If you’re bearish (on Greenspan’s legacy)

Yesterday, I posted an article about Greenspan’s warning that the Fed is targeting the irrationally exuberant housing market.  However, its highly likely that Greenspan himself caused the bubble in housing by 1) reducing short term rates to historic lows even while the economy was already recovering and 2) encouraging homeowners to use short term loans to reduce their monthly payments.

First, the increased use of Adjustable Rate Mortgages and interest-only mortgages caused much of the excessive increase in housing prices.  ARMs, which are cheaper than long term loans because they are based on short-term interest rates, make payments much lower for most home owners but come with the risk of rising rates and payments.  When Greenspan lowered short term rates to 1%, he essentially made the decision a "no-brainer" for most home owners because ARMs became so much more attractive.  These lower payments made houses more affordable for more Americans, which is generally a good thing, but it also increased demand beyond existing capacity.  And that sparked the housing bubble.  It also encouraged increased speculation and over-leverage, which is generally bad.

Second, Greenspan not only lowered rates excessively, he actually told home-owners to use short term loans to buy houses in a public forum.  In a speech to credit union leaders during April 2004, Greenspan said, "Recent research within the Federal Reserve suggests that many homeowners might have saved tens of thousands of dollars had they held adjustable-rate mortgages rather than fixed-rate mortgages during the past decade, though this would not have been the case, of course, had interest rates trended sharply upward…American consumers might benefit if lenders provided greater mortgage-product alternatives to the traditional fixed-rate mortgage."

Of course, subsequent to this speech, Greenspan began raising short term rates.  To me, this seems incredibly irresponsible behavior for a central banker. 

All of which, leads me to believe that Jim Rogers was right.  In "Adventure Capitalist" he wrote a scathing review of Greenspan’s career…

Greenspan has a long, long history of failure.  That is why he has a government job.  He has never been very successful.

In 1974, he was head of the Council of Economic Advisors.  The country was in the early days of inflation.  Greenspan’s solution to inflation was to give out little WIN buttons, for Whip Inflation Now. And, of course, during his tenure, inflation went totally out of control.  Whatever he tried failed miserably.  He went back to work int he private sector, from which he lobbied heavily to get the job as chairman of the Federal Reserve.

Almost immediately after he got the job came the Panic of ’87, the stock market went down about 20 percent in one day.  Percentage wise, it was the biggest stock market collapse ever.  Greenspan and his mutterings were part of the reason for the collapse.  The week before, Greenspan had gone on and on about how the U.S. balance of trade was getting much better and things were under control.  Two days later, the balance -of-trade figures came out, and they were the worst in the history of the world.
Right away, I and a lot of investors-especially internationally- realized, "This guy is either a foll or a liar.  He doesn’t have any idea what’s going on."  We now know that Greenspan is no liar.  He has simply never understood the stock market.  He has never understood the economy.

Cut to 1998 and Long-Term Capital Management, a major fund that got into terrible trouble, losing billions of dollars.  Its collapse was going to have an effect on a lot of Wall Street firms.  The investment firms went crying to Greenspan.  Instead of letting the company go under and cleansing out the system, as bear markets have done for centuries, Greenspan panicked and put a lot of money into the system, bailing out his friends.  That easy money is one of the things that led to the absolute worst of the mania, the bubble that has now burst with such devastating effect.

All of a sudden, there were massive amounts of easy money around and whenever there is a lot of easy money around, it goes somewhere.  And it almost always goes into financial assets first — stocks, bonds, commodities – because that is a simple place for it to go.  The worst of the bubble was in those eighteen months after Long-Term Capital Management collapsed.  That is when the NASDAQ skyrocketed.  Remember, corporate profits in America peaked in 1997.  IN 1998 the stock market was on its way down.  Sixty percent of shares in America were down that year. 

The same pattern was visible in 1999.  Profits had peaked.  The economy was slowing down.  Yet, if you looked at the averages or you watched TV, you saw everyone going nuts over the "New Economy" and the bull market.  That was the period when mutual fund sales started going through the rood.  The real trend was masked, because Cisco was going up every day and Microsoft never went down.  If you took out about thirty big stocks that were skewing the picture, it was very easy to see that the bear market was well under way.  Notwithstanding Greenspan’s efforts, the market understood. 

But Greenspan, in reaction to a short-term crisis, had panicked.  He printed money.  He caused the bubble, pure and simple.  Rather than calling an end to the party and taking the punch bowl away, rather than pricking the bubble in good times, he let it grow to massive proportions.  He kept refilling the punch bowl with stronger stuff.  Reading his various testimonies, it is clear that part of the reason is that he actually believed all that claptrap about a New Economy.  Had he left things alone and we had had a normal bear market, he would have made some people furious, but that would have been a lot better than the alternative, the outcome that his interference ensured people losing gigantic amounts of money.  In situations like these, the government inevitably reacts to the panic on the other end of the phone, rather than looking back over history and saying, "The best thing that could happen is for you guys to go bankrupt."  The government should do its best to do nothing and let the system clean itself out.  But politicians have their constituents and their contributors to please.

Greenspan conceivably could have saved Long-Term Capital Management without creating the bubble.  He could have loosened up a lot of money and at the same time raised margin requirements, making it more expensive to invest in the stock market.  And nobody seems to know why he did not.  As recently as 1996, he had spoken about margin requirements as a way to help control speculation.  Partly, he comae to believe the Wall Street hype, but I can think of no good reason for his not having done so, unless it was in some way connected to helping his friends at Goldman Sachs et al.

In 2001, Greenspan panicked again.  That year, the central bank of the United States printed more money on a percentage basis than it had ever printed in the history of the republic.  Greenspan has been relentlessly pumping money into the economy; the monetary expansion has never been so great.  At the same time, fiscal policy has been loose.  The government has been profligate on both sides.  President Bush has been spending as fast as Greenspan can print.  Both fiscally and monetarily, the world has been hit with a lot of money.  "Well," Americans say to themselves, "things are not so bad after all."  How long do you suppose that will last? The maestro has now perpetrated a housing and consumption bubble by driving down interest rates.  Bubbles always end badly, and even more people will be hurt when this one bursts.