September 28, 2006

Bubble Man

Next Monday will mark eight months since Alan Greenspan stepped down as chairman of the Federal Reserve, yet he keeps popping up in the news - twice in the last week.

Last weekend, rumors swirled of his mention of interest rate cuts to help a very troubled housing market, then earlier this week he referred to the Sarbanes-Oxley rules as a "nightmare" that should be quickly undone since they discourage foreign companies from listing their shares on the NYSE (he favored SarBox back in 2002).

Now is as good a time as any to take a look back to see how things have progressed while he's been busy writing his memoirs and pulling down $150,000 for speeches in front of well-heeled audiences.

A Look Back

The good news is that nothing has blown up yet. Well, except for Amaranth Advisors, and a few emerging economy stock markets around the world - the latter seem to be recovering, however, hopes of a rebound for the former must be dimming.

Even if you had many millions to spare, would you still write a check to Amaranth Advisors after the events of the last couple weeks? With 8,999 other hedge funds where you could seek superior returns with a little more risk, why not shop around?

Some say a commodity bubble has burst, though you'll get arguments on that score here - it's hard to have a real bubble with P/Es of 10 and just hedge funds driving prices. To get a real bubble you really need ridiculous valuations driven by much broader public participation.

And housing? That will be Mr. Greenspan's legacy. It must be maddening to be standing far away from the rudder of monetary policy, unable to cut rates to the bone after seeing some of the data coming out of the statistical reporting agencies.

It's too early to tell, but the odds of a soft landing for his last asset bubble do not appear to be improving with each new data release. Now that prices are actually going down nationally, that may put a whole different spin on individual home buying decisions (and home selling decisions too).

This chart from Northern Trust tells the story well.

Tim Geithner of the New York Fed seems a little worried lately - some of it probably involves the chart above. A few weeks ago he wondered if all the risk-mitigation built into the current system of hedge funds and structured finance was deceiving its many participants, allowing risks to build up that will ultimately lead to some unspecified, unhappy ending.

Earlier this week he wondered whether the Federal Reserve may have to extend its supervisory authority to get a better view of all the securities firms and hedge funds out there mitigating all that risk after taking on an ever-larger role in the financial system.

Ahh ... it's easy to long for the days when the Fed Chairman would reassure his detractors with soothing words like, "If there's a crisis, we'll all get together and solve it - or hopefully solve it".

When he marveled at the flexibility of the current financial system, some would ask one simple question, "Why did it take us so long to come up with a self-regulating system of ever increasing credit expansion?"

The Greenspan legacy is now taking shape.

Turn the Page

While the world awaits memoirs from the Maestro, two other books have appeared to help fill the void for those who miss the departed chairman so. Alan Greenspan: The Oracle Behind the Curtain came out immediately after the retirement send-off in February. It doesn't appear to be that popular - at not a single customer has reviewed it in the seven months that it has been for sale, and at $38, the price seems a bit steep.

Of more interest here is the tome that just arrived in the mail yesterday - Bubble Man. While its back has not yet been cracked, a little is known about this work.

Author Peter Hartcher appeared as a guest at Financial Sense Online a few weeks back and had an engaging interview with Jim Puplava. One of the more notable comments by Mr. Hartcher, something that should seem obvious to many yet is overlooked by almost all, "The handmaiden to any financial mania is cheap money - loose money - a relatively free flowing money supply."

It sounds even better with an Australian accent - the interview is still available here.

The reviews of this book over at tell an interesting story about the man and how he is perceived. To this day, there are those who still consider him to be the greatest central banker ever and the finest economist the world has ever seen. Bob Woodward's 2001 offering Maestro has served to cement this image.

This view is exemplified by Daniel W. Drezner of the Washington Post who in an editorial review wrote the following regarding the now famous 1996 "irrational exuberance" moment.

The problem is that Bubble Man assumes that, at the moment Greenspan uttered that sentence, his opinion was both fixed and true. Neither assertion holds up. Hartcher fails to demonstrate that Greenspan ever repeated his comment at any later Fed meeting. The record suggests that Greenspan was worried about asset-price inflation -- that is, skyrocketing stock and housing prices. Furthermore, he was not entirely sure he should be worried about it. As the 1990s progressed, he continually sought out diverse views on this point. The fact that his infamous caution against "irrational exuberance" was framed as a question symbolizes the extent of his uncertainty.

