Wizard or Village Idiot at the Fed?

Often those who are deemed “touched” or “simple” speak in nonsensical language, their associations and means of expressing them leading the listener to wonder what lies behind the impenetrable mist of confusion. Likewise those who are considered incredibly gifted, geniuses in their respective endeavors, sometimes express themselves in ways that befuddle their admiring listeners, who then ascribe this opacity to brilliance descended from another realm. The wizard and village idiot share the trait of expressing themselves in a manner that is at times beyond the realm of human understanding.

Which, then, is Alan Greenspan, President of the Federal Reserve since 1987, the man who presided over the greatest investment boom of the 20^th century and the subsequent bust currently being digested by the stock market and economy?

Mr. Greenspan certainly qualifies as an oracle of confusion and lofty elocution.  He is given to masterful  blending of economic theory and statistics, leaving onlookers aware of his erudition but often unclear as to what has really been communicated.

Mr. Greenspan also presents a study in contradiction and ambivalence. At one point during the stock market run-up of the nineties he publicly decried “irrational exuberance” but later retreated to state that there was no speculation taking place, in the process becoming a de facto cheerleader for the ascendance of technology in the economy. In Fed meeting notes of the late nineties he referred to a nascent speculation in equities, and conjured the possibility of stricter margin requirements to prick the bubble, yet in public stated that there was no way to assess the existence of an investment bubble, let alone control it by the use of margin. In 2001, by providing key testimony to shore up Bush’s $1.35 million tax cut package, he praised the administration’s move to eliminate budget surpluses which seemed worrisome due to the possibility that the government would actually run out of national debt. Yet in 2003, with the onset of the largest deficits in US history, he first stated that deficits were not a benign element in the formation of interest rates, cautioning against greater deficit spending, then later seemed to recant his testimony by allowing that the latest government tax package set forth would have no deleterious effects in the short term and that the point of no return was a long ways off.

Though his contradictions can be attributed partly to his stature as a man who carries the responsibility of concealment due to his power to potentially move markets, his impenetrable verbiage and reversals in thought leave one wondering if the head of the nation’s central bank has been the recipient of an adulatory reputation of which he is undeserving. Given the backdrop of a recently brutalized stock market and an economy which teeters on the edge of a serious recession caused by crushing debt, falling asset prices, and a shaky dollar, Mr. Greenspan’s byzantine pronouncements, formerly inspiring disassociated reverence in his listeners, are now encouraging at least some disbelief and suspicion. The conclusion of ineptness is borne by the facts, and unfortunately will be proven more so in the coming years.

The Federal Reserve’s mandate is quite simple: to maintain price stability and act as guardian of the health of the financial system. Though the Consumer Price Index has indeed been relatively stable since Mr. Greenspan assumed his position in 1987, prices of financial assets have demonstrated clear cycles of boom and bust despite the Federal Reserve Chairman’s attempted stewardship of the financial system. Though the 1987 crash in equities can clearly not be blamed on Mr. Greenspan, this crisis was soon followed by the Savings and Loan crisis and the attendant bust in real estate during the early nineties. The S&L crisis was in turn followed by the collapse of the Mexican peso and the Tequila Crisis of 1995, caused in large part by a rapid ascent of US interest rates in 1994 as the Fed moved to brake inflation. As a result of the Latin American blow up, the Treasury was forced to bail out Mexico, leading many to charge that Fed policies were leading to moral hazard in the overall system. Just a few years after the Mexico crisis, the Fed was forced to act again, as the Long Term Capital Management (LTCM) collapse threatened the entire US financial system at a time when world markets were declining due to a crisis in Asia. This averted catastrophe was followed by aggressive rate cuts and even surprise “intra-meeting” cuts that jolted investor psychology towards bullishness. The quick Fed moves of late 1998 followed by aggressive monetary easing in 1999 in preparation for Y2K arguably set the foundation for the NASDAQ’s blow-off phase in late 1999 and early 2000. During the subsequent market collapse, over $7 trillion of investor wealth was wiped out. This long string of crises and blow-ups brings up the question: is the Fed Chairman an astute crisis manager or a reckless steward who in fact has allowed the various financial crises to blossom?

The Fed Chairman has reacted to the latest threat in typical form, moving aggressively to cut US interest rates to their lowest levels in many decades. Despite Mr. Greenspan’s moves, the economy remains stifled by excess capacity, excessive debt, and anemic job growth. Though the stock market has performed well over the last year, it remains essentially unchanged since this time in 1998, six years ago. The Fed’s rate cuts may have succeeded in reflating asset prices temporarily, but the fact is that Mr. Greenspan has once again refused to curtail a financial bubble that has expanded on his watch. In this case his “bust avoidance” policy of providing massive stimulus in the form of cheap money has resulted in the formation of bubbles in real estate and in the US dollar. Either of these bubbles could have been avoided by allowing the nation to pass through a painful but necessary recession that curtailed mortgage and import demand. Mr. Greenspan instead has acted as a financial cowboy once again, taking center stage with his obvious efforts to manipulate asset prices and provide the semblance of recovery in the economy. Unfortunately, the bubble in residential real estate dwarfs the previous stock market bubble in magnitude, and the potential reversal in the US dollar will affect the entire US financial system rather than a particular asset class.

Commentators are fond of describing the Fed Chairman as an eccentric wizard who expertly reviews reams of financial statistics each morning in his bathtub. Perhaps with a closer look they might discern a confused man given to blowing bubbles in the nation's bath water.