Greenspan Speaks

There comes a time when, however alluring is the limelight, and however strong your thrust for action, you’d better opt for a graceful exit.

The exit of former Fed Chairman Alan Greenspan has been anything but graceful, made all the more frustrating by his stern refusal to leave.

Greenspan’s latest foray into the stage comes in the form of an op-ed piece in the Financial Times last week, which is so full of blunders that I’m embarrassed on behalf of the FT for publishing it without first doing even a Wikipedia check.

Worse… Greenspan’s thesis reveals either a mind that (for all its former greatness) can no longer think; or an ex-Fed Chairman who so misunderstood how the financial system works that it’s no wonder at all that we got into this mess!

So the first blunder comes early on when Greenspan talks about what he sees as a virtuous circle of rising stock markets, leading to improved credit conditions, higher lending and the resumption of economic activity… which in turn supports higher stock prices and so on.

While the idea that improved confidence can generate a virtuous circle has merits, what is questionable is Greenspan’s road to get there: The “newly created equity” in banks’ balance sheets as the prices of banks’ stocks go up.

Well that’s plain wrong. Regulatory capital, which is what matters for a bank’s ability to increase its lending, is not marked to market but at the price paid up originally to purchase equity in a bank. (Regulatory capital also includes other stuff, like retained earnings, which again are not marked to market but at the price when they were booked).

In other words, the increase in stock prices does NOT provide a “capital buffer that supports the debt issued by financial and non-financial companies” and does NOT “supply banks with the new capital that would allow them to step up lending.”

If there is one way higher stock prices help is if banks actually see it as an opportunity to raise new capital and expand their operations. Indeed, some banks have done so recently, but the main motivation was their urge to pay back the TARP money and rid themselves of the government’s watch. So new private capital replaced old government capital, without a meaningful improvement in banks’ ability to lend.

The Maestro goes on… “the rising market value of existing corporate assets (proxied by stock prices) relative to their replacement cost would spur new capital investment. […] A prolonged recovery in global equity prices would thus assist in the lifting of the deflationary forces that still hover over the global economy. I recognize that I accord a much larger economic role to equity prices than is the conventional wisdom. From my perspective, they are not merely an important leading indicator of global business activity, but a major contributor to that activity, operating primarily through balance sheets.”

Greenspan’s perspective is not entirely new—as a matter of fact, it’s out of date! The idea that companies’ investment decisions are driven by the difference between the market value of capital and the replacement cost of capital (a ratio economists call “Tobin’s q”) was floated a long time ago.

But research has questioned the extent to which investment actually responds to that ratio. Indeed, it has found that investment is better predicted by fundamentals that determine expectations for future profits and the discount rate.

Of course, one would think (/hope) that these fundamentals are closely interlinked with the current level of stock prices! But to the extent that stock prices can deviate from “fundamentals”, it’s the latter that tend to drive investment decisions and not so much the former.

Blunders aside, what I found most interesting is Greenspan’s almost-agnostic stance on why stock markets are up in the first place. The only explanation he offers is the “human propensity to swing between euphoria and fear, which, while heavily influenced by economic events, has a life of its own. In my experience, such episodes are often not mere forecasts of future business activity, but major causes of it.”

So that’s all it takes, sounds like... a slight push by the invisible hand and… boom! Fear gives way to euphoria, markets go up, business activity surges and.. you know the rest! OK, perhaps I’m over-interpreting here but I’m just struck by Greenspan’s silence on the role of the government’s (very visible) hand in getting the markets out their self-inflicted abyss.

If anything, Greenspan’s central point later on is a warning against the potential unraveling of this virtuous circle of rising markets/rising activity, due to government actions that lead to unsustainable budget deficits and inflation.

It is difficult not to share this concern. But even the most ardent market believers (and I consider myself one) should recognize that market confidence has recovered in part because of a bombardment of government policies:

Policies to backstop key segments of financial markets and contain tail risks (e.g. the Fed’s credit easing facilities); policies generating expectations (rightfully or not) of higher future growth than otherwise projected (e.g. rate cuts and quantitative easing); and, importantly, policies to eliminate investors’ uncertainty about the government’s course of action, esp. vis-à-vis the financials (e.g. the stress tests and the stated decision to refrain from nationalizing any major bank).

So why does this all matter? It matters because the key to the right course of action is a correct diagnosis. And, at this point, a belief in a self-fulfilling circle of market bliss and economic prosperity, which can only be interrupted by government stupidity, is pretty naïve.

Markets are up because of a sense of relief that last winter's horror show will not continue. A relief supported by government actions, as well as real economic data that point to a slower pace of contraction than earlier feared. Whether markets have moved ahead of themselves is another question, and one asked every single second within the investment community.

Given this diagnosis, for me the best indicator of a sustainable macroeconomic recovery is neither the stock market nor the usual economic indicators that people talk about (house prices, employment, ISM and so on).

Rather, it’s the withdrawal of the government’s intervention in the economy: The elimination of the Fed’s funding/backstop facilities; the withdrawal of quantitative easing without rattling the markets; the full emancipation of financial firms (for their equity, debt and asset prices) from government support.

As for Greenspan, well, it’s really time to stop the blabber, get off the stage and maybe revise his memoirs. Failing that, leading financial newspapers should just stop giving him a platform.