The legacy of Greenspan's Put

Maybe you remember the "Greenspan Put"? This was the financial gerrymandering done by Chairman Greenspan to step in to avert disaster by pumping up the economy with more fresly printed notes every time there was some blip on the radar. He has famously said that he knows better how to deal with a bursting bubble than an incipient one, so bring on the bubbles and let Alan take care of the busts.

In Kubrik's A Space Odyssey: 2001, HAL, the mutinous IBM computer, convinced the human pilot of the space ship that they should re-install a faulty part because, whilst they knew it was faulty, they couldn't figure out why or therefore how to fix it, so they would just let it run until it completely broke and then they would pehaps know enough of what was wrong with it to fix it. Sort of the same idea. It expresses an amazing bit of confidence that we can pull disaster out of a fire that we don't know how to control because we have the know-how to rebuild with the ashes. For instance, this bit of financial insouciance from 2003:

HSBC analysts take some comfort in the knowledge that the Greenspan Put is still very much alive, and rate cuts are still on the table if there is any sign of faltering economic recovery:
The market continued to edge higher earlier last week on better than expected economic data.

While the earnings were not particularly strong on a currency-adjusted basis, they met and in some cases exceeded market expectations. This led to a growing market perception that the economy may accelerate in the second half year, which was also alluded to in Mr. Greenspan's semi-annual testimony.

The bullish market sentiment carried on until the release of July employment report last Friday. Unfortunately, the monthly report turned out not as strong as expected, reversing earlier market optimism and casting doubts on the economic prospect. The sentiment was further set back after the ISM index rose less than expected.

The unexpectedly soft employment report may cause a deeper market correction in the near term, followed by a period of market consolidation. However, ample liquidity is likely to fuel interest in bottom fishing given the anemic return on money market funds. The recent sharp sell-off in bond market also tended to enhance interest in equity investment.

Most important of all, the 'Greenspan Put' is still very much alive with various Fed officials making it clear that interest rates will be cut if the U.S. economic recovery falters. The U.S. authorities are determined to reflate economic activities. This policy, in the near term at least, will boost market hopes and bode well for equity trading.

Anyway, after a while, discussion of the Greenspan Put just sort of drifted off into space, like the human who was sent out to re-install the faulty bid on HAL's space ship. Before it disappeared over the space horizon, a few people had some parting words for it. Brad DeLong offered a benediction for it back in July 2005:

Four years ago Barry Eichengreen and I wondered whether the "Greenspan Put" had been a powerful force pushing up lending to high-risk countries in the mid-1990s and pushing up stock prices during the dot-com bubble. But we found a problem: we couldn't find significant evidence that this was the case--indeed, we couldn't find that many mentions of the "Greenspan Put" in the financial press or the financial newsletters in the first place. If it was part of the Zeitgeist, it wasn't in any place very visible to us.

The idea of an important "Greenspan Put" lost plausibility as the Federal Reserve did not take steps to lower interest rates as the NASDAQ fell, but instead waited until it saw signs of slackening investment growth. How could anyone in the aftermath of the NASDAQ crash could speak--as John Makin does--of the Fed as providing "free insurance for aggressive risk-taking"?

Nevertheless, the Washington Post's Nell Henderson thinks it is back. But she rapidly gets badly confused between the effects of (i) good, stabilizing monetary policy which should make one optimistic about the future and cause appropriate rises in asset prices (which seems to be what James Grant is talking about), and (ii) the "Greenspan Put" proper--the belief that government rescues are in the offing--which would cause inappropriate rises in asset prices (which seems to be what John Makin is talking about).

And so the article dissolves into incoherence.

But the Greenspan Put has been studied by other economist folks who talk econo-speak way over Guambat's head, though he does pretend to understand a bit of their English (See, "MORAL HAZARD AND THE U.S. STOCK MARKET:
ANALYZING THE “GREENSPAN PUT”?" by Miller, Weller and Zhang):

Since there is no explicit role for monetary policy in our model, in which the real interest rate is constant, we simply assume that the observation of asymmetric monetary policy interventions leads investors to believe that there exists a floor under the market price, i.e., it is as if they have a put option insuring them against downside risks. As this put is available without cost, it must be priced into the stock market to characterize the asset prices under such asymmetric monetary policy.

But now there is more focus on the longterm effects that this "asymmetric monetary policy" may have on the world's market players, and some not inconsiderable concern that Greenspan's Put has lulled the players into a false, and dangerous, sense of security. For instance, Glenn Stevens, the Deputy Governor (and heir apparent) of the Austrlian Reserve Bank, asks, presumeably not rhetorically, "Might not the behaviour of borrowers, lenders, investors and price setters, in response to perceived lower risk, itself work to increase the probability of instability in future?"

