What Wasn't Said
Greenspan's
remarks on economic volatility at a symposium sponsored by the
FRB of Kansas City, Jackson Hole, Wyoming struck some important themes
for gold traders to contemplate. This of course includes the (sort of)
self-avowed gold bug himself, Alan Greenspan.
As an observation over the years I must
say that his speeches from Jackson Hole are particularly inspired. Maybe
that's because he's among the best of best friends.
The five main themes involved establishing
the innocence of the central bank in any of the bubble stuff that went
on, during the nineties in particular, by pinning the bubble phenomenon
on investors alone; the notion that greater market volatility is
part of a process of adjustment that has become quicker and more efficient,
and which should be sufficient to explain both the length of the expansion
as well as a reduction of the frequency and amplitude of the business
cycle; that not only were investors to blame for an unsustainably lower
equity risk premium in their euphoric state, but also that structural
productivity gains accounted for the lower ERP; that a nascent asset bubble
can neither be identified, nor preempted with gradualist tightening policy;
and finally, there was some indication of the desire to move the Fed to
a more hawkish position.
Ever heard the saying, "never fight
the tape\trend?" The other popular expression is "never fight the
Fed." What happens, however, when the Fed fights the trend? Double talk,
back peddling and pure nonsense… that's what.
I haven't seen so much taking credit for
the successes and shifting blame for the errors since leaving my post
as a broker. If that's not what it was then Mr. Greenspan's economics
has become, well, dumber over the years. I am not qualified to say that
it has in reality, since we cannot know his true views, but I think we
can prove this in his public "remarks," which have certainly become increasingly
Keynesian at any rate.
But we all know that.
His argument meant to show that the data
are consistent with what we would expect in an environment where structural
productivity gains were being crystallized, but as well, he meant to argue
it was the IT revolution which supported the fundamentals that led to
a bubble as investors got too giddy about them.
Unfortunately, what wasn't said
was that the same data are also consistent with what we might expect if
the economy were to be subjected to one of the longest running and easiest
money policies in the history of the Federal Reserve System.
Put it this way. If one wanted to learn
how to sustain a system of inflation they need go no further
than Mr. Greenspan. Think about it! Why else would the central bank stand
so prominently in an economy that is without inflation? What business
is it of theirs that productivity and markets are so efficient? I mean,
in other words, if they have nothing to do with any of the economy's remarkable
performance, and if the markets are so efficient all on their own, why
bother to have a central bank, and why on earth are the chairman's comments
so important to everyone? Obviously it isn't the case that the Fed is
neutral, and to that extent, Greenspan goes a ways in justifying the Fed's
existence by pinning the markets best gains on its prior sound interest
rate policies, suggesting:
"In fact, our experience over the past
fifteen years suggests that monetary tightening that deflates stock
prices without depressing economic activity has often been associated
with subsequent increases in the level of stock prices" - Greenspan,
August 30, 2002.
If the Fed wants credit for something,
it has to clarify exactly what it wants credit for? If it wants credit
for sustaining low interest rates for so long they've got it. If it wants
credit for sustaining any inflation (too much money) they've got it. If
it wants credit for proving that an economic system dependent on inflation
can achieve a full-employment doctrine they've got it. But these are all
distractions from the important questions: what exactly are the policy-mechanisms
employed, are such processes sustainable and just, and to what extent
can we give the Fed credit for causing economic imbalances to accumulate?
Of course, these are all difficult to assess if the Fed denies it was
inflation which stoked the greatest bull market in stocks the world has
ever seen.
Empirical evidence is hard to come by when
dealing in economic reality. But logical evidence is another thing, if
I can say that, since I agree that most things can only be regarded true
to the extent they've yet to be proven false.
Proving Mr. Greenspan wrong is the bottom
line (earnings). Proving us right is that a system of inflation (too much
money) could produce precisely the same results we saw during the last
decade, provided it could be sustained and controlled for long enough.
At any rate, Mr. Greenspan was careful
to pin credit for the reduction in the volatility of the economic aggregates
on market factors rather than the Fed's aggressive spate of rate cuts
since 2001. This way by not taking credit for the smoothing of the negative
wealth effect so to speak he establishes the Fed's innocence during the
bull market years. In fact, Greenspan spent considerable space explaining
why economic or political "shocks are more readily absorbed than in
decades past," by establishing a cause and effect dynamic between
investor confusion (market volatility) and "somewhat surprisingly,
(the) apparent 'reduction' in the volatility of output and in the frequency
and amplitude of business cycles for the macro-economy," entirely
omitting the impact of interest rate cuts and other government 'stabilization'
policies (or incentives) since 2001.
