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Published on April 13, 2008

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The Destabilizing Stability of the Greenspan Era:  The Destabilizing Stability of the Greenspan Era Presentation to The Global Borrowers and Investors Forum by Edward Chancellor London, 23 June 2005 The Greenspan reflation:  The Greenspan reflation ‘soft landing’ achieved since collapse of stock market bubble briefest recession since WWII. Double-dip pessimists confounded Federal Reserve policy vindicated: ‘Our strategy of addressing the bubble’s consequences rather than the bubble itself has been successful.’ (Greenspan, January 2004) Newspapers and stockbrokers hail the continuance of the Goldilocks Economy Concerns about Greenspan reflation:  Concerns about Greenspan reflation rising level of private sector debt to GDP leveraged speculation (‘carry trade’) and compression of risk spreads housing bubble increasing macro-economic imbalances bond market ‘conundrum’ Source: Smithers & Co Three arguments against Fed policy:  Three arguments against Fed policy Hayek: the pursuit of price stability can be destabilizing Minsky: the pursuit of financial stability is also destabilizing Mises: dealing with the aftermath’s of bubbles is destabilizing Hayek argument :  Hayek argument monetarists claim that price stability produces economic and financial stability ‘Every depression has been accompanied or preceded by a monetary collapse’ (Milton Friedman, 2002) ‘Monetary stability is a prerequisite of price stability, and price stability is a prerequisite of financial stability’ (Anna Schwartz, 1995) Hayek argument:  Hayek argument policy of price stability ignores changes in productivity when output grows relative to inputs, prices should fall (ceteris paribus) Monetarists fail to distinguish between ‘good deflation’ and ‘bad deflation’ Hayek argument:  Hayek argument D1 S1 S2 P1 P2 P y Source: George Selgin, Less Than Zero (1997) Supply curve shifts to the right after a productivity shock, prices fall Hayek argument:  Hayek argument D1 S1 S2 P1 D2 P y Source: Selgin, Less Than Zero (1997) Price stabilization policy: monetary policy used to push demand curve outwards to the right Hayek argument:  Hayek argument In order to achieve price stability interest rates held below their ‘natural’ level: investment and savings no longer held in balance credit, rather than savings, fuels economic growth real wage growth is suppressed and corporate profits boosted rising profits, low inflation and credit-fuelled growth causes people to identify a ‘new era’ and propels a stock market boom Hayek argument:  Hayek argument low interest rates cannot last: input prices climb, profits decline, interest rates rise ‘hidden’ inflation followed by appearance of overt inflation: ‘credit expansion will be inflationary, investment competes with consumption, we cannot eat out cake and have it too, bottlenecks appear, prices rise.’ (Röpke, 1937) deflation threat: if interest rates rise faster than expected and credit collapses Hayek argument: lessons from history:  Hayek argument: lessons from history policy of price stability pursued during productivity booms in US (1920s) and Japan (1980s) Japanese officials blame focus on consumer prices for errors in monetary policy during the bubble economy change of policy in US in 1928 and Japan in 1989 interrupts experiment in price stabilization however, monetarists continue to blame Federal Reserve policy from 1928 onwards for the Great Depression Hayek argument: supporting evidence:  Hayek argument: supporting evidence looser monetary policy since the mid-1990s due to productivity gains policy of price stability accompanied by strong credit growth and the appearance of ‘bubbles’ recently input prices (land and commodities) have been rising short-term interest rates climbing A productivity miracle? Hayek argument: supporting evidence:  Hayek argument: supporting evidence beneath the stability of retail prices is concealed a relative or ‘hidden’ inflation US consumer prices also influenced by falling import prices and massive expansion in global money supply Source: Andrew Hunt Economics, IMF 2. Minsky argument:  2. Minsky argument financial instability hypothesis: ‘each stage [of the business cycle] nurtures forces that lead to its own destruction.’ (Hyman Minsky, 1982) stability accompanied by financial innovation and reduction in the ‘margin of safety’ three cyclical financial states: ‘hedge’, ‘speculative’, and ‘Ponzi’ finance Minsky argument:  Minsky argument financial complexity and fragility increases during periods of stability competition drives both borrowers and lenders to take on more risk financial system dominated by Ponzi finance dependent on rising asset prices and further borrowing vulnerable to small rises in interest rates credit crunch may be triggered by ‘not unusual event’ Minsky argument:  Minsky argument crisis creates danger of debt deflation, requiring intervention by authorities intervention to prevent debt deflation leads to appearance of another ‘new era’ however, it encourages fresh risk-taking which increases probability of another crisis intervention also raises chances of stagflation Minsky argument: destabilising stability:  Minsky argument: destabilising stability Minsky argument: supporting evidence:  Minsky argument: supporting evidence stock market bubble accompanied by record corporate sector financial deficit telecoms firms and dotcoms were ‘Ponzi’ finance units, dependent on rising asset prices and access to capital when capital markets closed the bubble collapsed, triggering a corporate credit crunch Source: Wynne Godley, Levy Institute Minsky argument: the Greenspan reflation:  Minsky argument: the Greenspan reflation Federal Reserve has intervened on numerous occasions to prevent a financial crisis from having ill-effects (e.g. October 1987, early 1990s, LTCM) ‘Greenspan put’ encourages greater risk-taking: each of these interventions created a new source of instability (e.g. junk bond mania, Mexican crisis, tech boom) Fed saw off threat of debt deflation after collapse of stock market bubble in 2002 deflation avoided but no return to financial conservatism rising leverage increases risk of another financial accident Minsky argument: supporting evidence:  Minsky argument: supporting evidence Ponzi nation: since the bubble burst household sector has run an increasing financial deficit consumer borrowing (net new lending) running at c.15% of personal disposable income in 2004 Rising household sector financial deficit Minsky argument: supporting evidence:  Minsky argument: supporting evidence household sector’s margin of safety has declined balance sheets buoyed by illiquid residential housing assets debt-service levels at record highs despite low interest rates mortgage borrowers turning to exotic finance: hybrid adjustable-rate mortgages, interest-only and ‘pay option’ ARMS. Source: Andrew Hunt Economics Minsky argument: supporting evidence:  Minsky argument: supporting evidence financial operators taking advantage of stability to play the carry trade rising leverage in private equity, mortgage-backed securities, etc. “The quieter the markets get, the greater the leverage.” Gerald Lucas, chief bond strategist, Bank of America (FT, 17 June 2004) Source: Portales Partners, Bianco Research Minsky argument: supporting evidence:  Minsky argument: supporting evidence narrowing risk spreads: credit default swaps VIX index emerging market and high yield spreads record low quality of high yield issuance in 2004 Source: Leverage World Minsky argument: supporting evidence:  Minsky argument: supporting evidence financial innovation to evade regulation and increase leverage: CDOs-squared, etc. rapid growth of credit derivatives and other structured financial products financial system increasingly vulnerable to liquidity risk likelihood of another financial accident high Source: Fitch Ratings 3. The Mises argument:  3. The Mises argument hair of the dog: using credit to deal with bust only inflates further bubbles and hinders necessary adjustments to the economy boom can only continue as long as credit expands Mises argument: Korea’s cautionary tale:  Mises argument: Korea’s cautionary tale Korea stimulates consumer credit boom to offset industrial bust in 1997 and achieves rapid economic recovery on the back of rapid credit expansion: household debt doubles 1999-2002 and other familiar signs of a credit boom: high returns for lenders collapse in personal savings rate housing boom Mises argument: Korea’s consumer bust:  Mises argument: Korea’s consumer bust authorities move to prick consumer lending bubble in late 2002 followed by credit crunch and economic slowdown official inquiry blames ‘reckless’ credit card companies and the ‘government’s extreme policy to prop up domestic demand.’ Mises argument: inflating asset bubbles:  Mises argument: inflating asset bubbles Greenspan reflation has been accompanied by rapid growth of private sector debt which has stimulated asset price inflation: real estate, high yield and emerging market bonds, fine art, bloodstock, modern furniture, commodities, etc. larger amounts of credit required for same increment of GDP growth Source: Andrew Hunt Economics Mises argument: the real estate bubble:  Mises argument: the real estate bubble Source: Merrill Lynch Housebuilders’ earnings correlated with mortgage growth Mises argument: supporting evidence:  Mises argument: supporting evidence lack of ‘creative destruction’ leads to low levels of capacity utilisation; poor jobs growth; and lackluster capital investment in addition, the reflation has created an investment boom in China Source: Andrew Hunt Economics Conclusion:  Conclusion Federal Reserve pursuit of stability has left it ‘holding a tiger by the tail’ may end in either inflation or deflation volatility and risk spreads to widen at which point the new paradigm/Goldilocks economy will be consigned to history The Lorenz Attractor Inflation Deflation

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