Re-thinking Alan Greenspan

Alan Greenspan, like the US dollar, was for a long time believed to be almighty. But CFCÆs chief strategist argues his actions and inactions have had huge implications for the global financial system, some very negative.

The Fed Chairman has made several critical miscalculations and missteps since 1999 that have exacerbated, if not actually triggered, many of the woes the United States and global economy are currently experiencing.

Not that fiscal policy has helped, but the Fed's lack of coordination and inappropriate actions have buffeted the US economy to the precipice of depression. One could argue that many of the mistakes attributed to Chairman Greenspan are not within the purview of the Federal Reserve or the banking industry. However, unlike his unceremonious predecessors, Chairman Greenspan by the virtue of a nearly deified public persona - he has shaped public opinion and affected public policy on a myriad economic issues.

If he is going to keep interest rates artificially low for an extended time, Greenspan needs to tighten bank lending standards for consumer loans, especially home loans, where he has now created a second bubble.

It's time to replace the irrational reverence granted to Chairman Greenspan with sober objectivity and examine the fragility of the world economy and vulnerability of the US dollar. History teaches us that the Federal Reserve and monetary policy can either be the market's very best friend or its most perverse enemy.

Indeed, since the 1970s, the Fed has intentionally caused at least one major bear recession and bear market, and inadvertently helped trigger several others - including the present one.

On the other hand, the Fed has miraculously ridden to the market's rescue in numerous other crisis, most notably the 1987 "Black Monday" stock market crash, the 1997-1998 Asian Crisis and most recently (but less successfully) the terrorist attacks of September 11, 2001.

For these and any other reason, virtually every trader pro follows the adage; "Don't fight the Fed." Analyzing monetary policy and the Fed's recent actions provide clues about how the market will trade in the months to come.

Despite its good intentions, the Fed doesn't always get the "soft landing" it seeks. Indeed, over the last four decades, the Fed's polices have been just as likely to plunge the economy into a deep recession, or bring about high inflation and a horrific bear market as to "fine tune" us out of a precarious economic situation.

One major concern for the markets in the wake of a the terrorist attacks and the possible war with Iraq, coupled with President Bush's highly expansionary fiscal policy may be perceived by the Fed as highly inflationary. As a result, the Fed may delay much needed polices that might lift us out of the recession and buoy the markets.

However, if the Fed doesn't exercise restraint on President Bush, there is the risk that a massive double dose of expansionary fiscal and monetary policy will indeed lead to a horrific bout of inflation - and an ongoing bear market.

Alan Greenspan has learned to how to pump enormous amounts of liquidity into the markets on very short notice. Greenspan did this in the aftermath of the 1987 October "Black Monday" stock market crash, and this action is generally regarded as the single greatest factor in preventing a total market collapse at that time. In similar fashion, Greenspan stepped in with a huge injection of liquidity during the 1997-98 Asian financial crisis, an action that stimulated a quicker market recovery.

Most recently in the aftermath of the terrorist attacks of September 11, Greenspan flooded the US banking system with more than $80 billion of liquidity. At the same time, Greenspan engineered a $50 billion currency swap with the European Central Bank to provide dollars for European commercial banks that ran low on dollars in the wake of the attacks. While these actions did not stop the downward slide of global markets, they did perhaps stave off a much less orderly wave of panic selling and market collapse.

Despite these achievements at the helm of the Fed, Alan Greenspan's reign should be reconsidered.

Granted, Greenspan did warn US equity prices were overvalued with his now famous "irrational exuberance" comment in 1996. However, this single cautionary comment was a raindrop in a sea of testimony regarding the productivity-increasing technology revolution. Furthermore, he repeatedly claimed that the "business cycle" is dead and that productivity increase translated into higher corporate profits and in turn, justified higher stock prices.

However, Bureau of Economic Analysis reports reveal that US corporate profits peaked in 1997 and fell steadily into 2002, even as productivity continued to increase. By comparison, through out the 1960s gains in productivity outpaced those of the 1990s without comment from the central banker at the time. Nor did such gains eliminate the economic cycle or increase the equilibrium prices for equities. Eventually, recognizing the largest stock bubble in history, Greenspan raised interest rates to the highest real rate (the difference between Federal Funds rate and the rate of inflation) in 50 years, effectively killing an entire economy instead of just the stock market.

As if to prove the US did not learn much from the Japanese economic bubble and banking crisis of the 1980s, in the midst of the 1990s US stock market bubble Chairman Greenspan advocated the repeal of Glass Steagall, the law that erected a wall between investment banking and commercial banking. In effect, the law kept commercial banks from doing business in the stock market. The repeal of Glass-Steagall further exacerbated the stock bubble, caused a misallocation of capital resources and helped erode the objectivity of stock analysts.

It is axiomatic that large institutional banks are the cornerstone of a healthy economy; they act as gatekeepers for the efficient allocation of capital. Commercial banking (which is based primarily on profiting from the differential between the interest paid for capital and the interest received on loans) is a long-term, low-margin business, whereas investment banking is a high margin, quick profit venture.