"The increased volatility of stock prices
and the associated quickening of the adjustment process would also have
been expected to be accompanied by less volatility in real economic
variables. And that does appear to have been the case" - Greenspan,
August 30, 2002.
The omission was so obvious that anyone
untrained in reading between the lines would become expert after studying
the speech.
While taking the fifth on inflation, Greenspan
explains markets are more volatile not because of government and Fed policy,
as almost anyone would expect, but because earnings expectations have
become more assorted in the new economy. Noting a rise in analysts' earnings
forecasts coincident with rising risk spreads in corporate bond markets
during the late nineties he says:
"Higher average expected earnings growth
coupled with a rising probability of default implies a greater variance
of earnings expectations, a consequence of a lengthened negative tail.
Consistent with a greater variability of earnings expectations, volatility
of stock prices has been elevated in recent years" - Greenspan, August
30, 2002.
For Pete's sake you've got to be joking,
right? The Fed Chairman figures this to be a good indication of what,
that stock market investors are the only ones that didn't get it, and
so the stock market is volatile? Indeed that's what he implies, and later
supports with the 20/20 (hindsight) claim that stock values went beyond
what their fundamentals suggested.
"The danger is that in these circumstances,
an unwarranted, perhaps euphoric, extension of recent developments can
drive equity prices to levels that are unsupportable even if risks in
the future become relatively small. Such straying above fundamentals
could create problems for our economy when the inevitable adjustment
occurs" - Greenspan, August 30, 2002.
The way we understand it then, market volatility
in the stock market is a consequence of investor confusion, and it is
measured by the recently widening array of contradicting data in markets
that remain less confused.
In other words, analysts say one thing,
most markets say another, and the stock market says something different
entirely. That's nothing new. But Mr. Greenspan implies that the disagreement
is wider today than normal, which thus explains the greater than normal
volatility in stock prices. This is absurd because market participants
always disagree, which is why markets are liquid. The only time they all
agree is when the market moves in one direction for some time and by great
magnitudes. We call it a top or bottom. In an economy that has been flooded
with information technologies it is unsurprising that the greater evidence
of disagreement is easier to perceive. Good work Alan. You're so observant.
Of course, the proper way to interpret
the data is that uncertainty had been rising, or at least became increasingly
identifiable by the widening of bond spreads indicating a rising aversion
to risk. This doesn't mean that opinions became more varied. In fact,
they never were more united in one direction as they were during most
points in 1999/2000.
Mr. Greenspan uses his ingenious discovery
as proof of the investors complicity in order to shift blame for the resultant
stock market volatility to the investor and away from the Fed's inflation
policies, which would have produced the same results, since after all,
inflation is both unpredictable in its ultimate manifestation and affects
individual valuation judgments. Thus, risk spreads would widen equally
due to this source of uncertainty, particularly when default rates begin
to accelerate, practically proving the condition of too much money. Sigh.
Nonetheless, within the framework of Greenspan's
interpretation, it is clear why he feels as though the Fed had no business
interfering with such market processes. After all, who would have thought
that increased market volatility would quicken the adjustment process?
The crime, however, is that he very
well knows the Fed does nothing but interfere / guide market processes,
and thus cause confusion, uncertainty, and volatility, at least in the
raw unmanipulated data (as opposed to the aggregates).
Moreover, the idea that the greater market
volatility (independent of the Fed) is part of the process that is healing
the economy's excess is true, but this healing process has nothing to
do with the reduction of volatility in the economic aggregates.
That can best be explained by the degree
of statistical smoothing in the data as well as the aggressive rate reductions,
and government incentives, which have offset the negative effects of declining
stock values on wealth via, you guessed it, inflation.
The obvious source of market volatility
for which the empirical evidence is elusive is inflation. The
obvious source of support for the economic aggregates is inflation, or
monetary policy.
So while the markets try and absorb the
byproduct of profligate inflation policies, thus becoming volatile, the
government uses those policies to subsidize consumption (to counter that
volatility in the opposite direction), as though the Fed were a safety
net like we learned they were in school. The thinking is Keynesian; that
they could sustain certain growth engines while others heal, and it is
a widespread media and academic interpretation that they manage the economy
this way. It's in this way that monetary policy is intended to smooth
the amplitude of business cycles and has done so for the past twenty years.
