Greenspan Speech Offers Some Comfort For Markets - But Only Some

Tuesday, September 27, 2005


Will it be different this time? Federal Reserve Chairman Alan Greenspan finally found some comforting words for financial markets after two days of unsettling remarks about the US budget deficit and consumers lacking a financial cushion in the wake of extensive home equity extraction which has been the driving force behind the economic expansion in this millennium. In his speech about "Economic Flexibility" Greenspan praised the self-correcting abilities of an economy that is not over-regulated as markets and their new products allow for an incremental adjustment of imbalances in real-time.
Being a fan of balanced times Greenspan had something to offer to both bulls and bears.
Alluding to the highest public and private debt levels ever seen in American history Greenspan noted calmingly that
"recent regulatory reform, coupled with innovative technologies, has stimulated the development of financial products, such as asset-backed securities, collateral loan obligations, and credit default swaps, that facilitate the dispersion of risk.
Conceptual advances in pricing options and other complex financial products, along with improvements in computer and telecommunications technologies, have significantly lowered the costs of, and expanded the opportunities for, hedging risks that were not readily deflected in earlier decades. The new instruments of risk dispersal have enabled the largest and most sophisticated banks, in their credit-granting role, to divest themselves of much credit risk by passing it to institutions with far less leverage. Insurance companies, especially those in reinsurance, pension funds, and hedge funds continue to be willing, at a price, to supply credit protection.
These increasingly complex financial instruments have contributed to the development of a far more flexible, efficient, and hence resilient financial system than the one that existed just a quarter-century ago. After the bursting of the stock market bubble in 2000, unlike previous periods following large financial shocks, no major financial institution defaulted, and the economy held up far better than many had anticipated."
But Greenspan is not thoroughly optimistic as human emotions of euphoria and distress - translate that into the old formula of greed and panic - seem to be the weakest link in the wealth-chain in his opinion. He warned that
"a decline in perceived risk is often self-reinforcing in that it encourages presumptions of prolonged stability and thus a willingness to reach over an ever-more-extended time period. But, because people are inherently risk averse, risk premiums cannot decline indefinitely. Whatever the reason for narrowing credit spreads, and they differ from episode to episode, history cautions that extended periods of low concern about credit risk have invariably been followed by reversal, with an attendant fall in the prices of risky assets. Such developments apparently reflect not only market dynamics but also the all-too-evident alternating and infectious bouts of human euphoria and distress and the instability they engender."
The Fed chairman left no illusion that authorities would be able to clean up a financial mess, reminding listeners that the significant tightening in 1994 did not help to avoid the stock market bubble of the last century. He said that the "equity market's ability to withstand periods of tightening arguably reinforced the bull market's momentum."
Seeing difficult times ahead he said that a flexible labor market might be perceived as job-insecurity but that it actually promotes job creation. He repeated his urgent plea for a better education for Americans.
"Protectionism in all its guises, both domestic and international, does not contribute to the welfare of American workers. At best, it is a short-term fix at a cost of lower standards of living for the nation as a whole. We need increased education and training for those displaced by creative destruction, not a stifling of competition."
Altogether the speech sounded a bit distant to the slew of problems the US are facing and that are listed here and here. The market took Greenspan's own shoulder-padding for the period of his reign at the Fed, which saw the longest expansion in history, initially very positive and rallied, but the Dow failed to break through the 10,500-point mark and retreated in late trading.
Morgan Stanley chief economist Stephen Roach added in a Bloomberg TV interview some counter-perspective. He said that Greenspan will retire at a time when the US is confronted with the worst current account deficit ever, a housing bubble that will inevitably burst while the savings rate of Americans is negative at the same time.
Looking for a clue to the next interest rate step of the Fed one is left with with the impression that the chairman hopes to retire before the long list of problems will begin to leave their bloody marks on the economy. Record energy prices and gold prices are clear signs that all is not as well as everybody might wish. The conference he addressed is still optimistic. According to the Wall Street Journal
"the US economy is likely to continue its "solid expansion" into 2006, even as price spikes in oil and natural gas cause ripple effects in coming months, a new National Association of Business Economists survey of 43 forecasters says. In the storm's aftermath, the forecasters pared their prediction for inflation-adjusted economic growth by 0.4 percentage point for this quarter and by 0.2 percentage point for the next one. Overall, they expect gross domestic product to rise 3.5% this year and 3.4% next year."
Expect the Fed to stay on course with their baby-steps of 25 basis point rate increases for the coming last three meetings with Greenspan at the helm. And run for cover after that. But this is only a human emotion expressed by me as I fear that the transition from Greenspan to his yet unnamed successor will lead to severe ripples in the markets. There are simply too many problems to remain complacent, a feeling the latest FOMC statement has mirrored too.

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