Consequently, commercial banking requires much more rigorous financial scrutiny than investment banking. However, during the Greenspan years, conflicts abounded. Commercial banks that held large corporate debt could coerce investment banking revenue. Paradoxically, institutions would undermine their own long-term credit worthiness because of their desire for investment banking revenue, a condition that was aggravated by an environment in which they were judged by the stock market on short-term (quarterly) profits.

Despite his recent apology during Congressional testimony for his past opposition to the reform and regulation of accounting practices, Chairman Greenspan called for "unfettered" use of over the counter derivatives and reliance on "counter party surveillance", even at the cost of transparency.

As he said: "Regulation is not only unnecessary in these markets, it is potentially damaging, because regulation presupposes disclosure, and forced disclosure of proprietary information can undercut innovations in financial markets."

The same argument led Greenspan to call for the repeal of the Security Acts of 1933 and 1934 and a return to the financial gunslinger days of the 1920s. This is exactly what occurred in the 1990s when firms like Enron, WorldCom, to mention but a few, circumvented lumbering accounting and banking regulations through the use of increasingly sophisticated financial derivatives.

Currently, this laissez-faire approach jeopardizes the banking system. According to the US Office of the Comptroller of the Currency, major US investment banks are said to have more than $20 trillion (greater than the combined GDP of the US and European Union) of customized and other derivatives on its books. Every major derivatives exchange has position limits to avoid market manipulation and liquidity meltdowns. By dismissing the need for regulation in the over-the-counter derivatives market, Chairman Greenspan abdicates one of the primary responsibilities of the central banker: the oversight of the risk undertaken by the financial community.

Additional accounting woes stemmed from the confluence of burgeoning consulting practices among accounting firms and their metamorphosis from partnerships to LLCs (Limited Liability Corporations). As partnerships, senior accountants were faced with the prospect of forfeiting their personal assets if their corporate scrutiny was substandard. As LLCs, however, virtually no penalty exists if an accounting firm or its partners perform shoddy or unethical work. (A less draconian solution would be something similar to the loan-loss reserve system of a bank.) Additionally, profits from consulting outgrew those of auditing, which skewed the priorities of accounting firms like Arthur Andersen and undermined their integrity.

As the incentive for accounting integrity was eliminated, firms exploited the inadequacy of accounting rules. Without accurate accounting, transparency - a key investment tenet - became a meaningless buzzword. Through the use of derivatives, modern finance and accounting can convert liabilities into assets on a balance sheet and create fictitious income, as the Enron debacle and similar frauds have made clear.

The basis spread between corporate bonds and US Treasuries are now wider than at any time since the Great Depression.

Now to fix the problem he caused - the death of capital expenditures - Alan Greenspan is creating a credit bubble that will end badly for banks and consumers.

Because of the Fed's previous miscalculations, a 1.25% Fed Funds rate can be justified. However, Greenspan is once again using a blunt object to make a fine point. Every medicine has its side effects and contradictions. If he is going to keep interest rates artificially low for an extended period of time he needs to tighten bank lending standards for consumer loans, especially home loans where he has now created a second bubble. In the second half of 2002, the average American homebuyer has made a 7% down payment and is putting 40% of household income toward mortgage payments. This is unsustainable and will end just as badly or even worse than the tech bubble did.

Instead of starting several of his recent speeches asserting that there is no US housing bubble (to avoid rattling American consumers), Greenspan should have addressed bank lending standards to home buyers. "While the stock market turnover is more than 100% annually, the turnover of home ownership is less than 10% annually - scarcely tinder for speculative conflagration," Chairman Greenspan has said.

The housing bubble is not merely a consequence of transference of home ownership, but a consequence of refinancing. Refinancing is essentially trading one's home with oneself, whereby the homeowner leverages up his or her asset and creates a higher cost basis.

Equally important, Alan Greenspan should discuss the flood of money into CMOs) Collateralized Mortgage Obligations, as investors seek higher returns because of low Treasury yields. As a result, the American consumer has become doubly exposed to the symbiotic spiral of a housing bubble. The ratio of housing prices to average earnings is the highest in recorded US history, and the average amount of home equity is at an all-time low. The percentage of household income necessary to service debt is near all-time highs - and held down, ironically, only by the low interest rates themselves.

A small increase in interest rates or depreciation of the US dollar could cause catastrophic consequences.

Granted, one of the intended consequences of lower rates is to spur demand, since lower interest rates reduce the burden of existing debt through lower payments. However, a concerted effort should have been made to prudently ration the issuance of debt.

Nevertheless, burdening the consumer with a mountain of debt to temporarily boost demand is not a long-term solution to a business sector problem. Instead Chairman Greenspan should testify on Capital Hill to promote the only viable solution to the prevailing economic problem: tax incentives and credits for capital expenditures.

Admittedly, this is a fiscal policy, where leadership is equally adrift. Alan Greenspan has served the as Federal Reserve Chairman for approximately 15 years. Following a single perspective for too long magnifies its flaws. Given the position of Federal Reserve Chairman is arguably one of the most powerful positions in the world of finance, it seems prudent to limit the term of the Fed Chairman to eight years, or two terms.