The Greenspan Legacy
January 31st, 2006 marks the end of a financial era. The long-time Chairman of the Federal Reserve, Alan Greenspan, will retire after 18 years at the helm of the United States' central bank. Widely lionized at the pinnacle of his career, Greenspan's legacy will profoundly affect investors worldwide for many years to come.
As Greenspan's tenure as the most powerful man in the financial universe is debated among investors today and historians tomorrow, his many decisions will be dissected and evaluated. But I fear most of this debate will overlook the most foundational and crucial issue. Before Greenspan's actions are considered, the very notion of the Fed itself ought to enter the limelight.
The Federal Reserve is not a capitalistic entity compatible with free markets. Instead it functions just like the miserably failed old-school command-and-control Communism model. The core philosophy of the Fed and its Federal Open Market Committee that controls short-term interest rates is that mere mortals meeting in secret like a conspiracy cabal are better suited at setting the price of money than the free markets.
Regardless of who leads the Fed, the whole organization exists because price controllers, no different from those in 20th century Russia, think they alone can divine the price at which the supply of savings equals the demand for savings. The price of money, or interest rate, leads savers to decide how much of their income to save and debtors to decide how much of someone else's savings to borrow.
Out of all the goods and services available on the planet, the price of money is probably the most important one to ensure is not manipulated. Interest rates act as signals to direct capital from unproductive uses to productive ones, which helps build great wealth for nations when the free markets dictate interest rates. But when manipulators try to artificially manipulate interest-rate signals, capital is misappropriated and wasted leaving nations poorer.
Bubbles are the ultimate case in point. Whenever too much paper money floods into a financial system, which is the inevitable result of artificially low interest rates, it floods into some class of goods or services or investments and inflates prices far beyond where they would be if interest rates were set by free markets. It is ironic as the destination of this excess capital determines whether it is good or bad in investors' minds.
When artificially-low-interest-rate-driven excess money floods into technology stocks or tract houses in suburbia, Americans rejoice and think it is a great thing until the resulting bubbles inevitably burst and wreak great pain. But if this same excess money drives up the prices of general goods and services and commodities like gasoline, the inflation is considered bad. Indeed the Greenspan Fed spent much time trying to jawbone money into inflating politically correct assets like houses instead of politically incorrect ones like commodities.
So before we delve into Greenspan's record on monetary inflation and interest rates, realize he is as far away from being a free-market capitalist as one can possibly be. He is a Communist-style elitist who believes that the price of money and even money supplies should be centrally planned as if by the Communist Politburo. This is no less ridiculous than the idea of the Fed mandating the price of every dinner, every pair of shoes, or every book sold in America. History has proven time and time again what an asinine idea central planning truly is.
So how did Alan Greenspan, price fixer and market manipulator, do in his years at the Fed? His record is mixed. Initially he showed some constraint and tried to fight inflation, the scourge of the middle class, but five or six years into his run he started to embrace and nurture inflation. Amazingly in monetary growth terms he wasn't a great deal better than the horrible Fed chairmen of the 1970s, Arthur Burns and William Miller.
Our first chart this week looks at 45 years of annual broad money supply (M3) growth compared to annual price inflation as measured by the Consumer Price Index. From a free-market standpoint the more stable a money supply, meaning the slower it grows, the more prosperity it generates in all socio-economic strata of society. The faster money supplies grow the harder life becomes for average Americans with slowly growing incomes.
All these charts run from 1960 to the end of 2005. I chose this scale because I wanted to be able to see the results of Alan Greenspan's decisions in context with history. The blue-shaded area to the right marks Greenspan's tenure. Before we get into the Greenspan years though, it is useful to recall all the financial pain of the 1970s which was caused by excessive monetary growth and the severing of the remaining gold standard.
Note the red M3 line above, which is the year-over-year growth rate in the broad US money supply. For virtually the entire 1970s the Fed was allowing the money supply to expand at a breakneck pace usually exceeding 10% a year. With so much new money flooding into the system, the supply of real goods and services on which to spend it just couldn't keep pace. So relatively more money was chasing after and bidding up the prices of relatively less goods and services.
