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Generational Dynamics Web Log for 30-Aug-05
Departing Fed Chairman Alan Greenspan sings schizophrenic swan song

Web Log - August, 2005

Departing Fed Chairman Alan Greenspan sings schizophrenic swan song

Is the economy strong or is it in danger? Greenspan played both sides in a speech on Friday and another speech on Saturday. The two speeches were given to central bankers, and are likely to be Greenspan's last before he steps down as Fed Chairman in January.

Ever since February of this year, when repudiated and reversed his thinking of ten years, and later said that global interest rates are a "conundrum," Greenspan's speeches have been, at best, ambiguous, and the two swan song speeches he gave this weekend are the same.

Actually, Greenspan's analysis was very interesting in the way he tied together his view that the economy is doing well with his warnings about the future.

His argument about the strength of the economy is based in its flexibility. He's made this argument in previous statements, when he particularly praised hedge funds for acting as a kind of safety valve.

In Friday's speech, he said:

"The more flexible an economy, the greater its ability to self-correct in response to inevitable, often unanticipated, disturbances. That process of correction limits the size and the consequences of cyclical imbalances. Enhanced flexibility provides the advantage of allowing the economy to adjust automatically, reducing the reliance on the actions of monetary and other policymakers, which have often come too late or been misguided.

In fact, the performance of the U.S. economy in recent years, despite shocks that in the past would have surely produced marked economic contraction, offers the clearest evidence that we have benefited from an enhanced resilience and flexibility."

Now, here's how he turned his positive message into a warning. He said that stock values (asset values) and real estate home values have increased beyond their historic values.

He blamed these increases on the very same flexibility in the economy that he just said was valuable:

"Thus, this vast increase in the market value of asset claims is in part the indirect result of investors accepting lower compensation for risk. Such an increase in market value is too often viewed by market participants as structural and permanent. To some extent, those higher values may be reflecting the increased flexibility and resilience of our economy. But what they perceive as newly abundant liquidity can readily disappear. Any onset of increased investor caution elevates risk premiums and, as a consequence, lowers asset values and promotes the liquidation of the debt that supported higher asset prices. This is the reason that history has not dealt kindly with the aftermath of protracted periods of low risk premiums."

In other words, investors have been taking advantage of the economy's flexibility by investing too much, and creating a bubble in both stocks and real estate.

This paragraph ends with an extremely harsh warning: he says that the bubble will burst, and when it does, it will be painful.

Regular readers of this web site know that I've blown hot and cold on whether I believe that Greenspan knows what's going to happen, especially since his dramatic reversal last February. Logically he should: He was born in 1926, he grew up during the Great Depression of the 1930s, and he can't help but recognize that disaster is in the air because he's seen it before -- unlike younger investors and analysts who are too young to have any idea what's happening.

This speech seems to do what he has to do. He can't explicitly say the stock bubble will burst without being blamed for causing a panic, but he can give a warning that will be ignored, so that he can say "I told you so" later.

I would feel more confident of his views if it weren't for the following paragraph from his speech:

"We weathered a decline on October 19, 1987 of a fifth of the market value of U.S. equities with little evidence of subsequent macroeconomic stress--an episode that provided an early hint that adjustment dynamics might be changing. The credit crunch of the early 1990s and the bursting of the stock market bubble in 2000 were absorbed with the shallowest recessions in the post-World War II period. And the economic fallout from the tragic events of September 11, 2001, was limited by market forces, with severe economic weakness evident for only a few weeks. Most recently, the flexibility of our market-driven economy has allowed us, thus far, to weather reasonably well the steep rise in spot and futures prices for crude oil and natural gas that we have experienced over the past two years."

These are his examples of how the flexibility of the American economy but unfortunately they don't make sense.

Wall Street Historical Price/earnings ratio for S&P 500

Wall Street Historical Price/earnings ratio for S&P 500

He says that the flexibility of the US economy allowed all these good things to happen. There was a mild stock market panic in 1987, and the economy recovered without too much pain, but as the adjacent graph shows, the S&P 500 average price/earnings ratio was rising but was at a historic average, around 14-15. Stocks were already priced low enough, relative to earnings, so that they could recover quickly.

That's not true today. Price/earning ratios are much higher, and stocks are way overpriced, as Greenspan himself pointed out in the paragraphs above. A panic today would have much farther to fall than in 1987. (30-Aug-05) Permanent Link
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Generational Dynamics Web Log for 30-Aug-05 Departing Fed Chairman Alan Greenspan sings schizophrenic swan song

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Generational Dynamics Web Log for 30-Aug-05
Departing Fed Chairman Alan Greenspan sings schizophrenic swan song