This was reported in a Reuters wire report but I have not seen an online version of this quote. Bloomberg reported on the speech and extracted this from it:

Interest rates around the world can't stay low and steady ``permanently'' and central banks will continue to control inflation, Reserve Bank of Australia Deputy Governor Glenn Stevens said.

``While I believe central banks will continue to control inflation over the years ahead, this does require short-term rates to move,'' Stevens said in speech notes prepared for the Securities & Derivatives Industry Association Conference in Melbourne. The speech started at 9:20 a.m. local time. ``They cannot stay low and steady permanently.''

Australia's central bank joined others around the world in raising rates to curb inflation. The Fed has increased borrowing costs 16 times since June 2004 to 5 percent. China on April 27 raised its lending rate for the first time since October 2004. Canada raised its key rate for a sixth consecutive meeting to 4 percent.

The European Central Bank increased its benchmark rate by a quarter point in March to 2.5 percent. Central banks in Thailand and Malaysia have also raised rates this year.

``It certainly seems that long-term interest rates globally have in recent years been unusually low,'' Stevens said.

And John Garnaut, Economics Correspondent for the Sydney Morning Herald ,tried to make it sound as if Stevens thinks the Yanks are just swell for taking the bullet aimed at the rest of us by building up their trade deficit:

Mr Stevens is a widely respected economist, credited with strongly influencing Mr Macfarlane in recent years.

He said an examination of the US current account deficit from the perspective of capital flows, not trade flows, showed the US to be responding rationally to a global savings glut which had pushed down the price of capital.

"I perhaps have a slightly different view to much of the conventional wisdom here.

"I think that in the past decade the behaviour of the US has actually been stabilising for the global economy.

"I think to no small extent the rise in the US deficit was a lot to do with a rational response on the part of Americans to changes in prices.

"If it was really the case that the US was dragging this capital out of a world economy that was reluctant to give it, the price would have gone up. But the price didn't go up, it went down.

"The quantity rose and the price fell - the supply curve moved.

"I think one might say it was a good thing that the Americans and others were prepared to use that capital because that kept the global economy going a lot better than it would have if things had been different.

"That isn't to say that all of that can go on indefinitely. It can't."

David Uren, Economics correspondent for The Australian, focused on Stevens' concerns over the complacency of the credit markets:

EXCESSIVE home borrowing could bring the long run of prosperity to a messy end.

Reserve Bank deputy governor Glenn Stevens said the Australian and world economies had enjoyed 15 years of unusually smooth economic growth and low inflation.

But he told a Melbourne conference at the weekend there was a danger people would use that success as a reason to act and borrow recklessly.

Mr Stevens said households felt justified in taking on much higher levels of debt than in the past because of consistent growth and low interest rates.

But the level of household borrowing was now so much greater than ever before that policymakers such as the Reserve Bank did not know how households would react to an economic downturn.

"Nor, for lenders, could historical rates of default on mortgages be assumed to be a good guide to the future."

Mr Stevens said the world had been through long periods of sustained growth with low inflation and interest rates before, such as during the 1950s and 60s, and it was possible this experience would be repeated. But he warned that now was not the time for standards of risk and credit management to become lax.

"Experienced hands almost invariably have an uneasy feeling about developments," he said.

"In part, that unease reflects a conviction that the business cycle and the cycle of greed and fear in the markets have not gone away."

He said the worry reflected changes in behaviour such as excessive home borrowing that could increase risks or create new ones.

At some point, the ability of the financial system to withstand shocks would be tested. "But exactly when the bell might ring to signify a new phase of the game, and what might be the catalyst, we cannot say."

He said that as well as home borrowing, leveraged buyouts by companies and the credit derivatives market could also bring the sustained period of economic growth to a halt.

Meanwhile, John Mauldin covers a new working paper by the Bank for International Settlements in his recent weekly Thoughts from the Frontline which he calls, "The Problem with Stable Prices." The abstract of the BIS paper reads:

No one in the industrial countries should now question the substantial economic benefits associated with reducing inflation from earlier, high levels. At the same time, history also teaches that the stability of consumer prices might not be sufficient to ensure macroeconomic stability. Past experience is replete with examples of major economic and financial crises that were not preceded by inflationary pressures. Conversely, history shows that many periods of deflation, based on rising productivity, were simultaneously characterised by rapid growth. Recent structural changes in the global economy imply that this history might
have more contemporaneous relevance than is commonly thought. If so, the implication is that policies directed to the pursuit of price stability might have to be applied more flexibly and with a longer-run focus than has recently been the case.

