Ever deeper in debt: a case of fiscal madness.

Greenspan's Bubbles

The Age of Ignorance at the Federal Reserve

By William A Fleckenstein with Frederick Sheehan

[pounds sterling]12 McGraw Hill

ISBN: 978-0-07-159158-1

Alan Greenspan has, in equal measure, been lauded and lambasted; and make no mistake, this short book falls most definitely into the latter category. It is unfailingly critical of Greenspan's near two-decade reign between 1987 and 2006 as chairman of the US Federal Reserve (the Fed) and his record in overseeing the world's largest economy.

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For his faithful adherents, Greenspan ushered in an era of unparalleled prosperity. But his detractors argue that his decisions--and indecisions--have led to a near decimation of the world's largest financial system.

Looking at Greenspan's early record, Fleckenstein and Sheehan begin this book by examining a misplaced faith, if not a fixation, with US productivity. As the authors remind us, quoting George Santayana from The Life of Reason, "Those who cannot remember the past are condemned to repeat it".

It was not the old school type of industrial productivity that held Greenspan in thrall, with US factories and assembly lines creating more and more goods, employment and wealth--rather, it was technological productivity, a strangely abstract type of productivity that apparently (according to Greenspan) began in July 1995 and led to what this book describes as the biggest stock market bubble the US has ever experienced.

What is the definition of a stock market bubble? The book quotes John Makin of the American Enterprise Institute's neat explanation--it is "when the value of stocks has more impact on the economy than the economy has on the value of stocks".

Just his imagination?

"A rational person might ask 'what on earth caused Greenspan to shift from self-proclaimed bubble-fighter to bubble-blower in such a short time?" the authors muse. "One answer might be his imagination," they speculate.

For if we are to question the actions of Greenspan on a purely rational basis, it would appear that he as the Fed chairman, acted in direct contradiction to what that institution defines as the three primary responsibilities of its chairman.

These responsibilities are, we learn from the Fed's own website, to conduct the nation's monetary policy by influencing money and credit conditions in the economy in pursuit of full employment and stable prices; to supervise and regulate banking institutions to ensure the safety and soundness of the nation's banking and financial system while protecting the credit rights of consumers and; to maintain the stability of the financial system and contain systemic risk that might arise in financial markets.

But Greenspan failed to meet all three of these responsibilities, continually displayed poor judgement, suffering selective amnesia and exhibiting what might be called a denial syndrome when called to account. Instead, he seemed to make decisions based on the central objective of not allowing any significant fall in the value of the US stock markets. The instrument he used to meet this objective was cutting interest rates, thereby easing the money supply. This, it is argued, was the prime cause of the resulting stock market bubble.

As Fleckenstein and Sheehan comment, bubbles are rare. They cite the Dutch tulip bulb bubble as the earliest case, when at the height of the speculation frenzy a single coveted bulb could change hands at six times the yearly average income in Holland!

"As the Dutch tulip mania illustrates," the authors comment, "sometimes when the market conditions are just right, the madness of the crowd takes over and bizarre results follow." They further add: "When the right economic conditions meet an aggressive central bank with a proclivity to print money [the consequence of loosening the money supply by dropping interest rates] a truly large and ultimately destructive bubble will result." This is what happened in the great stock market crash of 1929 that preceded the Great Depression.

Almost plaintively, the authors ask what the nature of Greenspan's thinking was. Their conclusion: He was infatuated with the concept of productivity, so much so that he even adopted one of the most bizarre economic theories to justify his breezy optimism.

The theory was called 'helonistic adjustment'. This theory was applied to the way that inflation was calculated. Inflation has a clear correlation with interest rates; the lower the rates, the easier the money supply and the greater inflationary pressure. But not if you apply helonistic adjustment because then, if a products price rises but improves in quality, then the 'adjustment' would need to be applied--reducing the price by an amount that captured the (entirely subjective) value of how much the product had been improved.

Fleckenstein and Sheehan illustrate how helonistic adjustment can be so distorting by analysing what US business spent on computers. In 1998, that spend amounted to $95.1bn but after helonistic adjustment 'hey presto', "it was as though business had spent $351.8bn on computers". By itself, Fleckenstein and Sheehan calculate, that adjustment distorted the government's own budgetary calculations by adding 2% to its GDP figure.

The US Commerce Department dropped helonistic adjustments for computers in 2003 but not before this absurdity impacted social security payments for America's poorest, anyone receiving cost-of-living adjustments or holding inflation-indexed pensions. Everyone was affected indirectly, "by the distortions created in the economic data, which led to, or reinforced, many erroneous decisions made by Greenspan and others".

