Greenspan says he is worried that we could be facing another false dawn. Read our interview: http://on.mktw.net/1sXVxxU
Former Federal Reserve Chairman Alan Greenspan has always been a student of the economy. Since the financial crisis, he’s become a student of human nature.
MarketWatch: What is the biggest challenge facing the Fed?
Greenspan: How to unwind the huge increase in the size of its balance sheet with minimal impact. It is not going to be easy, and it is not obvious exactly how to do it.
MarketWatch: As the Fed is looking at the exit, do you think we can get through this without upsetting the economy?
Greenspan: I certainly hope so. I certainly think they will. But it is going to be difficult.
MarketWatch: Do you expect a sharp market reaction to the first hike?
Greenspan: Of course. Look what happened when the first indication of tapering occurred. Markets have always been sensitive. They reflect animal spirits.
MarketWatch: Will the Fed’s communication to markets be key here?
Greenspan: I am not sure. One area I was always doubtful about during my tenure is how much we could effectively communicate to markets, because they were always second guessing the Fed. It was a battle, and I am not sure we always won.
MarketWatch: The Fed has been talking recently about stock-market valuations ― do you think that’s wise?
Greenspan: You can’t get around the fact that asset values have a major impact on economic activity, and no central bank can be oblivious to what is happening, not only in credit markets, which is, of course, the Fed’s fundamental mandate, but in asset markets, as well. As a central banker, in addition to evaluating stock prices, you have to cover commercial-real-estate markets, commodity markets and the price of owner-occupied homes, as well. Without asset-market surveillance, you do not have an integrated view of how the economy works. How to respond to asset-price change is a legitimate issue. But not to monitor it, I think, is clearly a mistake.
Greenspan: There is a fundamental distinction. I happen to agree that bubbles are primarily an issue to be addressed by regulation.
The Fed tried in 1994 to defuse a bubble with monetary policy alone. We called it a boom back then. The terminology has changed, but the phenomenon is the same. We increased the federal funds rate by 300 basis points, and we did indeed stop the nascent stock-market bubble expansion in its tracks. But after we stopped patting ourselves on the back for creating a successful soft landing, it became clear that we hadn’t snuffed the bubble out at all. I have always assumed that the ability of the economy to withstand the 300-basis-point tightening revised the market’s view of the sustainability of the boom and increased the equilibrium level of the Dow Jones Industrial Average. The dot-com boom resumed.
When bubbles emerge, they take on a life of their own. It is very difficult to stop them, short of a debilitating crunch in the marketplace. The Volcker Fed confronted and defused the huge inflation surge of 1979 but had to confront a sharp economic contraction. Short of that, bubbles have to run their course. Bubbles are functions of unchangeable human nature. The obvious question is how to manage them.
All bubbles expand, and they all collapse. But how they are financed is critical. The dot-com boom [of 1994 to 2000] produced a huge financial collapse with almost no evidence of economic impact. You will be hard pressed to see it in the GDP figures of the early 2000s. Similarly, on Oct. 19, 1987, the Dow Jones Industrial Average fell 23% ― an all-time one-day record, then and since. Goldman was contemplating withholding a $700 million payment to Continental Illinois Bank in Chicago scheduled for the Wednesday morning following the crash. In retrospect, had they withheld that payment, the crisis would have been far more disabling. Few remember that crisis because nothing happened as a consequence. But it was the scariest experience I had during my 18 years at the Fed.
In both cases, equity values collapsed, with wrenching losses to the holders of stock, primarily pension and mutual funds and households, none of which were sufficiently debt-leveraged to induce contagious defaults.
It turns out the reason why the more recent housing bubble was so dramatically different was that its toxic assets, subprime mortgages, were out there exposed with very little equity buffer. In a collapse in stock prices with no debt, unleveraged holders get the full impact of the equity loss, but there is no serial contagion. That was not the case in the housing bubble or the highly leveraged stock market of 1929.
So it is not the toxic assets ― stocks or subprime mortgages ― that matter, but the degree of leverage taken on by the institution that is handling it. Contingent convertible debentures can importantly reduce the risk of serial debt contagion. The debenture debt can be converted to new equity as the overall equity buffer shrinks.
MarketWatch: Some economists argue that the economy has just been bubble after bubble and that we’re doomed to repeat this cycle.
Greenspan: Well, I agree with that. I have come to the conclusion that bubbles, as I noted, are a function of human nature. We don’t have enough observations, but my tentative hypothesis to what we’re dealing with is that both a necessary and sufficient condition for the emergence of a bubble is a protracted period of stable economic activity at low inflation. So it is a very difficult policy problem. I do believe that central banks that believe they can quell bubbles are living in a state of unrealism.
MarketWatch: Well, the comments I read from economists reflect concern that bubbles are a sign there are not enough productive investments, like factories, in the economy.
Greenspan: That’s a legitimate concern. The question is why. If you trace the history of the average maturity of the components of GDP, what you find is that all of the shortfall of economic activity following 2008 is in very long-lived assets, fundamentally structures. Every single one of the 10 major postwar recoveries was heavily driven by a faster-than-GDP growth in structures ― except this one. What went wrong? Business and household fear gripped the markets in ways not seen since before World War II. The share of nonfinancial corporate liquid cash flow that corporate management chooses to invest in illiquid long-term assets fell to the lowest peacetime level since 1938. Householders engaged in a massive shift from long-term homeownership to rentals.
Fear has diminished somewhat, but the shortfall in GDP from its potential is still predominately in these very long-lived assets that are discounted heavily. There is definite evidence the economy is picking up. The financial system is finally beginning to lend. But, what we don’t know is whether, when the recovery gets underway, it is going to run into another false dawn.
Gross domestic savings and capital investment as a share of GDP have declined significantly in recent years. It is the cause of the slowdown in productivity growth and standards of living. At root, the problem is government deficits suppressing the national savings rate. Until we come to grips with that, it is going to be difficult to get the economy moving in a sustainable way.