As Mauldin summarises it, "Cutting to the chase, White suggests that central banks need to reconsider thecurrent policy of solely targeting inflation and look at the other factors, like asset bubbles, etc." And as Guambat puts it, "Let's not wait until the bad guys make off with all the money and lose half of it on a drunken orgy before we round 'em up -- Let's head 'em off at the pass!" The BIS paper, and the Mauldin explanation, point out that the asymmetrical monetary policy (ease with disaster then coast until the next disaster), raises questions as to the sustainablity of the economy in the following ways:

Moreover, with prices subdued, monetary policy could be used to good effect to resist successive threats to growth arising from financial disturbances.
This success admitted, whether growth will prove sustainable remains an open question. One possibility is that the cumulative monetary stimulation seen to date will eventually culminate in overt inflation. Recent sharp increases in energy and commodity prices could provide a foretaste of such an outcome. With the short-run Phillips curve now seemingly flatter than before, reversing any shift upwards in inflationary expectations might be costly and necessitate a more significant tightening of monetary policy than is currently expected.

Another effect of this cumulative stimulation has been an upward trend in household debt ratios in the United States and in many other countries, accompanied by a trend downward in national savings rates, both to new historical records most recently. [A factor Glenn Stevens touched on.] In China, in contrast, domestic investment has been drifting up and now stands at a record high proportion of GDP. Moreover, in global asset markets, many risk premia have also descended to record lows even as house prices have risen to record highs. Global current account imbalances are also at unprecedented levels, with those countries having the largest external deficits generally exhibiting the largest internal imbalances as well. Should any or all of these series revert to their historical means, the sustainability of future global growth would also be open to question, perhaps leading to a deflationary rather than an inflationary outturn. To combine the two possibilities, the worst case scenario would be inflationary pressures, leading to a sharp tightening of policy, which in turn could precipitate a process of mean reversion in a number of markets simultaneously.

A further problem arising from the conventional approach is that, as imbalances accumulate over time, the capacity of monetary policy to deal with them could also become progressively reduced. A combination of raising rates less in the booms than they are lowered in successive busts could eventually drive policy rates close to zero. Once at the zero lower bound, the Japanese experience indicates that the power of monetary policy to stimulate the economy is much reduced. Should the economy then turn down, with inflation initially at a very low level, the possibility then arises that a more disruptive form of deflation might emerge. Were that to happen, it has been suggested that an even more “unconventional” monetary policy stance than that applied in Japan would be called for, with all its associated uncertainties. That this was the end point to which the conventional way of conducting policy almost led us would, in itself, seem a powerful argument for further refining the basic framework.

One of the major policy changes recommended by the BIS paper is that the Central Banks take a longer view of the economy and the things they do to help it on its way. It looks to me that this longer view would give scant regard to the stock market cycles in such a way that the Greenspan Put would expire out of the money. As they put it in their concusion:

Perhaps the greatest change required in a new framework would be to ensure that it rested firmly on minimising rather than maximising principles. Recognising the costs of cumulating financial imbalances, constraints would have to be put on policies designed solely to deal with today’s problems, given that they risked creating significantly larger problems in the future. Clearly it would not be easy to convince those affected by higher interest rates that tightening was required, not to resist inflation over the traditional horizon, but to avoid an undesirable disinflation over a still longer period.

Given this likelihood, it would be all the more important to have an institutional framework to encourage an appropriate policy response to the growth of perceived imbalances. Ensuring such a response would require both the robust identification of serious imbalances and the provision of institutional incentives to encourage monetary policymakers to respond. Neither of these would be easily provided.

Concerning the first, research work currently underway on financial stability
indicators needs to be extended. Moreover, it needs to be more widely appreciated that potential damage to the proper functioning of the financial system need not be the only source of concern. Overextended corporate and household balance sheets can also be the source of significant “headwinds”, reducing economic growth to levels well below potential.

Concerning the second, providing incentives to policymakers, they should express publicly their intention to respond to emerging financial imbalances even if, occasionally, this leads to an undershooting of near-term inflation targets. Indeed, there could be merit in understandings which shifted the “burden of proof” so that policymakers had to explain publicly why they chose not to respond to what others might see as a dangerous build-up of such imbalances. To gain government and broad public support for such an altered approach, an educational effort would clearly be required to convince people of the merits of the arguments for change set out above.

Following on these arguments, an altered framework for conducting monetary policy would demonstrate more symmetry over the credit cycle. There would be greater resistance to upswings. This, in turn, would obviate the need for asymmetric easing in the subsequent downturn and the problems arising from holding policy rates at very low levels for sustained periods. One important effect of more symmetric policies is that they would also act to prevent financial imbalances from cumulating over time. This, in turn, would free the authorities’ hands to respond appropriately to the upward phase of any given credit cycle, since there would be less fear of precipitating a crisis. In this way, a virtuous rather than a vicious circle might be more firmly established.

FOLLOW THIS THREAD IN GUAMBAT STEW.