Meanwhile, the US stock markets soared and in March 1997 Greenspan felt able to report to the Federal Open Market Committee (the FOMC, the body that has oversight on the chairman's performance) that "the reason why manufacturers in particular and business people more generally have the view that inflation is dead and the economy is in a new era is that is the way it feels to them ... having said all that, we are not at this stage moving into what I would describe as an overheated boom. We are short of that".

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The following year, Jerry Jordan from the Cleveland Fed explained the situation to the FOMC in this way: "[Everyone is commenting] that there is no risk that the stock market will go down because if it started down, the Fed would ease policy [i.e. cut rates and print money] to prop it back up."

A dot.com boom

It was this underlying sentiment that fed the speculative bubble that was the 'dot.com boom'. According to Greg Kyle's book The 100 Best Internet Stocks to Own, quoted by Fleckenstein and Sheehan, the 1999 Initial Public Offering market "was on fire". Kyle gives the following figures as the average first-day gains for companies going public: "January +271%, February +145%; March 146%; April 147% ..."

But as Fleckenstein and Sheehan point out: "Many of the companies enjoying these first day gains were companies in name only; in fact, often they were no more than lavish compensation schemes for their promoters.

"Most had little in the way of any operating record. Quite often they had never sold a thing, and not infrequently they neither had a product to sell nor were a real business."

Greenspan's predecessor as Fed chairman, Paul Volker, did sound a warning saying "the fate of the world's economy is now totally dependent on the growth of the US economy, which is dependent on the stock market whose growth is dependent on about 50 stocks, half of which have never reported any earning".

But Volker's words of caution were lost beneath the roar of a thundering herd of bulls that were stampeding into a stock market frenzy. The US stock market was valued at 180% of the country's GDP, over 100% higher than the 85% of GDP it reached in 1929. Little wonder, many less than sophisticated would-be investors saw the stock market as a one way bet and piled in adding day-after-day to the speculative frenzy.

By August 1999, the Nasdaq (the US technology stock market) had doubled from its October 1998 low and, adding to this heady mix, the Fed, as this book describes it, "force-fed the banking system with mountains of money as it fretted over the chaos that the Y2K transition might cause". In the event, computer clocks were able to handle the transition to the new millennium.

The 9/11 get-out

The new millennium saw stocks again race higher, but inevitably, the dot.com bubble burst. By 10 September 2001 (i.e. the day before the 9/11 terrorist attacks) the Nasdaq had declined by more than a third over the year. It led Sir John Templeton, the billionaire investor and philanthropist who pioneered the use of globally diversified mutual funds, to comment in October 2001 that what happened with technology stocks in the previous 18 months was "the greatest financial insanity to ever enter any nation".

The 2002 Nasdaq fall was a further 32%--from its peak in 2000 dropping by 74%. Predictably, Greenspan was in denial over any responsibility for this; he could and did blame 9/11 even though many commentators were unconvinced with this explanation. And he had another trick up his sleeve--use your house, he seemed to urge the US consumer, as an ATM!

And the US consumer listened and responded by mortgaging and re-mortgaging while Wall Street busied itself in sub-prime lending, creating collateralised mortgage obligations, asset-backed securities and other complex and exotic derivative financial instruments. These were the building blocks of the sub-prime housing crisis of 2007 that is still creating turmoil in the world's financial markets.

In effect, this book argues that Greenspan bailed out the world's largest equity bubble with the world's largest real-estate bubble.

This book is written by Americans for Americans and does not really touch on the implications for emerging markets or frontier economies such as Africa of what it calls Greenspan's "Operation Enduring Bubble". But the US continues to be the world's largest economy and the dollar the denominator for most of the world's major commodities--including oil.

Even with the growing importance of the Brics, the US remains an important market for many of Africa's commodity exports, and a recession or even depression experienced in the US has serious implications for Africa's economies. The US dollar's plunging value, and oil's soaring cost, are ringing alarm bells.

Even China's economy, fashionably in vogue as representing Africa's saviour, depends to an appreciable extent on US corporations outsourcing production to the country. Without US consumer demand, which would slump in a recession, China's economic growth will inevitably falter.

The lesson that this book teaches is clear: "The financial world Greenspan left behind will be a treacherous one to navigate that will leave many wounded in its wake ... the evidence speaks for itself." We cannot say we have not been warned.