The US economy is struggling under the weight of its massive twin deficits. The housing bubble is on the verge of collapse, just at the point when its heavily-indebted consumers are spending more than they earn for the first time since the Depression era.
But how did it get into this state? It’s time to take the opportunity to remind ourselves of just how big a mess ex-Federal Reserve Chairman Alan Greenspan has left behind for Ben Bernanke…
When Alan Greenspan was nominated by President Reagan for the chairmanship of the Federal Reserve Board on 2 June 1987 to succeed Paul Volcker, bond markets recorded their largest one-day fall in five years.
Within three months of him taking up the reins of the Fed, the US stockmarket saw its largest one-day fall since 1914. These experiences of market dislocation seem to have weighed heavily on him throughout his long tenure as Fed chairman (18 years and six months); his main aim since seems to have been to avoid such events happening again.
It is a measure of the complexity of the outgoing chairman that assessments of his legacy will range from glowing to grotesque. To some, he is still ‘the Maestro’, but to others he has become ‘the Maelstrom’. His reign has been littered with contradictions: has he been diligent or negligent? Has he promoted continuity or chaos? To the ideal of unfettered capitalism, is he apostle or apostate? Does he stand for prudence or profligacy?
For me, Greenspan is the savings saboteur, par excellence. There are two sorry tales of savings. On his watch, first we have seen the steady erosion of personal saving as a percentage of disposable income; and second, the eventual devastation of net national saving after the bursting of the equity-market bubble in technology, media and telecommunications shares in 2000. In 2005, after a spring and summer of wild credit excess, both the personal saving rate and the net national saving rate turned negative.
After building a well-deserved reputation as a safe pair of hands in his early years, Greenspan used his growing authority to dispense with policy rules and structures – such as monetary targets – and to conduct instead an entirely discretionary policy. Why?
That was never entirely explained, but a succession of presidents have been happy to endorse his methods on the basis that he has been getting what look like favourable results: low consumer price inflation and a brisk pace of economic growth ever since the 1990-1992 recession.
Most of the credit for vanquishing US inflation belongs to Greenspan’s predecessor, Paul Volcker, but it was during the Greenspan years that people dared to believe that low inflation could really be sustained and inflationary expectations settled down. The result has been an impressive fall in government and corporate bond yields, something that in turn paved the way for a revaluation of all financial assets in the 1990s (the lower interest rates are, the higher asset prices tend to go).
There was a bump in the path in early 1994 when – after government bond yields around the world had fallen much further than expected in the previous year – a small interest rate increase in February initiated a sharp reversal in bond prices, which erased in ten months most of the gains investors had made over the previous two years. But this was to be Greenspan’s last negative policy shock.
On all future occasions, he was careful to prepare the markets for bad news in advance. By degrees, the Fed has pursued a path of increasing transparency in its interest-rate announcements, beginning with cryptic clues in speeches and culminating in explicit language, such as to hold the funds rate at 1% “for a considerable period” and remove monetary accommodation “at a measured pace”. This unprecedented clarity seems to have been born of an increasing fearfulness of a repeat of the February 1994 bond-market event.
This same fearfulness has been in evidence at frequent intervals and particularly since the near-miss of August-September 1998 (when there was a Russian bond default and the hedge fund LTCM collapsed). One of the Fed’s favourite tricks is the “limited special offer” on the overnight funds rate. The rate set at successive Fed Open Market Committee meetings is the target Fed funds rate, but on a given day, the Fed is willing to force the actual rate lower in order to forestall a problem in the financial markets. The most recent instance of this was on 12 October in the context of the Refco scandal.
But there’s been a price to pay for Greenspan’s aversion to negative shock therapy, traditionally the Fed’s responsibility. The price has not yet been paid in terms of economic growth, nor in the volatility of economic growth. Nor has it been paid (until recently) in terms of a higher or more erratic inflation rate. Instead, the price has been met through a progressive increase in uninsured risk and vulnerability to shocks thanks to a rise in debt.
Greenspan, deliberately or otherwise, has, with his low interest rates, engineered a massive domestic-credit experiment that has had global ramifications. In total, the US private sector raised its debt to GDP ratio from 164% to 251% between 1987 and 2005. Households have increased their debt to disposable income ratio from 79% to 122%.
Since January 1993, the average Fed funds rate has been 4%, implying that savers get deposit rates of perhaps 2.5%. This low level of return has played a key role in the near-abandonment of household cash accumulation, embodied in the popular slogan, ‘cash is trash’.
Credit facilities have taken the place of precautionary deposits. Although most households now have two wage earners, they still have proportionately less discretionary income than 30 years ago, and they have found regular injections of new credit indispensable to maintaining their living standards. In a booming housing market, the mechanisms of mortgage refinancing and home-equity loans have provided abundant cheap credit over the past five years. Yet, remarkably, more than two million individuals filed for bankruptcy last year.
At the corporate level, where profitability has been wonderfully restored since 2000 by ultra-low borrowing costs and easy yield-curve profits, the assumption of increasing balance-sheet leverage has facilitated the over-distribution of profits as dividends and share buybacks. A golden opportunity for the rebuilding of corporate saving has been wasted. Consequently, the US as a whole has failed to make adequate provision to renew its capital stock.
Greenspan’s legacy is this: the exhaustion of personal debt capacity, the erosion of the savings incentive and the resulting fragility of consumer finances. If the US housing market follows the fading path of the UK this year, as the chairman expects, then this major engine of credit provision will begin to shut down. If equity markets fail to sustain their upward track after three solid years, then employment in the financial and real-estate sectors will also begin to turn down. No matter how robust the US economy has seemed in the recent past, its momentum could easily be lost in the space of six months.
Greenspan’s successor, Ben Bernanke, inherits a Fed that has become less of a monetary policy institution and much more of a risk-management operation. In his 18 years, Greenspan has failed to shake off the notion that his personal judgement and discretion are critical to market outcomes. Indeed, some would argue that he has come to enjoy his market-moving potential. If Bernanke chooses to operate in the same discretionary mode, it does not follow that the markets will trust his judgement to the same degree.
Moneyweek.com