The Perfect Fed Setup and Greenspan's Agony

By Dr. Duru written for One-Twenty

April 28, 2008

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Ben Bernanke has been called upon to rescue America's buckling financial system time and again these past many months. Several times, the media (OK, CNBC) have determined that Bernanke and the Fed faced its most important rate decision ever. I have heard no such hyperbole leading into this coming Wednesday's decision, but I think this decision deserves just as much, if not more, attention. The Fed has the perfect setup now. The stock market seems resolved to make a bottom and begin pricing in an economic recovery in support of the Fed's wavering projection of a wonderful second half bounce in GDP. The dollar looks ready to put in some kind of bottom and rally on expectations the Fed is finished cutting rates. With some luck, a stronger dollar could break the back of commodity inflation and answer the Fed's prayers that inflation expectations remain well contained (I am not betting on that one). Financial institutions are diluting their shareholders - sometimes being rewarded with inflated stock prices but always finding bidders with extra cash to spare. Almost "no one" thinks the continued descent of the housing industry can pull the economy down any further. And a multitude of earnings reports have demonstrated that the global economy continues to cooperate by buying the products of America's multi-national corporations. All the Fed has to do is "not mess up," and the party can really get started. It is almost as if the market has finally decided to work with the Fed and provide it a free pass...and that makes this latest decision seem easy. But we should not let that lull us into undervaluing the importance of this next decision. It will mark a turning point in Fed policy. If the Fed somehow suggests that what they have been doing is still not working and yet they will stop and wait to see what unfolds before taking further action, a lot of applecarts might get overturned.

But just what does the market want? CNBC reported that "late on Friday, rate futures showed a 76 percent chance of a cut, but an almost one-in-four chance the Fed would hold steady. They also suggest rates will end the year back at 2.25 percent." There is uncertainty at the edges, but near certainty that the Fed's rate-cutting cycle is coming to an end. So, the Fed's setup now is to just make sure to talk roses about the prospects of a recovery given all the liquidity measures that have been put in place to date. Maybe the Fed needs to deliver one more quarter-point cut just to make sure disappointed debt addicts do not cause momentary panic that the Fed has suddenly gotten behind the curve again.

Bernanke's management of this latest financial crisis has finally started to win him accolades. This is an amazing turn-around for a guy who seemed to cause market sell-offs every time he spoke last year. There are folks already prepared to crown Bernanke's legacy as Fed chairman as greater than that of the legendary Alan Greenspan's. But if there is anything we have learned from financial crisis to crisis is that many Fed actions expose us to the next financial crisis. I still suspect that the inflation genie is creeping out of its bottle. Nations from Australia to China to Vietnam to Qatar to Saudi Arabia to the Eurozone are now struggling with inflation - in some cases inflation rates are the highest in 10 to 20 years (see links). As we become surrounded by global inflation, something tells me that an economic recovery in America will NOT be anti-inflationary. Perhaps all that is missing for the next inflation domino to fall is for the consumer to demand higher wage increases now that the credit cards are tapped out and the home equity ATM has run dry.

So, as long as the market continues to rally and enough people pretend that inflation in America is dead, Bernanke will be proclaimed the hero who saved modern capitalism. But as Greenspan has painfully learned, judgment comes harshest from the hindsight of current results and NOT from the quality of the decision based on the information and choices at hand. Whenever the next financial crisis unfolds from today's massive liquidity injections, Bernanke could quickly find himself in history's doghouse. Just look at how Greenspan recedes in agony, dogged by public doubts about his legacy. Once proclaimed as the best central banker ever by over-enthusiastic cheerleaders, he has lately found himself on the defensive, trying to deflect blame for the current housing bubble and the related credit crunch.

Ever since Greenspan fortuitously retired at the peak of the madness that was the housing bubble, he has been laboring to secure his legacy. Recently, the silly debate about whether he is either the greatest or the worst central banker ever in the history of the universe has heated up big-time - at least in the media. The media has fervently reported that folks are now questioning Greenspan's job as the Fed chairman. Now that the housing and credit bubbles have burst and the economy has turned sour, folks are dragging out Greenspan as the scapegoat. The crux of the neatly packaged argument is that he lowered interest rates too low after the tech bubble burst and then took too long to raise them again once the economy stabilized. But anyone who has been paying attention knows that Greenspan has had plenty of critics, especially in the last 10-12 years. Even I have done some anti-Fed whining and complaining. There is absolutely nothing new in the criticism that we are hearing in the press these days. People complained about Greenspan's" irrational exuberance" remarks in 1996. It made him seem out of touch with the New Economy: everything was supposed to be different now. People did not like the Fed's swift move to provide liquidity in the face of the collapse of Long-Term Capital management. There was moral hazard in backstopping failed risk-taking. There were plenty of folks who did not appreciate Greenspan when he finally embraced the technology bubble and the "New Economy." By that time, the tech bubble was hitting the peak of its madness, and Greenspan looked like a cheerleader urging on the recklessness. He even looked like a quarterback taking credit for the paper riches. Heck, folks have even blamed Greenspan for creating the crash of 1987 as the rookie Fed chairman held interest rates too high when markets were vulnerable. The Fed of course proceeded to lower rates after the crash. Etc, etc, etc...

