Wednesday, December 12, 2007

Greenspan's Theory on the Bursting Bubbles

Former Fed Chairman, Alan Greenspan, gives his take on the bursting of the housing bubble in this WSJ article. The popped bubble, he contends, is much less a result of domestic policies than of a major shift in how domestic economies interface with the global economy. With the clarity hindsight provides, Greenspan admits that some of his assumptions that governed his actions as Fed Chairman were faulty.

During his long tenure at the Fed, Greenspan’s lack of clarity was one of his hallmarks. While he is uncharacteristically clear in the WSJ article, he still muddles around and more or less says that his view amounts to an educated guess.

Following the collapse of communism, Greenspan contends, capitalistic fervor produced dramatic gains in real GDP in many developing nations. But newly monied people in these societies still had inadequate outlets for spending, so they saved and invested. With a larger supply of investment money, the cost of risk became “underpriced.” This fueled “market euphoria” throughout the world. Greenspan writes:

“The crisis was thus an accident waiting to happen. If it had not been triggered by the mispricing of securitized subprime mortgages, it would have been produced by eruptions in some other market. As I have noted elsewhere, history has not dealt kindly with protracted periods of low risk premiums.”

Greenspan says that based on his many years of experience, he has “reluctantly concluded that bubbles cannot be safely defused by monetary policy or other policy initiatives before the speculative fever breaks on its own.” That is, central banks and governments are largely powerless to halt price bubble situations. Greenspan doesn’t discuss whether central banks and governments can or ought to play a role in trying to provide a soft landing when a price bubble does burst.

In his article, Greenspan resigns himself to the fact that central banks and governments have far less control over their economies than used to be the case. He writes, “More generally, global forces, combined with lower international trade barriers, have diminished the scope of national governments to affect the paths of their economies.”

Mainly, it appears that the pricing of long-term debt instruments has shifted to the global economy. While that shift has been underway for decades, it appears that the scales finally tipped only recently. But this was not immediately clear, so the Fed continued making decisions based on the way things used to be. Central banks, Greenspan seems happy to report, still substantially control short-term debt instruments, which allows them to contain inflationary pressures.

So, following the collapse of communism, there was a lot of economic growth worldwide due to implementation of capitalism where it had previously been suppressed. This temporarily caused an over abundance of investment capital, which decreased the cost of risk, since investment money was easier to get. Markets throughout the world responded by engaging in more speculative behavior, since the immediate cost of such behavior was cheaper than it had been. But eventually, markets caught up. Monied people in developing areas began to have opportunities to use their money more efficiently than in low-return investments. So the cost of risk adjusted to a more appropriate value. Speculative activities suddenly became more expensive, causing a rapid decline in these activities. The bubble burst. The highly speculative subprime mortgage industry happened to draw the short straw, so it took the brunt of the pain from the adjustment of the cost of risk. At least, that’s what I understand Greenspan to be saying.

Central banks have lost a significant portion of their power. Long-term instruments are now naturally priced according to market signals and pressures. That is a good thing. No group of people, no matter how intelligent and experienced they may be, can possibly hope to manage pricing as well as a broad-based self-organizing market. Can the day be far distant when central banks can no longer effectively control short-term instruments so that they too are pegged to market forces?

F.A. Hayek argued “that the market economy might well be better able to develop its potentialities if government monopoly of money were abolished” (The Fatal Conceit, p. 104). While we are used to our current monetary system, it is not necessarily a good system. Many would argue that the Fed causes more problems than it’s worth. Hayek asserts, “The history of government management of money has, except for a few short happy periods, been one of incessant fraud and deception. In this respect, governments have proved far more immoral than any private agency supplying distinct kinds of money in competition possibly could have been” (pp. 103-104).

At any rate, it seems that pricing bubbles are uncontrollable. The only way for them to stop is for them to burst of their own accord, which necessarily results in pain. People managing money policy are powerless to do anything about this. They can sit in their mahogany paneled conference rooms and issue mystical edicts on short-term interest rates. But they ultimately cannot control the market.

No comments: