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Generational Dynamics Web Log for 8-Aug-07
Alan Greenspan defends his Fed policies, as people blame him for the subprime crisis

Web Log - August, 2007

Alan Greenspan defends his Fed policies, as people blame him for the subprime crisis

Greenspan never ceases to amaze, and he did so again on Monday.

Let's recall:

Greenspan was Fed Chairman from 1987 to 2005.

When the dot-com bubble began in the late 1990s, he decided to "allow" the bubble to occur.

Instead, he would deal with its aftermath by setting interest rates to near-zero when the bubble was bursting.

That was, in fact, the Fed policy after 2000, and the Fed reduced interest rates 12 times by June, 2003. That was the policy that Greenspan believed would have worked in 1929, to prevent the Great Depression of the 1930s. His successor, Ben Bernanke, believes the same thing.

In recent months, many people are blaming Greenspan's near-zero interest rate policy as the cause of the housing bubble (which is true).

You may recall that last October tried to blame the housing bubble on the fall of the Berlin Wall. (The fall of the Berlin wall led to globalization, which led to low interest rates, which led to the housing bubble. That explanation was really an act of desperation.)

Greenspan must be getting very worried, for he's now giving a new explanation in a Monday interview with the Wall Street Journal.

He now says that his interest rate cuts can't be the cause of the housing bubble, because the housing bubble got worse after interest rates were increased again. He concurs with Ben Bernanke that the REAL cause of the credit bubble and the housing bubble are the fact that other countries are saving too much -- i.e., there's a "global savings glut."

I can only roll my eyes in disbelief at this. I used to think that Greenspan had more sense than Bernanke, but I guess they're really both the same. To blame America's credit binge on other countries' savings is, well, presumptuous, to say the least.

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From the point of view of Generational Dynamics, the reason for the credit binge is completely obvious although, as usual, these "experts" seem totally blind to a generational explanation, no matter how obvious it is. The credit binge came about when the risk-averse generations of people who survived the 1930s Great Depression all disappeared (retired or died), all at once, leaving behind people born after the Great Depression, with no personal memory of its horrors. The 1930s Great Depression occurred because of a similar credit binge in the 1920s, which occurred when the survivors of the Panic of 1857 all disappeared, all at once. To say, as Greenspan and Bernanke do, that the Great Depression could have been avoided by a simple policy change of near-zero interest rates is completely absurd.

And now we've seen it. Greenspan put into effect precisely the plan that was supposed to have been able to prevent the 1930s Great Depression, and it produced the housing bubble and the credit bubble and the stock market bubble.

According to Greenspan, they feared that the country would have negative inflation, or deflation, and that was because of what had happened to Japan in the 1990s.

OK, here's what happened in Japan, a brief summary of what I wrote about Japan in February. Japan had a huge real estate and Tokyo Stock Exchange (TSE) bubble in the 1980s, and the bubble burst in 1990, and prices have been falling until very recently. (It may be surprising that prices fell for about 15 years, but that's what happens when a bubble bursts, if it took many years for the bubble to expand.)

Now, it turns out that the TSE had a previous major stock market crash in 1919. Then, 65 years later, the next stock market bubble began in 1984. This parallels Wall Street: Crash in 1929, new bubble in 1995, 66 years later; Tokyo Stock Exchange: Crash in 1919, new bubble in 1984, 65 years later.

Once again, you can see Generational Dynamics in action. A new bubble occurs as soon the generation of people who lived through the last crash are gone. I've said many times on this web site that analysts, journalists, and pundits are totally blind to even the simplest generational relationships, no matter how obvious they are.

So anyway, according to the new WSJ article, Greenspan used to believe that deflation was impossible with paper currency, since the government could simply print money until it created inflation. But Japan in the 1990s proved that view wrong.

So that's why Greenspan felt it necessary to keep interests close to zero in the early 2000s -- because he feared deflation.

According to Greenspan, "We decided that in 2003 that though we judged the probability of severe deflation as small, were it to happen, its consequences were seen as devastating. So we chose to take out insurance against them, fully recognizing at the time that we were taking risks in the process. But central banks cannot avoid taking risks. Such tradeoffs are an integral part of policy. We were always confronted with choices."

