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“Alan, you're it. Goddammit, it's up to you. This whole thing is on your shoulders."
E. Gerald Corrigan, president of the New York Federal Reserve Bank, speaking with Greenspan on the telephone following the 1987 Stock Market Crash. Maestro: Greenspan's Fed and the American Boom.
With the impact of fiscal and monetary stimulus schemes expected to diminish in the latter half of 2004, and the Fed expected to raise interest rates if the jobs situation improves, the investor can not help but consider a couple of fantastic interrelated fears. First and foremost, the so called ‘housing bubble’ could blow up when, and if, the Fed raises interest rates. Second, and of equal or greater concern, the US consumer could be forced to curtail spending if jobs/wage growth does not soon arrive and/or once Bush’s tax refunds are spent. Suffice it to say, and like a drum in the distance, we have been repeatedly warned that these two pillars of the US economy are about to collapse. The drums, ever nearing, threaten to soon reach a climax.
Notwithstanding how crucial consumer spending/rising asset prices are to the US economy, what is often overlooked is that the Fed’s zero bound interest rate policy – while clearly helping fuel GDP growth - may be unsuited to deal with the next unexpected financial crisis. To be sure, with rate cuts nearly exhausted, the monetary sorcerers’ grab bag contains fewer magic wands today than at any time during Greenspan’s tenure. As such, you cannot help but wonder what role the Fed – credited for pulling more than one rabbit out of its in recent years - will play when the next unexpected financial crisis arrives.
As Stephen Roach aptly states, “ammunition is to be used in bad times and then replenished in good times.” Because the Fed is unable to replenish ammunition as the US economy and financial markets recover strongly does this mean that the Fed led attack against deflation – an attack orchestrated by cutting interest rates and buying US Treasuries* - has failed?
* Perhaps it is a stretch to argue that the Fed has been active in the Treasury market. However, the seed for this speculation was planted by Fed Bernanke in late 2002 -- or before the Fed decided to cut interest rates again, and before the Fed began to continuously jawbone long-term interest rates lower (in 2003 and early 2004). In short, that the Fed has been actively suppressing US interest rates is ‘almost certainly’ a valid speculation.
“A broad-based tax cut, for example, accommodated by a program of open-market purchases to alleviate any tendency for interest rates to increase, would almost certainly be an effective stimulant to consumption and hence to prices.” Bernanke. Deflation: Making Sure "It" Doesn't Happen Here
It goes without saying that as the Fed aggressively attacked the threat of deflation this has aided the soaring price of assets. After all, lower interest rates equate to lower mortgage rates (stronger housing market), and investors have long acted on the adage ‘don’t fight the Fed’. With this in mind, the contradiction, at least to those that care to see it, is clear: when using up ammunition to stave off price deflation the Fed has been promoting (some would say ignoring) asset inflation.
Suffice it to say, unless the loose monetary stance at the Fed soon changes – Roach recommends the Fed ‘raise the federal funds rate immediately to 3%’ – the next financial crisis may not be as easily purged as those in recent memories. Rather, the next financial crisis might lead to a crisis at the central bank, and the rewriting of the legend that is Greenspan.
The Next Crisis
One of the most basic fears today is that another Long-Term Capital Management type crisis is about to erupt. This type of crisis, or one that threatens to dry up financial market liquidity and cascade insolvency/panic among many derivatives players, would not come as a surprise to the Fed. Rather, Greenspan has previously warned of the dangers associated with the ‘concentration of risk’ in the OTC derivatives market. Moreover, Greenspan has acknowledged that ‘there undoubtedly will be further risk-management failures.”1
Despite his fears of another LTCM type blow up, Mr. Greenspan has remained sanguine. Indeed, Greenspan – even as the notional value of the OTC derivatives market has skyrocketed from $70 trillion in 1998 to nearly $170 trillion in 2003 - claims that no oversight of the OTC market is needed. Rather, and as if 6-years of history can be trusted, Greenspan hopes that the blow ups will be contained: “those [risk-management] challenges are manageable and thus far have generally been managed quite well.”
