by Ollie Curme, Wellesley, MA

Image Source: Geostrategischen Idiotikon

Alan Greenspan was nominated as Chairman of the Federal Reserve Board on August 11, 1987. Two months later, his mettle was tested in the biggest stock market crash ever. Dr. Greenspan flooded the markets with money and the stock market quickly recovered. Dr. Greenspan learned his lesson and has been flooding the markets with money ever since. But Dr. Greenspan has announced that he does not intend to serve past the end of his current term which ends on January 31, 2006. In this article we pay tribute to the man who gave meaning to the term “irrational exuberance” and we speculate on the economic legacy he will leave behind.

Dr. Greenspan’s famous “irrational exuberance” speech of December 5, 1996 is an interesting read. He bemoans the difficulty of the Fed, which is armed with limited tools to affect short term interest rates and the money supply in its goal of “maximum employment, sustainable economic growth, and price stability.” Despite these limited tools, his speeches bore great weight. His “irrational exuberance” comment seemed quite innocuous at the time but the stock markets promptly plunged. All Dr. Greenspan said was:

“Clearly, sustained low inflation implies less uncertainty about the future, and lower risk premiums imply higher prices of stocks and other earning assets. We can see that in the inverse relationship exhibited by price/earnings ratios and the rate of inflation in the past. But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade? And how do we factor that assessment into monetary policy? We as central bankers need not be concerned if a collapsing financial asset bubble does not threaten to impair the real economy, its production, jobs, and price stability. Indeed, the sharp stock market break of 1987 had few negative consequences for the economy. But we should not underestimate or become complacent about the complexity of the interactions of asset markets and the economy. Thus, evaluating shifts in balance sheets generally, and in asset prices particularly, must be an integral part of the development of monetary policy.”

It’s hard to see how a simple comment like that could provoke a major market selloff, but this was early in Internet days and some people were worried that the Internet mania of that time was turning into a bubble. There was a lot of soul searching at the time and by May 1997 the NASDAQ had dropped from 1400 to 1200. Not to worry, the Fed expanded the money supply, and the NASDAQ took off and never looked back (at least until March 2000).

Should we send the Thank You cards to Dr. Greenspan’s house?
To what extent was Dr. Greenspan responsible for the tech bubble of the late 1990’s? The Fed can directly affect short term interest rates by changing the Federal Funds rate. The Fed can also influence money supply by issuing money (by purchasing T-bonds or T-bills and issuing cash). But the biggest way the Fed influences monetary policy is by making speeches and having the markets interpret which way interest rates are going. As Dr. Greenspan said above, his goals are maximum employment, sustainable economic growth and price stability, with a big concern about inflation and asset bubbles. A former Federal Reserve Chairman, William McChesney Martin, once described the role of the institution that he led in the 1950’s and early 1960’s as taking away the punch bowl when the party was really getting going. In other words, faced with an overheating economy or a speculative investment bubble, the Fed should warn the financial markets, and maybe even raise interest rates or tighten the money supply to prevent inflation or a speculative bubble from getting out of hand. Clearly, Dr. Greenspan had that opportunity in late 1996. Thank goodness that Dr. Greenspan was in power and not Mr. Martin, otherwise we might not have all gotten rich during the tech bubble.

The following graph shows growth in the broadest measure of the money supply (M3) versus the growth in the nominal GDP (including inflation) during Greenspan’s term. According to conventional economic theory, if the money supply grows much faster than the economy grows, inflation is likely to break out, which is contrary to the Fed’s goal of stable prices. Paul Volker, Dr. Greenspan’s predecessor, focused the Fed almost exclusively on controlling the money supply and in doing so, broke the back of significant inflation which had taken hold in the US economy in the 1970’s as a result of the deficit spending during the Vietnam War. As can be seen below, Dr. Greenspan began his term as Fed Chairman with a tight money approach, but by the mid 1990’s he forswore monetary growth targets as a tool for managing the economy. In the aforementioned 1996 speech he said, “Unfortunately, money supply trends veered off path several years ago as a useful summary of the overall economy.”