Through all the trials, tribulations, and celebrations, Greenspan's central defense is that the Fed does the best it can at forecasting with the information it has available. On April 8, 2008, Greenspan agreed to an interview on CNBC to publicly defend himself: Greenspan Fights Back, Pt. 1 and Greenspan Fights Back, Pt. 2. This was released in conjunction with a WSJ interview printed the same day: "His Legacy Tarnished, Greenspan Goes on Defensive." In the CNBC interview, Greenspan argues that Fed actions were rational and "professionally done." If the Fed could forecast with 60% accuracy, it would be doing very well. Greenspan leans on a fundamental tenet of decision analysis: you do not judge the quality of a decision by the result but by the information and processes available at the time of the decision. When the future is unknown, the resolution of that uncertainty can unfold in many different ways. But it can only unfold in one way. Even if you believe there is a 99% chance of one outcome, you can still be "unlucky" enough to experience the 1% outcome and be as clever as can be with the analysis. And in most economic scenarios, you will never get the exact same set of circumstances to retest the cause and effect of the system you are dealing with. You never really get to discover the actual probability distribution; economists get to debate it until the end of time. All of this logical mumbo jumbo is of little comfort to the people who suffer from the "unlucky" outcome...and thus, Greenspan's agony.

But Greenspan goes beyond calling himself unlucky. Greenspan more directly blames the highly combustive combination of greed and irrational human nature for our economic problems. For example, in his CNBC interview, Greenspan explains that we ended up with a liquid system driven by the euphoria that there was no limit to anything. The problem only occurred once sub-prime mortgages were securitized and hedge funds and institutions realized that they had a great opportunity to chase higher yields. Their greed put pressure onto lenders to push this bad paper, presumably despite their better (rational) judgment. Since these were the most sophisticated people in the world making terrible mistakes, regulators were somehow effectively rendered powerless to stop the madness.

In another example from Greenspan, on March 16, 2008, The Financial Times published commentary from Greenspan titled "We will never have a model of perfect risk."
  1. Greenspan tells us that the greed compels us to participate in bubbles for fear that we will otherwise get left behind and miss out on the easy money: "One difficult problem is that much of the dubious financial-market behaviour that chronically emerges during the expansion phase is the result not of ignorance of badly underpriced risk, but of the concern that unless firms participate in a current euphoria, they will irretrievably lose market share."
  2. Next, Greenspan also tells us that we simply do not learn from our mistakes. Our greed essentially dooms us to repeat our bubble-chasing addictions over and over again: "But these models do not fully capture what I believe has been, to date, only a peripheral addendum to business-cycle and financial modelling the innate human responses that result in swings between euphoria and fear that repeat themselves generation after generation with little evidence of a learning curve." (emphasis mine)
  3. Finally, Greenspan makes it clear that neither he nor the Federal Reserve in general can break this negative feedback loop of greed leading to bubble after bubble: "But if, as I strongly suspect, periods of euphoria are very difficult to suppress as they build, they will not collapse until the speculative fever breaks on its own."
So, given all this inevitably, Greenspan asks us not to blame the Fed for bubbles and busts. But it is exactly because these forces of greed and euphoria can be so strong and so irresistible that the Fed must take special care in providing the kindling for the fire. It is as if you gave matches to your child playing house in the living room and then told the insurance company not to blame you for the house burning down. To that argument, Greenspan tells us that it was a global savings glut, not the Fed's massive injection of liquidity, that generated housing bubbles all over the globe. In "His Legacy Tarnished" Greenspan repeats that the blame rests with a global savings glut: "Savers were competing to make loans, keeping long-term interest rates low in many countries and fueling housing demand." But in the same article Greenspan admits he used low interest rates to start a housing boom that would goad consumers into spending: "...Mr. Greenspan expected his policy to boost housing because the rest of the economy was relatively unresponsive to lower interest rates. Based on decades of his own research, he believed a buoyant housing market would spur consumers to borrow against home values and spend more. This would not produce a housing bubble, he predicted, because it was difficult to speculate in homes and the memory of the 2000 tech-stock bust remained fresh." In other words, Greenspan provided kindling expecting the kiddies to light cozy blazes in the fireplace and not to burn the entire house down. He took a risk, and it failed (in aggregate). Should he be blamed for the result? Perhaps not. After all, Greenspan persists to this day in his claims that "no sensible policy...could have prevented the housing bubble." But we should blame him for taking such a high stakes chance, especially in the face of this purported savings glut that stood ready to overwhelm his plan stimulate the economy "just enough." (In previous missives, I chronicled Greenspan's slow acknowledgement that a housing bubble might even exist: "There is No Housing Bubble Unless There Is One" and "The Fed As Foe.") There has also been plenty of reasonable disagreement over whether the risk of deflation from 2000-2002 was really has high as Greenspan claims.

Since Bernanke is a well-studied academic, I am sure he is taking great interest in the current attempts to deconstruct Greenspan. He should note most the 20/20 hindsight of the economists who now turn their backs on Greenspan after everything has unraveled. This latest economic crisis has compelled Bernanke's Fed to choose growth stimulus over inflation risk. Bernanke will be heralded as long as he is "lucky enough" to avert inflationary disaster. I for one think his luck will run out sooner than we all would like.

Be careful out there...!

DR. DURU®, 2008