James Grant on bubbles

greenspun.com : LUSENET : TimeBomb 2000 (Y2000) : One Thread

Comment / Personal View JAMES GRANT: Look at Greenspan's record The Fed chairman is regarded by many as some kind of clairvoyant or oracle, but his record tells a different story

The balance sheet of the Federal Reserve System discloses one of the mightiest credit expansions in recent memory. In the three months ended on January 5, the central bank's consolidated assets surged at an annual rate of 64.3 per cent. Over the preceding 12 months, they climbed by 19.7 per cent. In the run-up to the millennial liquidity crisis-that-did-not-happen, the Fed created more than $100bn of new credit, thereby stimulating a stock market that hardly seemed to need any additional encouragement.

The reappointment of Alan Greenspan to a fourth term as chairman of the Federal Reserve Board perpetuates both an irony and a misconception. The irony is that a man who, early in his career, preached the gospel of Adam Smith according to Ayn Rand should today be lionised for his matchless skill at fixing a particular interest rate. The misconception is that any one individual can control the destiny of the world's largest economy by such an improbable method.

"Pierpont Morgan . . . is carrying loads that would stagger the strongest nerves," wrote the American man of letters Henry Adams a century ago. "Everyone asks what would happen if some morning he woke up dead."

Essentially the same question is asked today about Alan Greenspan. Long may the chairman live! Long may we all! However, the apprehension embedded in the question is misplaced. Mr Greenspan, being mortal, is incapable of doing what his legion of fans credit him with already having done. If it were actually possible to see into the future and improve it before it happened, the Berlin Wall would still be standing. Socialism would long ago have defeated capitalism. The US Interstate Commerce Commission would still be in the business of micromanaging railroad freight rates.

Governments through the ages have tried to fix prices. In general, they have botched the job, because the information necessary to set a key price (much less to manage an entire economy) is unavailable to them. It is dispersed broadly among buyers and sellers, actual and potential.

In praising Mr Greenspan, many have cited the economic results of the past dozen years. To be sure, the economy has prospered and the stock market has zoomed. It is all very well in practice, to borrow from the French academicians, but what about the theory? The unspoken theory is that Mr Greenspan is supremely wise, more knowing, even, than the far-flung futures markets in which interest-rate futures are traded almost around the clock. By supposedly intuiting the correct market interest rate, time and time again, a lone federal official has become the ostensible author of American prosperity.

Cynical US Army infantrymen used to define a Marine Corps squad as nine riflemen plus a photographer. The Fed's press is even better than the Marines'. So thoroughgoing is the trust now lodged in the central bank that most investors have stopped paying attention to its actions, instead projecting their own hopes and fears on the chairman's often opaque words. As the master is Delphic, his acolytes are always happy. The Fed creates more than credit; it also manipulates expectations.

Mr Greenspan, though easily the most celebrated American central banker in modern history, is not the most powerful. The deregulation of the financial system has greatly circumscribed his field of action. In days gone by, the Fed exerted control by regulating the dollars called bank reserves. Figuratively speaking, Citibank (to name one of the central bank's charges) was a dog at the end of a leash. The Fed was the master, and the leash was the monetary transmission mechanism. Nowadays, in a freer environment, Citi may be thought of as a cat. No longer inclined to walk at heel, it can lend and borrow without undue reliance on these Fed-supplied balances.

In 2000, the Fed works its will chiefly by fixing the funds rate. In this way it heavily influences the cost of financing a securities portfolio, a very large consideration in a highly leveraged financial system.

Still, the Fed is free to create as much credit as it chooses at the rate it establishes (a rate that well may be lower, or higher, than the rate the market would have chosen itself, in the absence of central-bank intervention). And, late in 1999, concerned about the transition to the new century, the Fed created credit by the bucketful.

Although the Fed, like the British monarchy, has tried to make itself more accessible, the public continues to insist on a decent minimum of mystery. For months, the record of the balance sheet was one of expansion.

But the chairman was known to be concerned about the tightness of the US labour market, and the funds rate had recently been raised (although only back to the level at which it stood before the 1998 crisis). Ergo, the Fed is almost universally deemed to be tight.

The overwhelming evidence in the marketplace, of course, runs in the opposite direction. Stock prices (last week's spill notwithstanding), house prices, stock-market margin debt, non-financial debt and the broad-based money supply all suggest a superabundance of liquidity. Indeed, Mr Greenspan himself seems to agree. Last week's Fed balance sheet indicates that a gigantic mop-up operation has begun.

Mr Greenspan was misinformed about Y2K. He created an unnecessary bulge in Reserve Bank credit that, at the margin, distorted financial decisions and threw additional logs on the fire of speculation. He did not exercise the clairvoyance that is widely attributed to him. In short, the alleged greatest central banker is as mortal as all the preceding less-than-great central bankers. New Era enthusiasts, please copy.

James Grant is the editor of Grant's Interest Rate Observer. www.grantspub.com

-- Ed (ed@lizzardranch.com), January 11, 2000

Moderation questions? read the FAQ