Yet Mr. Greenspan denies it by claiming it's the resolution of investor
confusion that's healing the economy while at the same time he has the
pedal to the metal so to speak.
For instance, where Greenspan blames investors
for being overly bullish we blame the Fed, since inflation has been the
cause of such poor valuation judgments more often than not in the twentieth
century. Why is 1995-2000 different? For years we have cited inflation
as responsible for the rising default rate, rising risk spreads, and bullish
analyst outlooks. How's our theory wrong? It isn't, which is why he's
gone to great pains to prove that there are other explanations for the
confluence of events, which led to the bubble and which followed it.
However, in arguing that structural productivity
gains accounted for the permanent lowering of the equity risk premium
during the late nineties he incriminates himself, sooner or later, because
the facts contradict his statement of proof:
"There can be little doubt that if the
nation's productivity growth has stepped up, the level of profits and
their future potential would be elevated" - Greenspan, August 30, 2002.
Where are the profits then Mr. Greenspan?
Forget about expectations, which can be easily influenced by inflation
policy; and pray tell why it is that more Dow companies had their best
growth years from 1990 to 1995, but their best valuation years in the
subsequent five year period?
Investor exuberance is the only answer.
There could be many factors that drove this exuberance directly, including
an infatuation with technological developments, but it was fueled by easy
money policy as is typical in our economy, only not normally to the extent
of the nineties. Bull markets like that can't subsist on psychology alone.
But all this talk is academic now. What
is important to us is the future. The bottom line is the Fed's used up
its real ammunition, and it is now thinking about how to pull off an interest
rate hike without upsetting the US capital markets. He's 'splaining.
Obviously, further reductions in interest
rates seem increasingly inappropriate, but it is interesting to note that
if the Fed hadn't had the ability to lower interest rates in several key
situations over the past 20 years (including 1987's stock market crash)
it would not be able to sustain anything, especially not the longest running
expansion on record today, and the resultant reduction of volatility in
the business cycle.
Consequently we argue the Fed's ability
to lower interest rates and its skill in sustaining the inflation allowed
it to keep interest rates below market equilibrium for so long that imbalances
piled up in many markets. By sustaining the inflation we mean it influenced
stock values and supported dollar policy, which in turn allowed them to
keep rates low, and which in turn allowed them to sustain the inflation...
get it? But keeping rates low wasn't good enough. They had to lower them
to lower and lower levels to sustain the record expansion. Each time it
led to crisis, rates could go lower still, thus postponing the inevitable
corrective process of the market. But now we're near zero!
The past 20 years is irrelevant, at least
until rates get back to market equilibrium levels, where ever that is.
If such a condition materializes then the outcome is comparable within
the context of the near 20 year monetary experiment. We've already showed
that inflation could be sustained over long periods of time to the benefit
of the purchasing power of fiat currency. Another 10 years would surprise
me in this age of information technology.
Despite the claim that hawkish monetary
policy has been the source of stock market gains in the long run, it appears
that in the long run it is hard to prove that monetary policy was anything
but easy (see chart above).
If inflation (too much money) was the cause
of the expansion in earnings multiples (PE ratios) then it also engendered
illusory or temporary profits as a consequence of its dislocative effects
on prices - signaling what and how much of something producers should
produce. Thus, capital was probably over invested in some places and under
invested in others.
When the business cycle troughs we expect
to find out where those imbalances were and then we'll have a better idea
of what the decade's real earnings were.
So even though earnings grew somewhat in
the late nineties, many grew slower than they did in the early nineties;
and if we're right that the late nineties earnings weren't quite real
in the first place then it is likely the deterioration in earnings over
the next few years will accelerate with the decline in stock values as
further excesses are wrung out.
There seems to me to be much more evidence
that too much money drove valuations in equities to the nosebleed section
than there is that structural productivity gains did over those years.
The debate will go on for some time to come, but one thing is for sure.
While not quite denying inflation, by its omission as well as the eager
offering of the only other (so far) cogent explanation for the data, the
Fed is as guilty of bias as any corporation is of making its own
earnings forecasts, or as any analyst is of supporting research where
he or she stands to gain by doing so. At least their bias is disclosed.
Worse is that if the problem is too much
money then the Fed is an outright fraud. This is only true of course to
the extent it presents its operating activities in a light that isn't
true, as it seems to do often.
