Instruments increased 900% to $4.88 Trillion, including holdings of GSE securities which grew from $22 billion to $826 billion.

During Chairman Greenspan's tenure, Commercial Bank Assets expanded 332% to $8.713 Trillion, including a 624% increase in Mortgages. The Bank Asset "Security Credit" expanded 475% to $216 billion. The Liability "Fed Funds/Repo" increased 500% to $1.023 Trillion, while Deposits expanded 270% to $5.14 Trillion. Over this period, M3 Money supply inflated 280%. When it comes to Greenspan's legacy, one must note that Total Mortgage Debt expanded 404% to $10.774 Trillion, with Home Mortgage borrowings up 480% to $8.282 Trillion.

No group has so luxuriated in Mr. Greenspan's leadership than Wall Street. Security Broker/Dealer Assets have increased more than ten-fold, from $185 billion to $1.941 Trillion. Broker/Dealer holdings of Credit Market Instruments jumped from $66 billion to $443 billion (670%). On the Liability side, Security Repos ballooned from $36 billion to $623 billion. Security Credit jumped from $84 billion to $777 billion.

Almost walking distance from the Marriner S. Eccles Federal Reserve Board Building, Fannie and Freddie perpetrated one of history's greatest Credit expansions. On Greenspan's watch, GSE Assets ballooned 830%, from $346 billion to $2.872 Trillion. Agency MBS (some included in GSE assets) surged 670% to $3.55 Trillion. Outstanding ABS exploded from $75 billion to today's more than $2.70 Trillion (and counting!). I saw no indication that Greenspan had any problem with the GSEs when they operated as marketplace liquidity backstops in 1994, 1998, 1999, 2000, 2001 and 2002, emboldening the blossoming speculator community in the process. Allowing GSE debt and MBS liabilities to surpass $6 Trillion is at or near the top of a list of serious blunders unbefitting of a lionized chief central banker.

When attempting today to gauge his legacy, it is fundamental to appreciate that there was a momentous transformation of finance, at home and then abroad, under Greenspan's prolonged reign. Not since Benjamin Strong (in the 1920s) has one man's ideas, brilliance, personality, and personalization of policy had such a profound impact on the nature of financial (and, thus, economic) activities. It is no exaggeration to state that Alan Greenspan is the father of "contemporary Wall Street finance," having nurtured and accommodated a marketable securities-based Credit system from its infancy some 18 years ago. The loan officer, banking system, and borrowing for business investment were supplanted as the prominent creators of finance by a New Paradigm securities, "structured finance", and asset-based financial apparatus. At the same time, Fed open-market operations and bank reserve requirements were relinquished as purveyors of system liquidity. The benign bank loan was cast out as an anachronism, replaced by myriad "sophisticated" securities, instruments, derivative contracts, and leveraged speculation. The US securities markets evolved into The Global Fountainhead of Liquidity Overabundance.

The Greenspan Federal Reserve's move to transparently pegging short-term interest-rates - slashing them aggressively to mollify heightened systemic stress, while invoking market-pleasing gradualism when moderating accommodation - played a profound role in mitigating the risk of leveraged speculation. The upshot was an energized Credit system with a powerful expansionary (inflationary) bias, as well as a financial system and economy relatively easily stimulated by rate cuts and public assurances. The downside of such a haphazard policy "regime" is that at some point along the way it becomes virtually impossible to face the consequences of taking away the punchbowl.

In today's Jackson Hole speech, Mr. Greenspan stated, "The Federal Reserve System was created in 1913 to counter the recurrent credit stringencies that had so frequently been experienced in earlier decades." From my reading of history, recurring Credit-induced booms and busts were the impetus for the creation of a U.S. central bank. The Fed was created specifically to undertake the regulation of Credit, most importantly acting against the propensity for unchecked finance to propagate speculative Bubbles and their inevitable agonizing busts. It was not until later, under New York Fed President Strong, that a more activist approach to countering "stringencies" and sustaining prosperity was deemed operative.