Source: Bureau of Economic Analysis and Federal Reserve

Where’s the inflation?
Given the huge growth in the money supply why didn’t the US experience inflation? Inflation is typically measured by the Consumer Price Index, which measures the price of a basket of typical household purchases. During the past decade, CPI increases have been very tame. Why?

Source: US Department of Labor

Two reasons. One is that the government changes the market basket of goods that make up the CPI from time to time. Some would say that this is done in bad faith, to remove items whose price is escalating. But more importantly, the biggest reason CPI prices didn’t take off in the last half of the 1990’s was globalization. With the onslaught of cheap goods from China sold in Walmart, consumer prices moderated significantly. But that doesn’t mean that there was no inflation! All that money had to go somewhere, and many argue that it went into the Tech Bubble. From all outward appearances, Alan Greenspan spotted the bubble brewing back in 1996, but instead of taking away the punchbowl, he added more vodka until the bubble blew in 2000. We high tech venture capitalists will be forever indebted to Dr. Greenspan for his aggressive monetary approach, which resulted in our tech bubble riches. In fact, among rich cognoscenti, Dr. Greenspan is known by his affectionate sobriquet, Bartender Greenspan.

Were he mad?
Why would a Fed Chairman let the money supply more than double during his reign?

Source: PrudentBear.com

Several reasons. There was a succession of financial crises during the last half of the 1990’s, any of which could have significantly derailed the markets. Dr. Greenspan’s stature achieved mythic proportion as he navigated each crisis by applying a liberal dose of credit to the markets.

Mexican Peso Crisis of 1995
Asian Currency Crisis of 1997
Long Term Capital Management Rescue of 1998
Russian Debt Default of 1998

And, last but not least, the Crisis that Wasn’t: Y2K!

The following graph shows the Fed Funds Rate, which is the interest rate that the Fed sets for overnight loans to banks.

Source: MSN and Federal Reserve

Bouncing from Bubble to Bubble
When Y2K proved to be a non-event, Dr. Greenspan decided it was time to call a halt to all this easy money. He ratcheted up the Fed Funds Rate from 4.76% in 2Q 1999 to 6.53% in 2Q 2000. However, that unleashed Dr. Greenspan’s largest crisis to date: the bursting of the tech bubble and plunge in the stock market, which triggered a recession in the US economy by March of 2001. This was quickly followed by 9/11, and Dr. Greenspan took the Federal Funds rate into a steep dive, bottoming out below 1% in 3Q 2002. That, together with President Bush’s tax cuts, technically ended the recession in only eight months. But there was one funny thing about that recession. It was the only recession since WWII where the money supply did not contract. The 2001 to 2003 period coupled continued money supply acceleration with the lowest Fed Funds rates since 1958. The good news was that all this fiscal stimulus got the economy growing again. The bad news was that the speculative party didn’t stop; it just moved from the tech sector to hedge fund interest rate arbitrage and from there to housing.

The Carry Trade
For a long time I was puzzled as to why long rates followed short rates down to historic lows over the past few years. In the summer of 2003, when the Fed Funds rate fell below 1% (a negative interest rate after taking inflation into account), the 20 year government bond rate got down to 4.34%. The financial press at the time was full of talk about deflation, primarily because low cost goods were flooding into the US from China. However, the more likely explanation was that long rates were artificially distorted by a huge demand, which swamped the limited supply of long term governments. Much of the demand comes from the Carry Trade, where speculators borrow at low short term rates and invest in much higher long term rates in order to lock in the spread as profit. The carry trade is played by hedge funds, which lever up their positions many fold, as well as commercial banks in the US, and Japanese savers, for whom 4% interest rates are huge compared to Japan’s 10 year government bonds which yield only 1.25%. Dr. Greenspan started aggressively ratcheting up the Fed Funds rate a year ago, and has taken short rates from 1% to 2.75% but the 20 year government rates have actually dropped over the past year, from 5.16% to 4.89%. This perverse market behavior is due to the fact that Dr. Greenspan has carefully telegraphed his intentions, so as not to upset the market. Since there is virtually no risk that short rates will jump more than 0.25% per Fed meeting, the carry trade speculators can continue their speculation with little risk that unexpected rate jumps could spoil their trade. At some point, as the yield curve flattens, carry trade speculators may decide that there is too much risk and unwind their positions. That could cause long rates to jump, with interesting effects.

