US Fed: Greenspan out, Bernanke in!
Source: Equitymaster.com
The last week (ended February 4) marked the exit of Alan Greenspan as the 'first banker' of the world in his 19-year stint as the thirteenth US Federal Reserve Chairman. On Wednesday, Ben Bernanke was sworn in as the fourteenth Fed Chairman. This change at the top has raised many a questions regarding the continuance of the current monetary policy stance of the US Fed, which has in fact guided other central banks' policies. However, to leave this matter for discussion later in the future, we shall hereby pay our tribute to the role that Greenspan has played so perfectly in his 'long' term at the top of central banking.
Under the stewardship of Dr. Greenspan, the US (and the world) has survived many crashes. The crash of 1987, the Asian crisis of 1998, the bursting of the stock market bubble in 2000-2001 were all shocks that might have had far worse consequences for the global financial sector and the world economy, were it not for appropriate intervention by monetary authorities (especially, the Fed).
The term 'irrational exuberance' became Greenspan's most famous quote, out of all the millions of words he has uttered publicly. This term is often used to describe a heightened state of speculative fervor in global financial markets (as was witnessed in the 2000-01 dotcom boom). Greenspan had used this term in a speech before the American Enterprise Institute in December 1996, where he posed a question to the world central bankers - "But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade?" He added that "We as central bankers need not be concerned if a collapsing financial asset bubble does not threaten to impair the real economy, its production, jobs and price stability."
Well! Immediately after he had uttered these words, the stock market in Tokyo fell sharply and closed down 3%. Hong Kong fell 3%. Frankfurt and London fell 4%. And the US fell 2% at the open of trade. The strong reaction of the markets to Greenspan's seemingly harmless question was widely noted, and made the term irrational exuberance famous.
However, the subsequent tightening (interest rate hikes) that followed Greenspan's speech was aimed not only at the asset bubble itself, but at the impacts such excessive appreciation in equity markets were having on the real economy. As the noted economist, Stephen Roach from Morgan Stanley quipped, "It was a classic example of the Fed playing the role of the tough guy - the central bank that takes away the punchbowl just when the party is getting good." Unfortunately, the tough guys weren't so tough after all.
As the Fed took aim on the US markets by tightening its monetary policy, there was opposition from Washington's political circles. And ironically, and depressingly for the world economy, the Fed ran for cover in the face of political criticism instead of standing by its stance in its role as an independent central bank. And as Stephen Roach adds, "Not only were its initial bubble-containment efforts put aside, but Alan Greenspan went on to champion the notion of a sea-change in the macro climate - a once-in-a-century productivity miracle that would justify the stock market's exuberance as rational. That was the Original Sin that has since been compounded in the years that have followed."
The asset-based spending model has, since then, given rise to a number of imbalances that the world is witnessing now. The US has piled up a huge current account deficit (to the tune of around 6% of their GDP). Now, despite such a strong consuming demand for credit, interest rates in the US have been lying low and the real interest rates (adjusted for inflation) have remained negative. There are two key reasons for the continued strong consumption demand from US consumers. One, they are buying at negative interest rates and investing in emerging market equities that provide them with higher return than the much safer US treasury bills and bonds. Two, to counter risks of currency appreciation due to high dollar inflows, the foreign exchange reserves that these emerging nations have built up are re-invested in US debt thus adding to the liquidity in the US money markets, which consequently results in interest rates remaining low. This has turned out to be vicious circle and has caused the current imbalance in global money and currency markets.
Greenspan had, recently, confessed that some of these imbalances have been a consequence of the extensive liberal policies of the Fed with respect to interest rates in the past few years. in the recently held 'Advancing Enterprise 2005 Conference' in London, Greenspan had owned up that the fall in US interest rates since the early 1990s has supported both home price increases (the asset bubble as it is termed) and, in recent years, an unprecedented rate of existing 'home turnover'.
These decisions aside, we believe that Dr. Greenspan has done a remarkable job for the US economy over these long years of his stay at the top. While his rate cuts of early part of this decade have led to the current imbalances (developing countries with their export based dependency model are also to be blamed), he has been an excellent crisis manager. His legend was largely built, in fact, on guiding the Fed's quick and reassuring action in the wake of the 1987 stock-market crash, the 1998 crises in Asia and Russia, the 9/11 terrorist attacks on the US and more. He has indeed done a good job! And with his going, an era has come to an end.