Many are today comparing Mr. Greenspan to the legendary central banker William McChesney Martin. Well, I have read much about Mr. Martin, his distinguished career, his statesmanship, and his unassailable integrity. I feel as if I have come to know him - Bill Martin is a friend of mine. Mr. Greenspan is no McChesney Martin. The essence of Chairman Martin - exemplifying the worthy tradition of central bankers generally - is one of conservatism (in the monetary sense) and caution. Mr. Martin was a straight-talker and sincere public servant and statesman. He erred on the side of prudence and stability.

Truth be told, Mr. Greenspan is a monetary policy radical. He presided over the greatest expansion of speculative finance in history, including a Trillion dollar hedge fund community, bloated Wall Street firm balance sheets approaching $2 Trillion, a $3.3 Trillion repo market, and a global derivatives market surpassing an unfathomable $220 Trillion. During the late-nineties, when leveraged speculation was heavily infiltrating the financial system, he became the leading proponent of the "New Economy." He became a powerful advocate of derivatives and Wall Street finance, all the time avoiding any discussion of the impact these new financial instruments and practices were having on Credit growth, marketplace risk perceptions, speculation, asset prices and the underlying structure of the economy.

Greenspan has stood idly as our Current Account Deficit has ballooned to almost $800 billion annually, with foreign central banks accumulating several Trillion dollars of claims on our economy. He watches as crude approaches $70. And now he warns us against the scourge of "protectionism," an inevitable response to the gross global imbalances his activist inflationary policies have fostered. He ignored the most reckless of mortgage lending Bubbles, and now warns us that prices and wealth/income ratios may not be sustainable. Worse yet, he is arguably guilty of committing the ultimate in central banker derelictions by targeting household mortgage borrowings as the primary mechanism for his post-technology Bubble "reflationary" policies (policy error begetting ugly error). The "greatest central banker" incited history's greatest real estate borrowing and speculating Bubble, a legacy our financial system and economy will have to live with for decades.

There is today a joyous consensus view that Greenspan's policy of not preempting asset Bubbles as they inflate - but rather being well-prepared for acting aggressively when they burst - is pure policymaker genius. Well, bull markets do fashion abundant "genius." Let there be no doubt, however, that the inevitable housing bear/bust will expose the grievous policy flaw of mitigating one Bubble by inciting an only larger one. Greenspan's use of the leveraged speculating community as a policy tool was also a grave mistake. There will come a day of policy reckoning.

I earlier today watched former Fed Vice-Chair Alan Blinder on Bloomberg television responding to a question in Jackson Hole: "Has Greenspan been lucky or good?" Dr. Blinder, answering reasonably, stated that while Greenspan has enjoyed his fair share of luck, it is too much to Credit good fortune for 18 years of success. Good enough. But I do believe strongly that the secret to Mr. Greenspan's "success" has been the Financial Sphere's capacity for uninterrupted (and previously unimaginable) Credit expansion. While our Fed chairman avoids the important issues related to Credit growth and excess, not for a moment does he take his eye off the ball. Greenspan can Credit the economy's flexibility and resiliency, but the reality of the situation is that our Fed Chairman has relished in his capacity over 18 years to sustain both Credit expansion and speculative excess. I believe this extraordinary power has much more to do with the epic "Wall Street finance" Credit boom than it does with adept policymaking.

In so many ways, Chairman Greenspan's legacy is conjoined with Wall Street Finance. Does "structured finance" work over the long-term, or are a Trillion dollar hedge fund community, $3 Trillion of ABSs, upwards of $6 Trillion of GSE exposure, and $220 Trillion of derivatives the residual of the type of crazy Credit Bubbles that have occurred every once in awhile throughout financial history? Will derivative hedging and dynamic trading strategies function as expected during the inevitable bouts of financial stress, dislocation, deleveraging and panic? And what is the prognosis after a doubling of mortgage debt in seven years, with all the attendant financial excesses and economic distortions?