Double Bubble, Toil and Trouble. Hope this Housing Bubble don’t wobble.
Long term investments are evaluated by discounting cash flows with a long term interest rate. Since long rates have been artificially distorted by the Carry Trade, it has led to distorted capital investment decisions throughout the American economy. The biggest distortion has been in the housing market, where a bubble of gargantuan proportions has taken hold.

Source: PrudentBear.com

In many coastal markets, most notably California and Florida, housing prices have more than doubled over the past ten years. In these markets, it is clear that housing prices have greatly exceeded their “inherent value” because the after tax cost of housing greatly exceeds rental costs in that area. Houses are being bought by speculators who are counting on the price rises continuing. But of course, the housing prices won’t rise if long term rates, and thus mortgage rates, rise. It’s not just the speculators who are getting in trouble. The entire population is up to its eyeballs in mortgage debt:

And it’s not just the amount of debt that’s worrisome, it’s the type of debt. As an article in the LA Times reported:

“In 2001, as the current housing boom got underway, fewer than 2% of California homes were bought with interest-only loans, according to an analysis done for The Times by LoanPerformance, a San Francisco mortgage research firm.

By last year, the level had risen to 48%. Nationally, LoanPerformance says, interest-only loans were used in about a third of all purchases.”

Homebuyers are also loading up on Adjustible Rate Mortgages. Approximately one third of mortgage applications are for ARMs. In a speech given in February, Dr. Greenspan exhorted homeowners to save money on mortagages by using ARMs instead of conventional fixed rate mortgages. This advice is inexplicable, given Dr. Greenspan’s statement last November 19 that: "Rising interest rates have been advertised for so long and in so many places that anyone who has not appropriately hedged this position by now obviously is desirous of losing money."

No need to save, our house has appreciated in value
Another perverse result of the housing bubble is that American consumers have stopped saving. They see the value in their homes go up, and decide they can spend their cash and accumulate house appreciation instead. As Morgan Stanley’s chief economist noted:

“The net national saving rate -- that portion of national saving that is available to fund the actual expansion of productive capacity -- fell to a record low of 0.7% of gross national product in the first period of this year. That’s off sharply from the year-earlier reading of 2.3% and is well short of the nearly 5% average of the 1990’s and the 11% norm of the 1960’s. There are few macro gauges that tell us more about an economy’s internally generated growth capacity. Sadly, America has all but depleted its reservoir of net saving -- the sustenance of longer-term economic growth.”

We’re spending other people’s savings. The Japanese save 5% of their income, and those thrifty Chinese save 40% of their household income!

Source: http://www.prudentbear.com/

Not only do Americans not save, many are even spending their house appreciation with second mortgages and home equity loans. Goldman Sachs senior economist Jan Hatzius estimates that sellers and owners cashed in $640 billion of the nation's home equity in 2004, up from 2003's $528 billion. Ms. Hatzius refuted Dr. Greenspan’s argument that housing prices can’t collapse like stocks because selling is not as frenzied. Ms. Bostjancic: "The argument Greenspan uses – that houses aren't like stocks – well, that doesn't hold if one in every four homes is being purchased as an investment."

Consumption: The Economic Kind is almost as bad as the Pulmonary Kind
The economy doesn’t seem to be listening to all this bad news. After limping out of the recession in 2001, the economy grew slowly, at an annual rate of around 2% until 3Q 2003, when the economy jumped by 7%, and has grown at over 4% ever since. However a close examination of the data shows that over half of this economic growth is in personal consumption. In fact, personal consumption now represents 70% of the Gross Domestic Product, up from 61% in the 1960’s, while net exports have gone from around 0% (imports=exports) to a record -5% of GDP. So while we can be happy the economy is growing fast, what is really growing fast is personal consumption of a lot of imports, financed by borrowing against our houses. We have ceded the manufacturing sector to low cost China and high cost Japan. The manufacturing sector in the US represents only 13% of GDP. 40% of the S&P's earnings come from financial institutions. Borrow and consume; borrow and consume, sounds like a healthy economy to you?

Who’s Paying for my Savings?
Since we’re importing 15.2% of GDP, and only exporting 10% of GDP, we’re bringing a lot more stuff in than we’re sending out. And since it’s cheaper to build a new container in China than ship a used one back, spare containers are stacking up in huge piles in America’s ports. But the real question is not what we’re going to do with tens of thousands of used containers, the real question is why are foreigners sending us all this stuff? And the answer is that we’re sending them dollar denominated IOU’s to pay for it. The trend of the annualized trade deficit is dramatic:

Foreigners used to like to hold dollar denominated investments: US government bonds, US corporate bonds and US stocks. But it looks like that’s changing. The Bush administration has pursued a weak dollar policy (as exemplified by Mr. Cheney’s “deficits don’t matter” quote), and foreign investors holding dollars have seen their dollar investments fall in value by 35% since 2001 as compared with the Euro. Meanwhile, the amount of dollar denominated assets that we’ve traded for our consumption has grown dramatically.

These liabilities are greatest with our largest trading partners. The government of Japan holds over $700 billion of US Treasury securities, more than $5,500 for every man woman and child in Japan. China is the next largest trading partner and holds $194 billion in Treasury securities. The next largest holders are England, the Caribbean (think hedge funds), and Korea. (see ustreas.gov). The conventional wisdom is that foreign governments need to keep buying our debt so that they can continue to ship us their products. That seems a little far fetched to me. And within the past few months, Japan, China, South Korea and others have all threatened to cut back on their purchases of US financial assets.

A Cacophony of Cassandras: Nattering Nabobs of Negativism
The financial press has been filled lately with doom and gloom stories. But this is to be expected. The financial markets thrive on fear and greed; the markets climb a wall of worry. Alan Ableson’s wonderful weekly column in Barrons is always bearish. But gloom and doom has been coming from unexpected quarters lately:

Warren Buffet has turned bearish on the dollar and has started diversifying away from the US dollar for the first time ever.
Bill Gates, the world’s richest man is shorting the dollar, betting on further falls.
Dr. Greenspan recently warned the Senate that the economy could stagnate or worse if massive federal and trade deficits weren’t reined in.
Paul Volker, the former Fed Chairman who broke the back of inflation in the early 1980’s, recently said that the huge economic imbalances have made the current economic situation the most dangerous situation that he can remember. “The United States is absorbing about 80% of the net flow of international capital. And at some point, both central banks and private institutions will have their fill of dollars.”
Stephen Roach, the chief economist at Morgan Stanley, has predicted privately that the US has no more than a one in ten chance of avoiding “economic Armageddon.”

These arguments seem credible and scary. All of these people share a common view: the current account deficits are unsustainable. Interest rates must go up dramatically and the dollar must decline dramatically. A recession or worse is almost inevitable.

Should I sell my stocks or my house?
What is about to happen to our economy? About six months ago I became so concerned about these economic issues that I decided to diversify out of dollars. But what to buy? The Euro seemed too high, and who knows when China will revalue the yuan? (If you want to buy yuan denominated deposits, you can at http://www.everbank.com/). I decided that oil was the best currency and bought a boatload of oil futures at http://www.nymex.com/. So bolstered with the courage of the lucky, I hereby offer my scenarios for America’s economic future:

A Bull Market in the Making
The rosiest scenario is an intriguing idea from Richard Benson of Specialty Finance Group. Mr. Benson points out that the recent rise in oil has increased annual world oil costs (to consumers) and revenues (to oil producers and exporters) from $900 billion to $1.5 trillion. Much of that revenue will flow to the Middle Eastern oil providers, and if they are good US allies, it will flow right back into US Treasuries, corporate bonds and stocks. That could forestall a current account day of reckoning for quite a while; in fact, we might even get a bull market out of it.

