Artificial Exuberance

November 12th, 2010

William McChesney Martin, the longest-serving head of the Federal Reserve before Alan
Greenspan, declared that a central bank was in “the position of the chaperone that has
the punch bowl removed just when the party was warming up.” It is undoubtedly true
that Paul Volcker understood the sentiment of a former champion of price stability, but
his ultimately successful battle to throttle runaway inflation and the tough monetary
policy required, saw him removed from office and replaced by the politically-astute and
serial bubble-blowing ‘maestro.’
One would think that the central bank would know better in the post-Greenspan years,
but Ben Bernanke, the chief architect of his predecessor’s policy, is now in charge and is
hell-bent on inflating asset prices in a desperate attempt to thwart the private sector’s
rational effort to repair their overstretched balance sheets. The current Fed chairman’s
justification for the latest round of long-term asset purchases, that will take the central
bank’s liabilities close to 20 per cent of GDP, rests on deflationary impulses, but the
artificial manipulation of security prices is just more of the same that caused America’s
asset-based economy to malfunction in the first place.
Ben Bernanke’s predecessor, Alan Greenspan, stated in public on more than one occasion
that bubbles are difficult if not impossible to identify, a convenient excuse for a man who
presided over and nurtured two of the greatest bubbles in U.S. history. The evidence
suggests otherwise and the stock market and housing bubbles spawned by the Federal
Reserve were not only easy to spot, but difficult to miss even to the untrained eye. Even
worse, this particular fan of efficient market theory, though only when prices are rising,
stated on prime-time television in the summer that, “if the stock market continues higher,
it will do more to stimulate the economy than any other measure we have discussed
here.”
Greenspan’s words make clear that he was a serial bubble-blower and has no concept of
the damage his actions while head of the Federal Reserve, inflicted upon the U.S.
economy. After all, the stock market euphoria during the latter half of the 1990s saw
valuations soar to levels unprecedented in all of American financial history and at their
peak in the spring of 2000 equities offered an inferior long-term real return than that
available on risk-free Treasury inflation-protected securities. His predecessor, Paul
Volcker observed the exuberance and declared that “The fate of the world economy is
now totally dependent….on about 50 stocks, half of which have never reported any
earnings.”
Needless to say, the technology bubble sowed the seeds of its own demise and imploded
as the lower cost of funds reflected in surging stock prices attracted competition like bees
to honey. Greenspan, who bought into this ‘new era’, claimed that the tools available to
the Fed could not have prevented the mania. However, the same man observed in 1996
that “if you want to get rid of the bubble” increasing the requirements on margin debt
“will do it.” He never did raise margin requirements and as the market neared its peak,
margin debt relative to GDP soared to the highest level since 1929.
The recession that inevitably followed betrayed Greenspan’s brave new world but he
blamed 9/11 for the economy’s continuing malaise in early-2002. He lowered interest
rates aggressively and held them almost four percentage points below that prescribed by
the respected Taylor rule for almost a year. Real interest rates were below the rate of
inflation for two and a half years but the former Fed Chairman demonstrated no concern
in the face of rising home prices and explained that real estate “was especially ill-suited
to develop into a bubble.”
The potential threat to financial stability was dismissed as Greenspan marvelled at his
achievements and observed that “New financial products – including derivatives, asset-
backed securities, collateralised loan obligations, and collateralised mortgage
obligations….have contributed to the development of a more flexible and efficient
financial system.”
Greenspan’s asymmetric policy – ease quickly, tighten slowly – precipitated a nation’s
love-affair with bricks-and-mortar that saw the ratio of median house prices to median
income jump to three standard deviations above the historic norm. His belief that
bubbles are undetectable in advance and the notion that housing is not well-suited to
irrational exuberance on a national scale, proved to be extraordinarily incompetent and a
massive disservice to the American people.
Unfortunately, Ben Bernanke is proving little different than his predecessor. Artificially
inflating stock prices simply won’t work without a proportional increase in long-term
cash flows or a commensurate reduction in risk premiums. Hoping that consumers will
bring consumption forward via increased borrowing that is premised on illusory gains in
wealth is ludicrous.
An increase in security prices arising from the Fed’s asset purchases lowers expected
returns and capital losses could ultimately be the result, should fundamentals fail to
justify the higher valuations. America’s monetary authority is playing a dangerous game
and its credibility is waning fast.
www.charliefell.com

The views expressed are expressions of opinion only and should not be construed as
investment advice.
© Copyright 2010 Sequoia Markets