Thus, by being active in this debate, the
Fed makes itself a target of future accusations of wrongdoing, which if
it were passive it may have been able to avoid. And by the extent of its
increasingly generalist economics and double talk Greenspan is essentially
verifying its complicity in the inflation scheme of the nineties.
Leave it alone Alan; why say anything if
your confidence is so great that the "associated quickening of the
adjustment process would also have been expected to be accompanied by
less volatility in real economic variables. And that does appear to have
been the case." If it is the
case, hush up and let profits come back to validate your productivity
argument.
The most important aspect of Greenspan's
remarks, however, was the specter of the move to a tightening he raised
by citing the success of prior tightenings in weeding out the excess and
bringing valuations back in line with earnings realities so that earnings
can grow sustainably again. His words paraphrased.
"Certainly, a bubble cannot persist indefinitely.
Eventually, unrealistic expectations of future earnings will be proven
wrong. As this happens, asset prices will gravitate back to levels that
are in line with a sustainable path for earnings" - Greenspan, August
30, 2002.
What he's saying is that bubble valuations
have to vanish before earnings growth can be sustained in the future.
If he could establish that valuations still imply unrealistic estimations
of future earnings then he has established pretext for a sharp rise in
interest rates to wring out the excess. He sounds to be lobbying for just
that.
But concurrently he argues that the Fed
does not possess the ability to make the judgment that expectations are
unrealistic; that they lack the measures.
"Short of such a measure, I find it difficult
to conceive of an adequate degree of central bank certainty to justify
the scale of preemptive tightening that would likely be necessary to
neutralize a bubble" - Greenspan, August 30, 2002.
The contradiction is somewhat puzzling
and raises the question, why bring it up then if you can't ID a bubble
in time to take action? Maybe 'cause its a warning shot across the bow.
Greenspan argues that bubbles can't be
preempted by incremental interest rate increases, he skillfully denies
the Fed's responsibility in creating them, and then says that the only
way to preempt a nascent bubble is with "a sharp increase in short-term
rates that engenders a significant economic retrenchment." He could
be setting us up for a spike in interest rates and rationalizing an expansion
in the Fed's powers to "mitigate the fallout when it occurs and, hopefully,
ease the transition to the next expansion."
Conclusion
"Accumulating signs of greater economic
stability over the decade of the 1990s fostered an increased willingness
on the part of business managers and investors to take risks with both
positive and negative consequences. Stock prices rose in response to
the greater propensity for risk-taking and to improved prospects for
earnings growth that reflected emerging evidence of an increased pace
of innovation" - Greenspan, August 30, 2002.
Allow us to rewrite that, and indict the
Fed:
Innovative easy money
policies over the decade of the 1990s fostered an increased
willingness on the part of business managers and investors to take risks
with both positive and negative consequences. Stock prices rose because
risk became easier to manage; they rose because of the effect on long
term risk-reward assessments for equities by participants as the result
of the Greenspan put; they rose because interest rates were too low;
they rose because real profits appeared to grow; they rose for all the
reasons one would expect them to rise in an environment of successfully
engineered monetary policy; and they rose in response to several
bullish factors, whether sustainable or not, including the greater confidence
in earnings forecasts as well the prospects for profits
resulting from the emerging evidence of an increased pace of
innovation.
C'mon Mr. Greenspan, you liked getting
credit for it on the way up. The credit for any stability in the economic
aggregates goes directly to the Fed and the administration's efforts to
stabilize or postpone the consequences of the imbalances. And so the Fed
should also get credit for the way the imbalances unwind.
"An increased appetite for risk by investors,
for example, is manifested by a shift in their willingness to hold equity
in place of psychologically less-stressful, but lower-yielding, debt"
- Greenspan, August 30, 2002.
The Greenspan Put is as effective an explanation
for this shift as is productivity. We saw it happen. We saw that when
the Fed stepped up to the plate to ward off a crisis, investors forgot
completely about risk. We saw this clearly in 1987 & 1998, and less
clearly in other circumstances over the past 20 years.
Asset bubbles are indeed the consequence
of investor exuberance, but that irrational behavior is easily, and dare
I say better, explained as the manifestation of inflation (too much money).
If inflation didn't exist, bubbles would
not be the problem they are today. They would be fleeting at most. For
the Chairman of the central bank to talk of the source of a bubble, and
not cite inflation, he is obviously establishing its defense. Look out
below.
Ed Bugos
Editor - The GoldenBar Report
www.goldenbar.com
September 2, 2002
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