Surprisingly, Greenspan does not feel the same way about GSEs. Rather, growth in GSE debt already has Greenspan worried: “To fend off possible future systemic difficulties, which we assess as likely if GSE expansion continues unabated, preventive actions are required sooner rather than later”.
Another potential crisis is seen in the US dollar. Although a slumping dollar is largely regarded as positive today, it is worth remembering that a falling dollar was one of the reasons why the Crash of 1987 was made possible. To be sure, with the Fed opting not to support the dollar and former Treasury Secretary James A. Baker III appearing on television threatening to devalue the dollar, the financial markets crashed on October 19, 1987 (the Dow dropped by 22%).
With government deficits becoming increasingly ominous and a ‘weak dollar’ policy now silently being adopted by US policy makers, parallels to 1987 can certainly be made. However, with foreign central banks playing an ever important role in supporting the dollar, the argument could be made that there is no parallel to 1987: the outlook for the dollar today is considerably more treacherous.
How will the Fed stop the next crisis?
Even though another LTCM or chaotic US dollar sell off would be bad news, recent history has shown that the Fed can quickly deal with these two problems. In the case of LTCM, the New York Fed helped orchestrate a bailout by arguing to LTCM’s derivatives counterparties that it was mutual beneficial to bail the firm out. In the case of the stock market crash of 1987, Greenspan, two months on the job, crafted one concise sentence. Until he uttered ‘irrational exuberance’ in 1996 this sentence – primarily because of the rebound in the markets the next day – was the most famous Greenspan headliner.
“The Federal Reserve, consistent with its responsibilities as the nation's central bank, affirmed today its readiness to serve as a source of liquidity to support the economic and financial system."
Would another Greenspan statement quell investor fears today given that the Fed does not have the ability to concurrently push interest rates significantly lower? Would anything but higher US interest rates keep a violent sell off in the US dollar from becoming a crisis? Will the derivatives counterparties of the next LTCM eat what could be considerably higher losses to ensure that the financial markets remain liquid?
Although the questions are many, the realization is that it will be difficult for the Fed to handle the next LTCM/dollar/stock market crisis in the same manner as those before. Rather, the stakes today are higher, and the Fed’s ammo belt - while perceptively larger (investors have more faith in Greenspan today than they did 16-years ago) - is factually smaller.
Conclusion
Greenspan’s accomplishments since 1987 have been recognized world-wide as heroic. However, a select few – Roach, Fleck, Russell, Faber, etc. – make the legitimate claim that Greenspan’s policies are reckless. The reckless theory goes that by cutting interest rates at any hint of economic/financial trouble this has led to one thing: a zero bound interest rate policy which might not be able to effectively contain the next financial crisis.
Sir Alan – whose ‘heroics’ won him a Knighthood – would disagree with his critics. Indeed, Mr. Greenspan would argue that the Fed cannot be held responsible for the proliferation of asset bubbles. However, despite claiming ‘its not my fault’ when dancing around the issue of stock market and housing market bubbles, what Greenspan is more than willing to take credit for is his containment skills.
It remains to be seen if skill has anything to do with it. Rather, so long as ammo is not being replenished and the stakes for the next financial crisis continue to rise, the next crisis threatens to become more damaging than any before.
Those authoring the final chapter of Greenspan can only hope that Alan does not retire in June (as some have speculated). Rather, it would be a shame if Greenspan - known for his spectacular bailouts and various forms of plunge protection – leaves before the most challenging bailout attempted since the Fed was formed comes to pass. Quite frankly, this next bailout could be of the central bank itself….After all, Greenspan can cut, print, and buy any financial instrument he wants, but he might have a serious problem when he tries to sell higher interest rates to investors, home owners, consumers, etc. The good times seen in the US economy and stock market over the last year mean bad times ahead for the Fed if ammo can not be replenished.
1. What the Fed has failed to do, even after LTCM nearly caused a systemic meltdown, is try to better manage/regulate risk. Rather, Greenspan has taken a hands off approach, arguing that “Regulatory risk measurement schemes are simpler and much less accurate than banks' risk measurement models”, and “…the success [of OTC derivatives] to date clearly could not have been achieved were it not for counterparties’ substantial freedom from regulatory constraints on the terms of OTC contracts.”
BWillett@fallstreet.com
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