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What Wasn't Said
1 September 02
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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 1991 to 1996 (correction), 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."


"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. It's true the Fed couldn't do anything to prevent the bubble from developing, but what it denies is it's complicity in its development.

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

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