The results of this excessive monetary growth spawned by the Fed artificially manipulating interest rates far lower than the free markets would have set them was the massive inflation of the 1970s. The blue CPI growth-rate line above tracks some of this, with costs of living rising 12% and 15% in just a year during their worst spikes. Everything in the US became more expensive in the 1970s and Americans felt poorer since incomes didn't grow as fast as money supplies.
This was such an enormous problem for our nation that, like an elephant in the living room, even Washington and the Fed couldn't hide it under the rug. So Paul Volcker, the Fed Chairman for the 8 years before Greenspan's appointment, finally let interest rates float high enough in the early 1980s to strangle the damaging monetary excesses out of the system. Volcker also ensured monetary growth rates continuously declined in the 1980s which drove down inflation to multi-decade lows.
When Greenspan became chairman in August 1987, the Fed was doing about as well as it possibly could for a Communist-style command-and-control price-fixing entity. Monetary growth rates continued to fall, inflation was acceptable, and other than the fluky October 1987 stock market crash Greenspan had it easy. All he had to do was not mess around with interest rates and keep the Fed from mucking around too much in money supplies by buying and selling US Treasuries.
And Greenspan was largely successful at this in his early years. Broad monetary growth continued lower and inflation stabilized for the first time in decades. But for some reason near the beginning of 1995 Greenspan forgot about his mission to keep prices stable by not allowing excessive monetary growth. The M3 annual growth rate began to rocket higher and challenged 11% in the late 1990s and exceeded 13% in the early 2000s.
As you can see on this chart above, after 1995 monetary inflation exploded upwards to staggering rates not witnessed since the 1970s. Whenever excessive money supplies are pumped into the pipeline of an economy, they will have to find a home somewhere. Typically this is in the form of general price inflation shown in the CPI growth spikes of the 1970s. But strangely in the mid-1990s the CPI ignored the monetary surge and a major discontinuity was created.
Some believe that the Clinton reelection effort ahead of the 1996 elections involved cooking the books in terms of government statistics. If the CPI was reported to be low through the use of statistical wizardry like hedonic deflators, then the stock market would thrive, Americans would feel happy about the economy, and the Democrats would win another term. Whether this was the reason or not, the CPI seemed to stop reflecting true monetary inflation in 1995 or so.
With no gold standard and no accountability in the official inflation stats the markets watched, Greenspan allowed M3 growth to rocket up to 1970s levels. This was the bubble fuel for the massive stock market bubble of the late 1990s, as we'll see in the next chart. Alan Greenspan warned of "irrational exuberance" in 1996 and then he inexplicably kept feeding the very stock-market bubble he saw growing. Eventually he even bought into the New Era nonsense and foolishly believed the "productivity miracle" justified extreme stock prices.
By the dawn of 1999 Greenspan seemed to once again get concerned and start pursuing Fed policies for lowering the blistering monetary growth rates. But then Y2k came along and everyone including the Fed was scared so it injected huge amounts of new money into an already frothy system. Then the NASDAQ crash of early 2000 led to another long surge of increasing monetary growth in an irresponsible attempt to bail out stock speculators.
All of this incredibly excessive 1970s-type monetary growth created the situation in which we find ourselves today, with prices of goods and services rising as the Fed's monetary promiscuity floods into the general economy. In terms of monetary growth, Greenspan didn't do much better than the terrible 1970s Fed chairmen and he certainly utterly squandered the inflation-fighting legacy of his predecessor Volcker.
History will rightfully remember Alan Greenspan not as an inflation-fighting hawk, but as a socialist Keynesian advocate of endless inflation that betrayed his own principles that he expressed early in his life. In 1966 Alan Greenspan wrote an awesome essay, "Gold and Economic Freedom", where he said the following. "In the absence of the gold standard, there is no way to protect savings from confiscation through inflation. Deficit spending is simply a scheme for the "hidden" confiscation of wealth."
In light of his surprisingly poor monetary record Greenspan's legacy will be remembered as one of the confiscators of Americans' wealth that he so despised early in his life. His senseless inflation contributed to the moral decay of this nation, gutting the purchasing power of retirees' savings and ensuring that most American families would have to have two wage earners in order to keep a semblance of middle-class living.