The Achilles heel of such a highly leveraged, speculative and liquidity-dependent Credit system is the necessity for uninterrupted liquidity and "continuous" market trading/pricing. Mr. Greenspan provided both positive assurances and the marketplace liquidity backdrop. In a system that creates increasingly untenable systemic risk that is amassed by highly leveraged speculators, it was Greenspan the convincing salesmen that could extol the virtues of "unbundling" and transferring risk to "those most able to manage it." But can they? Ironically, it is his cleverly crafted "risk management" policy approach - not surprisingly, given significant billing in today's speech - that many view as the culmination of his years of accomplished policymaking.

"Given our inevitably incomplete knowledge about key structural aspects of an ever-changing economy and the sometimes asymmetric costs or benefits of particular outcomes, the paradigm on which we have settled has come to involve, at its core, crucial elements of risk management. In this approach, a central bank needs to consider not only the most likely future path for the economy but also the distribution of possible outcomes about that path. The decision makers then need to reach a judgment about the probabilities, costs, and benefits of various possible outcomes under alternative choices for policy."

The eventual failure of such ostensibly sound policy doctrine is dictated by Credit and speculative dynamics. In The Age of Securities-based Credit Systems, when Bubbles become pronounced - significantly impacting financial stability and economic vulnerability - policymakers will naturally view the cost of a bursting as unacceptably high (Dr. Bernanke going so far as to ridicule the "Bubble poppers"). Policy mistakes will tend to elicit additional compounding errors, and there will be over time a tendency to condone excess and pander to the powerful securities trading community. There is, then, in discretionary "risk management-based" decisionmaking, a dangerous propensity to act in a manner that nurtures catastrophic Bubbles. Or, in a metaphor Mr. Greenspan was known to employ back in the 1960s when he discussed causes of the Great Depression, there is a strong predilection for the Fed to repeatedly place "Coins in the Fuse-box." It is his incomparable aptitude - as the Master of Where, When and how Aggressively to Place the Coins - that is most deserving of his legacy.

And, in regard to Lessons to be Learned, at the top of the list is the necessity for strict term limits for the Fed Chairmanship. It is a disservice on many levels when one individual so completely dominates policy and public discourse, especially over a lengthy period. This is especially true for Fed Chairmen that - in "good times" - lack sufficient oversight and effective checks and balances. Then, when boom turns bust we will be faced with the dilemma of politicians meddling in monetary management.

When it comes to asset Bubbles, it is incumbent upon the Federal Reserve to endeavor to identify them early and have effective tools to temper Credit and speculative excess as early in the boom process as possible. The Fed's first mandate must be to maintain financial stability over the short, intermediate and long-term. Such a mandate cannot escape the challenging task of monitoring excesses and implementing disciplinary measures to repress behavior at odds with long-term system stability.

I suggest that the most important Lesson to be Learned from the Greenspan Era is the necessity for the Federal Reserve to regulate Credit, both liquidity extended throughout the real economy as well as leveraging within the financial sector. There is today no appreciation that an Unfettered Financial Sphere is incompatible with effectively functioning pricing mechanisms throughout the Economic Sphere. Additionally, Asset inflation, Current Account Deficits, and over-liquefied speculative markets should be recognized as primary contemporary indications of loose monetary conditions (minimal "core-CPI" notwithstanding). Policymakers must also take a cautious approach to financial innovation, certainly including major changes in the nature of financial institutions and intermediation, instruments, market processes and practices.

Mr. Greenspan is heralded for his early identification of changes in the real economy (the so-called productivity boom) that he and others presumed afforded the Fed ample slack to accommodate accelerated growth. Yet profound Financial Sphere developments - and with them greater marketplace liquidity, Credit Availability and attendant speculative proclivities - beckoned for restraint. The Greenspan legacy should rest upon his failure to effectively manage financial innovation, along with his weakness and incapacity for ever taking away the punchbowl. He has left many things, including his replacement, in most unenviable positions.

Doug Noland
The Credit Bubble Bulletin
PrudentBear.com

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