Ambrose Evans-Pritchard: Greenspan was more rock star than feared sage

By Ambrose Evans-Pritchard
The Telegraph, London
Monday, September 17, 2007

http://www.telegraph.co.uk/money/main.jhtml?xml=/money/2007/09/17/ccview...

We forget now, but Alan Greenspan rose in Washington as a political aide to Richard Nixon -- not as an economist.

As domestic policy boss for Nixon's 1968 campaign, he wrote the speech calling for an end to the Vietnam draft -- the mischievous pledge that clinched a tight race.

His mentor was Arthur Burns, the Fed chief who flooded the money supply to re-elect Nixon in 1972 and fathered the Great Inflation.

When Greenspan took over the Fed in 1987 critics doubted whether anybody coming from this stable would resist the inevitable demands for easy money from Washington and Wall Street, once push came to shove.

Twenty years on their misgivings have proved justified, although not in quite the way they expected. Retail inflation has remained tame, thanks to cheap imports from China. Asset inflation has not. This virus is just as deadly.

As in the US in the 1920s and Japan in the 1980s, loose money has leaked into stocks, property, and lately into every kind of exotica, from commodity funds to Argentine bonds. It is on a global scale this time, with greater debt leverage.

Greenspan knows the risks, since he blamed the Fed for the Great Depression in his 1966 pamphlet "Gold and Economic Freedom."

"The excess credit which the Fed pumped into the economy spilled over into the stock market, triggering a fantastic speculative boom. Belatedly, Federal Reserve officials attempted to sop up the excess reserves and finally succeeded in breaking the boom. But it was too late. By 1929 the speculative imbalances had become overwhelming," he wrote.

He has since changed his tune, arguing that the Fed's job is to clean up after the party -- as he did by slashing rates to mitigate the dot-com debacle. "The human race has never found a way to confront bubbles," he now says.

Really? This is not a view shared by central banks in Europe or (now) Japan. Nor is it remotely compelling.

Greenspan talks as if the Fed were a bystander. In reality the bank itself caused America's serial bubbles, and its debt addiction. By holding rates too low for too long, it mispriced credit and warped behaviour.

Exhibit I: Rates were 1 percent until June 2004. By then growth was 4 percent and the Dow had surged 40 percent in 15 months.

"It was our job to unfreeze the American banking system if we wanted the economy to function. This required that we keep rates modestly low," he said.

Modestly low? For much of the stretch from 2002 to early 2006, "real" rates were negative -- below inflation. You were punished for not taking on debt.

Greenspan now admits that he was caught off-guard by the subprime madness that ensued. "While I was aware a lot of these practices were going on, I really didn't get it until very late in 2005 and 2006," he said.

Exhibit II: The Fed cut rates a third time to 4.75 percent at the end of the Russia/LTCM crisis in 1998, just to be sure. By then Wall Street was roaring back. Growth would reach 6.2 percent that quarter. "It may have been a mistake," dead-panned Alice Rivlin, then the Fed's vice-chair.

Greenspan allowed bubbles to run their course but was always quick to put a floor under asset prices, a reflex dubbed the "Greenspan put." He never allowed a liquidation purge to flush out the toxins. The day of pain was put off ever longer, and prosperity robbed ever more from the future.

The result of this asymmetry -- and moral hazard -- is a country living far beyond its means. America switched under his watch from top world creditor to top debtor, with net external liabilities of $3,000 billion. The savings rate has fallen below zero for the first time since the Depression.

No doubt Greenspan had an uncanny instinct for catching tops and bottoms in the cycle. This was his party trick as partner of the New York forecasting firm Townsend-Greenspan, where he crunched data in one of the first computers on Wall Street.

The Fed transcripts from November 2000 offer a glimpse of his skill. While fellow governors fretted about inflation, he sensed that the economy had begun to nosedive. He rubbished the Fed's "linear" staff model, deeming it useless at the onset of recessions -- always non-linear -- that is, a surprise. Within weeks he was proved right. The Fed slashed rates at an emergency session.

A tactical maestro, yes. But wise? That the Fed should even try to micro-time the cycle -- a speculators' game -- shows how far the institution has lost its way. It takes a year or two for monetary policy to percolate, and no banker can see that far ahead.

Is it really sensible for the Fed to cut rates to 1 percent, then yank them up again 17 times to 5.25 percent in a frantic effort to undo the effects of its own policies, lurching from over-stimulus to overkill? Surely it should hold a steadier course and attend to deeper matters.

Greenspan has his alibi for the latest bubbles: Asia's "savings glut." The vast reserves of China, Japan, Korea, et al. have flooded the capital markets, driving down the cost of credit.

But this is the flip side of America's disorder. If the US had not run a current account deficit of 6.5 percent of GDP for year after year, and if the Fed not smiled so benignly on America's shopping malls, Asia would not have accumulated these reserves.

A central banker should be feared, like a judge. Greenspan was too eager to please. By the end he had become a rock star, so enthralled by media attention that he was unwilling to retire quietly and leave his successor in peace.

America will probably work off this legacy of debt, deficit, and tumbling house prices -- with a salutary stint of hard labour, or "sub-trend" growth, in the argot.

But there is a school of thought that Greenspan has made such a hash of capitalism that it will take a strong dose of socialism to contain the consequences. For an apostle of Ayn Rand's ultra-libertarian creed, that is the cruellest charge.

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