As it turns out, Greenspan was right to be unsure. For all the talk about stock market bubbles, the returns on tech stocks in the decade since 1996 have proven way higher than the historical average. Price-to-earnings ratios are now higher than the historical average, albeit significantly lower than they were at the peak of the dot-com era. When one takes a step back, Hartcher's case falls apart completely. To assert that Greenspan's Fed was the primary regulatory authority responsible for the dot-com bubble requires the reader to swallow an awful lot. For one thing, you need to accept that other government agencies -- say, the Securities and Exchange Commission or the Treasury Department -- should be completely exonerated for their roles in the mishap; for another, you need to accept that the Fed would somehow be able to deflate stock prices without harming the real economy.

Greenspan's response in 2005 to skyrocketing housing values demonstrates another difficulty with Hartcher's broadside. Despite Greenspan's speeches about the "frothiness" of the housing market and the Fed's repeated increases of short-term interest rates, the Fed has had a minimal impact on both housing prices and long-term interest rates. Even if Greenspan had wanted to lower stock prices, it is not clear, in retrospect, that he would have succeeded.

Bubble Man does contain some interesting questions. How can a central bank simultaneously manage inflation in both the goods market and the asset market? How can asset-price inflation be distinguished from a genuine shift in the real value of assets? Unfortunately, Hartcher never digs into these questions. Instead, he seems determined to write a literary retort to Maestro, Bob Woodward's 2000 paean to Greenspan's financial acumen. Every trait that Woodward praises, Hartcher scorns. For example, Woodward paints Greenspan's political network as essential for doing his job; to Hartcher, the chairman's contacts are merely evidence that Greenspan was like every other politician, subject to pressure and eager to be liked.

Diametrically opposed to this view are the thoughts of Justice Litle of The Daily Reckoning notoriety.

The emotional pinnacle of the book is the "irrational exuberance" moment: the point at which Greenspan must decide whether to fulfill his duty as leader and protector, and risk sacrificing all he holds dear, or preserve popularity at the cost of his soul. We know which path he chose. If Hartcher's account were made into a movie it could be an Oliver Stone docu-drama, with all the elements of a Greek tragedy and the conflicted Chairman at center stage.

As Bubble Man demonstrates with great attention to detail, the brilliant Maestro turned out to be a coward. In a job that required backbone above all, Greenspan failed us. (Though we the people, by way of our elected politicians, first failed him.) To make things worse, once the decision to sell out was made, all sense of propriety went out the window. Greenspan expressed bubble concerns as early as 1996, but later denied those concerns completely. Instead of providing sober adult supervision, he cheered Wall Street's madness from 1996 on. Instead of encouraging thoughtful discussion at policy meetings, he neutered debate as much as possible. Instead of trying to maintain political objectivity, he cut implicit deals and grew closer to the White House with each passing year. By electing to go with the flow when he should have been fighting it, this banker's banker wound up a rock star, an economic hero "so square he was cool," and to those Wall Streeters who made millions from his easy money policies, a god.

Greenspan's eventual bitter defense that bubbles cannot be spotted in advance was self-serving, self-contradicting, and something he probably did not believe himself. His successor, Ben Bernanke, has inherited an unbelievable mess--one that is probably too big to be cleaned up. Hartcher's clear-eyed account, and others to follow, will hopefully inform history and help set the record straight on the Bubble Man's true legacy.

Yes, an unbelievable mess to be sure.

In thinking about the many memorable musings of the old guy, the one that comes most easily to mind after taking this little stroll down memory lane came in response to questions about the transition from the stock market bubble to the housing bubble.

When asked whether unleashing the forces of easy money in response to one bubble might set in motion an even bigger one, the response came that the course of action chosen was deemed better than the alternative.

Hairshirts are both unpopular and uncomfortable.

The book awaits, as does the fate of the U.S. economy.