A business school alum sent us a recent article Greenspan wrote: The Roots of the Mortgage Crisis.
The first image came to my mind after reading is a retiring sheriff defending his legacy before the town descending into anarchy. Among all people, Alan Greenspan perhaps did the most damage to the credit situation. Not that he didn’t have good execuses, but he certainly did not put up a fight. Therefore he shouldn’t have it BOTH ways! Just like what Bob Dole said about John Kerry: he can be a war hero or an antiwar hero. But he can’t be both.
Yes, Greenspan is right to point out that recent growth created so much wealth and anticipation that “there was clearly little the world’s central banks could do to temper this most recent surge in human euphoria.” What he didn’t mention explicitly is that the plethora of financial innovations also created higher leverage and liquidity that money supply directly controlled by CB is only part of the liquidity equation.
However, CBs do have the ability to curb the growth of leverage and liquidity by allowing bubbles to burst, by sending speculative wealth back to ether and by maintaining a proper risk-reward perspective. There are many sources of the increased funding liquidity, some are of good faith based on calculated risk management, some are not–subprime mortgage being one of those. Regardless, the common theme is that there is an unrealistic expectation of market performance. When the market finds out one morning that the expectation cannot be sustained by underlying asset values, everyone goes into panic.
The question then becomes how CB should restore confidence and stablize the market? Should CB let the overshooting market recover by itself or should it infuse large sum of money to backup the failed promise? The argument against the former is that there is a risk of economy-wide slowdown. Against the latter is the problem of moral hazard, or unintentionally rewarding bad behavior.
Greenspan ALWAYS weights the former more than the latter (see Grep Ip’s article, “Bernanke Breaks Greenspan Mold” and my earlier comment). He believes that a wounded financial market will drag down the entire economy. Therefore, at every turn, he didn’t hesitate to feed more money to the market: the 1987 market crash, the Mexico bailout in 1995 and LTCM in 1998. So much so that there is a term coined after him: the Greenspan Put, meaning he always covers the market loss, regardless of why.
However, if one can disprove Greenspan’s assumption that a stock market downturn will hurt economy as a whole, then the moral hazard effect of Greenspan Put suddenly becomes so much more prominent. So what happened since the credit crunch began in summer? Let’s see, there is an upward revision of GDP for the 3rd quarter, the employment rate remains historically low, there is some fluctuation of consumer confidence but no clear downward trend, and most importantly, the most recent purchasing manager survey shows an expanding economy. What is more, who are crying wolf of an upcoming recession? The bankers, the financiers, the home owners who don’t live in their homes and the economists surveyed by WSJ but not those by the Economist.
So far, there is not enough historical evidence to suggest a Siamese Twin-like coupling of financial market and the economy. The most telling example is the Great Depression–an event occured some 70 years ago. But there is eneough evidence to get alarmed about the other side of the argument: that bailing out bad investments sends the wrong signal. In fact, the loud cries heard on the Street may be indictive of a collective cognitive shift of what the investors are entitled to. If that were ever the case, we should all look back at who actually started the shift.
Yes, I am pointing at you, Mr. Greenspan.
Had a lousy day today until got hit by this news: “