However, the near-zero interest rates had unintended consequences, as he said at the time: "I don't know what it is, but we're doing some damage because this is not the way credit markets should operate."

From the point of view of Generational Dynamics, the credit markets were acting strangely because the generations of post-Depression babies were now completely in charge, and had no fear of credit. It was simply a change from a risk-averse generation to a no-fear-of-risk generation. But these people are completely oblivious to these simple explanations.

Greenspan and the Fed decided that the credit bubble was OK because of the innovation of credit derivatives, which permit large financial institutions to make "bets" on whether interest rates are going to go up or down. Greenspan believed that this removed any risk in the economy away from the ordinary investor, and concentrated the risk in large institutions that could afford it.

Instead, the new risk-seeking generations of investors found ways around the rules, and essentially bet every penny they had on these credit derivatives, especially the collateralized debt obligations (CDOs). There are now tens or hundreds of trillions of dollars worth of the CDOs in the portfolios of mutual funds, investment trusts, hedge funds, savings banks, pension funds, college endowments, money market funds, insurance companies, and so forth, so everyone is at risk, not just large financial institutions.

But here's how Greenspan sees it:

"History tells us it�s far better to have people periodically going to excess with its adverse consequences than to try to block it off in the beginning. These adverse periods are very painful but they�re inevitable if we choose to maintain a system in which people are free to take risks, a necessary condition for maximum sustainable economic growth. We have learned to move risk from the leveraged institutions which are the major lenders in this country to those far more capable of absorbing loss. It�s why our economy in recent years has developed the flexibility to absorb severe adjustments."

What does he mean by this???? What history is he talking about?

In my article last year on "System Dynamics and and the Failure of Macroeconomics Theory," I described a pivotal moment in Greenspan's history:

"Another difficult period occurred in 1994 when inflation began to increase, along with bond yields (interest rates). Alan Greenspan and the Fed took a very tough stand and tightened the money supply, stopping inflation in its tracks, but also causing bond yields to crash. This caught a number of investors by surprise. Remember when Orange County, California, went bankrupt? They blame Greenspan for that."

So that's why Greenspan decided not to deal with the dot-com bubble in the 1990s, but to deal with it later by lowering interest rates to zero.

You know, Dear Reader, It's hard to believe all this. Could it be possible that Greenspan really believes all the blithering nonsense he talks about? I can understand the Wall Street Journal reporter, Greg Ip, and his journalist colleagues not having the vaguest idea what's going on, and I've always known that Bernanke held many airhead views, but I always thought that Greenspan had a little more sense. I guess he doesn't. How could everyone be so oblivious?

Well, let me make a couple of closing points here.

Greenspan used to think that deflation was impossible, but Japan's 1990s experience proved him wrong.
I frequently make the point that mainstream macroeconomics has failed to predict or explain anything since the 1990s, and this shows it as well as any. Why did Greenspan think that deflation was impossible?

Then, in 2003, Greenspan attacked deflation by setting interest rates to zero, flooding the markets with money. Sure enough, all the money created several bubbles -- a housing bubble, a credit bubble, a stock market bubble.
But Bernanke and Greenspan evidently don't believe in bubbles. Do they even know that Japan was in a big bubble in the 1980s, leading to the bubble bursting and deflation in the 1990s? Do they even connect those two events?
Apparently not. They treat deflation as the CAUSE of the problem, rather than a SYMPTOM of the problem, with the result that they've made the bubbles much bigger, and the problems much worse.
And once again, they didn't anticipate that, since mainstream macroeconomics does predict or explain anything.

From the point of view of Generational Dynamics, the "adverse consequences" we're headed for is a new 1930s-style Great Depression.

What Alan Greenspan has done is to take responsibility for the "adverse consequences," leaving no ambiguity whatsoever. Even though he's 80 years old, he may well live to regret doing that. (8-Aug-07) Permanent Link
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Generational Dynamics Web Log for 8-Aug-07 Alan Greenspan defends his Fed policies, as people blame him for the subprime crisis

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Generational Dynamics Web Log for 8-Aug-07
Alan Greenspan defends his Fed policies, as people blame him for the subprime crisis