If you are blessed enough to have surplus capital to invest and not live on a fixed income like older or less fortunate Americans, you may not be worried about inflation. Last spring I had a discussion about the Greenspan record with the CEO of a medium-sized publicly-traded US corporation. As one blessed to earn a lot of money, he couldn't care less about inflation and didn't seem to understand how damaging it is to average folks. Well, Greenspan's policies also inflicted enormous pain on the wealthy investor class too.
This next chart shows the actual M3 money supply versus the S&P 500. Excessive monetary growth courtesy of the Greenspan Fed directly kindled the dangerous stock-market bubble of the late 1990s.
The investor class can often earn more than enough to stay ahead of inflation. Who cares if a hamburger at McDonald's costs $20 if you are earning $500k+ a year? But Greenspan's pro-monetary-inflation policies at the Fed also caused literally trillions of dollars of damage to investors. If there was one individual alive who could have greatly moderated the 1990s stock-market bubble, it was Alan Greenspan using his Fed.
Early in his career he continued Volcker's policy of disinflation, slowing the monetary growth rate as the red actual M3 line above shows. When Greenspan took the reins at the Fed there was well less than $4t US dollars in circulation. But in 1995 when Greenspan suddenly became a manic inflationist, he unleashed the floodgates of monetary growth just like the failed Fed chairmen of the 1970s. M3 literally started soaring.
As these torrents of paper money freshly created out of thin air cascaded into the economy, many of them gravitated to the stock markets. The surge in monetary inflation that started at the Greenspan discontinuity marked the very moment in time when the US stock markets left a reasonable normal growth ascent slope and went parabolic. While the Fed-fed equity bubble may have been fun for a few years, its ultimate consequences were, are, and will continue to be catastrophic.
After five years of relentless monetary inflation pouring into stocks, by March 2000 the flagship S&P 500, the 500 biggest and best companies in America, was worth about $13t, a staggering sum of capital. Yet all this was only an inflation-fed fiction just like past bubbles. These companies didn't have the earnings to support these tremendous valuations, but investors just bid them up indiscriminately anyway because Fed money kept flooding in.
But the Greenspan bubble, like every other bubble in history, eventually had to end. It topped in March 2000 and its first Great Bear downleg lasted until March 2003 or so. Over this period of time the S&P 500 companies lost about 40% of their bubble value, about $5.5t in these elite companies alone! This loss is just mind-blowing, and it damaged the investor class immeasurably. Monetary inflation hurts the wealthy too when the bubbles it creates suddenly pop and wreak great havoc.
At this point Greenspan, if he had loved free-market capitalism, would have acknowledged he screwed up in the late 1990s with his monetary promiscuity and he would have stepped back to let the necessary painful readjustment happen. But instead he did the dumbest thing he could possibly do, something that fits in with his true character as a central planner and market manipulator. He brazenly attempted to bail out stock speculators by slashing interest rates to artificial half-century lows.
Before we get to our next chart showing Greenspan's unbelievably aggressive interest-rate manipulations, note that the red M3 line exceeds $10t today as he leaves the Fed. Why is everything getting more expensive today, from food to medical care to insurance to cars to houses? Because under Greenspan's watch the Fed allowed US money supplies to rocket 185% higher! This is becoming such an embarrassment that the Fed is actually going to quit tracking and publishing M3 in a couple months to hide its horrific Greenspan record.
Our final chart compares 1-year interest rates with the value of the US dollar. After the 1995 discontinuity the dollar went on a wild ride that ended soon after Alan Greenspan attempted to bail out stock speculators upset that they were foolish enough to buy in to a massive bubble. While the Fed's primary mandate is to not grow the money supply very fast in order to prevent inflation, the stability of the dollar's purchasing power is a related mission and the Greenspan Fed failed miserably on this front too.
When money supplies grow too rapidly and inflation and inflationary expectations take root as they did in the late 1970s, the only way to sop up all of this excess liquidity is with far higher than normal interest rates. Greenspan's predecessor understood this and was willing to be unpopular in order to get the US economy back on track. For nearly six years straight in the early 1980s one-year interest rates exceeded 10%.
