No, Greenspan, Conditions Are NOT Like 1998

The Wall Street Journal is reporting, “Greenspan Says Turmoil Fits Pattern”:

“Former Federal Reserve Chairman Alan Greenspan said the current market turmoil is in many ways ‘identical’ to that which occurred in 1987 and 1998, when the giant hedge fund Long Term Capital Management nearly collapsed.

“‘The behavior in what we are observing in the last seven weeks is identical in many respects to what we saw in 1998, what we saw in the stock market crash of 1987, I suspect what we saw in the land-boom collapse of 1837 and certainly [the bank panic of] 1907,’ Mr. Greenspan told a group of academic economists in Washington, D.C., [on Sept. 6] at an event organized by the Brookings Papers on Economic Activity, an academic journal…

“Bubbles can’t be defused through incremental adjustments in interest rates, Mr. Greenspan suggested. The Fed doubled interest rates in 1994-1995 and ‘stopped the nascent stock market boom,’ but when stopped, stocks took off again. ‘We tried to do it again in 1997,’ when the Fed raised rates a quarter of a percentage point, and ‘the same phenomenon occurred.’

“‘The human race has never found a way to confront bubbles,’ he said.”

The truth of the matter is the Fed (and, in particular, Greenspan) has embraced every bubble in history, adding fuel to every one of them. Let’s consider the last two bubbles.

The Fed’s Role in the Dot-com Bubble

Acting in misguided fear of a Y2K calamity, the Fed stepped on the gas with unnecessary liquidity, having previously stepped on the gas to bail out Long Term Capital Management in 1998.

And after warning about irrational exuberance in 1996, Greenspan embraced the “productivity miracle” and “dot-com revolution” in 1999. Midsummer 2000, Greenspan believed his own nonsense, and right as the dot-com bubble started to burst, he started to worry about inflation risks. The May 16, 2000, Federal Open Market Committee minutes prove this:

“The members saw substantial risks of rising pressures on labor and other resources and of higher inflation, and they agreed that the tightening action would help bring the growth of aggregate demand into better alignment with the sustainable expansion of aggregate supply. They also noted that even with this additional firming, the risks were still weighted mainly in the direction of rising inflation pressures and that more tightening might be needed…

“Looking ahead, further rapid growth was expected in spending for business equipment and software…Even after today’s tightening action, the members believed the risks would remain tilted toward rising inflation.”

How could Greenspan have possibly been more wrong? Over the next 18 months, CPI dropped from 3.1% to 1.1%, the U.S. went into a recession, and capex spending fell off the cliff.

The Fed’s Role in the Housing Bubble

In 2001, Greenspan went overboard in the other direction, embarking on a campaign that eventually slashed interest rates to 1%, while embracing the miracle of derivatives and encouraging consumers to get into ARMs along the way.

And right as the bubble was bursting, Greenspan dismissed the idea of a national housing bubble.

No National Housing Bubble

Flashback, May 21, 2006: Greenspan says housing prices won’t fall nationally.

History suggests that betting against Greenspan is the correct thing to do. Thus, I mockingly talked about his call on May 27, 2006, in “Greenspan Predicts Housing Bust.”

Confronting Bubbles

As for “confronting bubbles,” the Fed foolishly watches (takes action on) only consumer prices. Thus, the Fed ignores expansion of credit when that credit fuels asset bubbles, as opposed to the prices of consumer goods.

The Fed could easily target credit with higher interest rates if it cared to, but it does not.

This is not a matter of attempting to identify bubbles in advance — this is a matter of attempting to identify credit conditions that create bubbles. And the fact is runaway expansion of credit fuels one or both of two things in some combination: asset bubbles and/or consumer price increases.

Bernanke is equally as bad as Greenspan, if in fact not worse, by supporting positive inflation targets. (See “Inflation Targeting Is Flawed” and “Can the Fed Control Prices?” for more on the silliness of inflation targeting.)

Is It 1987 or 1998?

  • In 1987, we had the Internet revolution to look forward to. Yes, that was a productivity miracle, but it also allowed the Greenspan Fed to open the credit spigots wide open because rapidly increasing productivity is highly disinflationary
  • In 1998, as the Internet boom was starting to peak, there was still one more bubble up the Bubblemeister’s sleeve: the housing bubble
  • In both years, the ability of consumers to take on (and afford) debt was vastly different than it is today
  • In both years, there were numerous new credit products to exploit coming up on the horizon: CDSs, CDOs, SIVs, ABSs, LBOs, conduits, MBSes, “swaptions,” etc., etc., etc. See “Swaptions and Financial Turmoil” for more on swaptions and off-balance sheet conduits at Citigroup, as well as leveraged buyout turmoil at Citigroup, JPMorgan Chase, Lehman, and Bear Stearns
  • Massive junk bond-financed share buybacks, LBOs, and speculation in mergers and swaps, etc. were on the horizon in 1998. Those are now history
  • Credit standards were poised to fall to insanely low levels, but are now swinging back in the other direction. In fact, loose credit standards made a secular low that will not be seen again for decades, if ever
  • Off-balance sheet garbage not marked to market was never as high as it is today
  • Various carry trades fueled all sorts of speculative investments. Those carry trades have yet to be unwound, but they will be. And they are orders of magnitude bigger than anything we saw in either 1987 or 1998
  • The China factor is vastly different today than it was even as late as 1998. The resultant deflation in wages as a result of outsourcing and manufacturing moving to China and service jobs to India is still being felt
  • There is now $300-500 trillion (yes, trillion with a “T”) in derivatives floating around, depending on whom you believe. But even the smaller number is many orders of magnitude greater that either 1987 or 1998.

By suggesting that conditions are “identical” to either 1987 or 1998, Greenspan is one or more of the following:

  • A misguided fool
  • Lying
  • Blinded by his own arrogance
  • Attempting to rewrite history
  • Attempting to lay the blame on Bernanke
  • Some combination of the above.

Whatever it is, Greenspan is above all…wrong. Furthermore, Greenspan has been consistently wrong at every major turn in his entire history as Fed chair. The only thing he has been correct on is his unwavering support for free trade. And on that issue, ironically enough, hardly anyone listens to him.

With that in mind, I have to wonder just what Pimco thinks it can get out of hiring Greenspan as an adviser. All I can figure out is: 1) Pimco is hoping somehow to cash in on Greenspan’s list of contacts, or 2) Pimco is asking for Greenspan’s advice and betting the other way.

September 11, 2007

The Daily Reckoning