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
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
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
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
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
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
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
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
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
Allow us to rewrite that, and indict
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
"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
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.