Pop goes the Housing Bubble
The conventional wisdom is that interest rates will increase. As shown below, the futures markets are anticipating another 100 basis point increase in the short end of the yield curve.

Source: Silicon Valley Bank

If the short rates go up a point, I think the yield curve will be too flat to continue the carry trade and it is more likely that long rates will also go up 1%. A 100 basis point increase in mortgage rates makes housing 20% more expensive. That is likely to stop the speculative buying in housing and reverse the psychology in the housing markets. I don’t think that housing prices are likely to crater, but a sharp slowdown in the housing markets will probably halt the consumer consumption binge as consumers feel poorer and realize that they may have to save for college bills or retirement. These changes in psychology are non-linear events and can feed on themselves in the downdraft the same as they did in a bubble, so they are hard to predict. But I tend to think a simple housing slowdown wouldn’t lead to a recession, just a dramatic slowdown in economic growth.

Further Dollar Weakness
The US Senate is threatening trade sanctions against China if China doesn’t revalue the yuan. This is completely ridiculous. China’s current annual trade surplus of $68 billion is tiny compared to the US annualized trade deficit of $720 billion. But if the US continues to threaten China, China might be tempted to retaliate by selling its hoard of dollars. That could roil currency markets, and tempt other foreign dollar holders to sell before they suffered more losses. Again, these trends are non-linear and often diverge from an equilibrium point, so the extent of a dollar drop is hard to predict. Certainly, any substantial additional drop in the dollar would force the Fed to raise rates even more to defend the dollar. A potential dollar drop together with a slowdown in housing leads many to predict stagflation: a stagnant economy with high interest rates and strong inflation.

Derivative Defaults
A bad economy could get worse if waves of defaults start crashing through the system. We haven’t had systemic financial system risk since the bank defaults of the great depression, but the crisis caused by the default of the Long Term Capital Management hedge fund does cause you to wonder what the default risks are now that the hedge fund industry is much larger. People don’t talk much anymore about derivatives risk, but the size of the derivatives contract market is over $100 trillion. These contracts are not settled on an exchange with a clearing house, they’re more usually bilateral contracts with one of the parties often a large bank. It doesn’t take much imagination to see how a discontinuity in the economy could trigger a wave of defaults on interest rate or credit default derivatives. Even the start of a derivative default crisis would lead to an enormous flight to quality, with US government rates probably going way down, and banking rates and corporate rates skyrocketing, if securities were quoted at all. Currently the spread between junk bonds and US government bonds is around 400 basis points; still close to a historic low. An interesting trade in this environment is to short a basket of junk bonds and go long US government bonds.

Conclusion
As Dr. Greenspan prepares for his retirement nine months from now, he must be breathing a sigh of relief that someone else is going to take his thankless job. But he should not go unthanked. If a more cautious person had been Fed Chairman, we would not have enjoyed the tech bubble, and all the prosperity that came with it, nor would we have enjoyed the housing bubble, and the great wealth which that has given us. So I urge all of you this evening, while enjoying some sherry or perhaps a claret, to say a silent thank you to Bartender Greenspan for letting us ride atop this money bubble for the past decade. And to all of you I wish you the best of luck in profiting from the exciting opportunities that may present themselves in these interesting times to come.

***DISCLAIMER***

The views of the author are his alone and in no way represent the opinions, or lack thereof, of Battery Ventures. The author uses “satire” which is a literary device in which human vice or folly is attacked through irony, derision, or wit. The author apologizes if his wit is offensive or unintelligible.

For a more pessimistic viewpoint see: http://www.prudentbear.com/. The author wishes to thank Mr. Doug Noland and the other contributors to prudentbear for many of the ideas and charts which were borrowed and reprocessed in this article.

For a clearer discussion of Federal Reserve Policy, consult the Mogambo Guru.

To subscribe to a daily newsletter with depressing view of our economic world, see http://www.dailyreckoning.com/.