At times during this painful period of sopping up excessive 1970s monetary growth, 30-year fixed mortgage rates exceeded 18%! Thanks to the massive Greenspan inflation of the late 1990s there is a very good chance we will again see mortgage rates well into the teens before his inflation is purged from the system. Folks with adjustable-rate mortgages will be ripped to shreds if this happens, all courtesy of the Greenspan legacy.
Early in Greenspan's career he established the precedent of slashing interest rates rapidly for long periods of time in a Keynesian attempt to centrally plan and manage economic growth. It appeared to be successful at the time, but now a decade later the folly of this approach is quite evident. If interest rates hadn't fallen so far in the early 1990s then the speculative culture that helped drive the stock-market bubble would probably not have taken root to such an extent.
But the biggest mistake Greenspan made was when he launched his bold gambit in early 2001. Even though artificially cheap money had never stopped a bubble bust from fully running its course in history, Greenspan's supreme hubris led him to try anyway. He didn't want his precious public image and acceptance tarnished (read Bob Woodward's excellent "Maestro" to learn of Greenspan's love of status") so he decided to bail out stock speculators. Rather than letting stock speculators learn from their own mistakes, Greenspan mollycoddled them.
In order for a free-market society to work, people must be free to succeed or fail. Failure is more important than success in many ways since it teaches the best lessons of life, builds character and wisdom, and lays the foundation for future successes. By trying to buoy the stock markets with artificially low interest rates Alan Greenspan attempted to short-circuit countless valuable financial lessons from the bust. Instead of becoming more conservative and learning just as speculators in the 1930s had, in the 2000s speculators exercised the Greenspan Put.
A put, of course, is an options contract that protects an investor from downside by guaranteeing him a selling price regardless of market conditions for a period of time. Greenspan's bailout was widely seen as putting a floor under the stock markets which encouraged 1999-style speculative excesses all over again such as we see in Google today. Stock speculators never learned the lessons they should have in the past five years.
When speculators and businesses aren't free to fail, it creates a huge moral hazard problem. After all, if the Fed is going to pull out all stops to keep capital cheap and flowing into the stock markets, then why not continue to bet aggressively? Rather than being wise and prudent and deploying capital in sectors that really needed it like commodities infrastructure, the Greenspan bailout encouraged a renewed tech-bubble focus.
But Greenspan's Gambit of artificially low interest rates created other problems. Capital markets rely on a balance between savers and debtors, between savers earning a fair return on the income they didn't spend and debtors paying a fair price for the income they didn't earn. When interest rates are not where the free-markets would set them, the saver-debtor transactions are no longer mutually beneficial and capital flows are grossly distorted.
Thanks to Greenspan aggressively punishing prudent savers to subsidize wanton debtors, savings rates in the US fell to all-time lows. Rather than save capital and put it into productive assets that will make America a stronger nation, many Americans instead stuck it into overvalued real estate and created the housing bubble. The bursting of this second Greenspan-spawned bubble in housing will be far more devastating than the stock crash since it will affect all Americans with a mortgage, not just the wealthier stock-investing class.
In light of Greenspan's inflationist record, I suspect his legacy won't be very positive. He made many poor anti-free-market decisions as a command-and-control price fixer and it will take years or decades for the consequences of these to work through our system. For instance, due to the Greenspan bailout our current stock bear is likely to last 17 years instead of just a few as in the early 1930s, and we are only 6 years into it today. Thanks Mr. Chairman.
And when the housing bubble spawned by Greenspan's attempt to bail out stock speculators with artificially low rates bursts, watch out. Markets are cyclical and artificially low prices are always followed by higher than normal ones to balance things out regardless of what the manipulators want. Hence the price of money is headed a lot higher. The economic pain as real estate prices correct in most places and crash in some is going to be tremendous. It is all courtesy of Alan Greenspan's brazen interest-rate manipulations.
I realize this is a heavy and sobering narrative and I don't like the Greenspan legacy either. There are a few bright spots though, ways investors can capitalize on Greenspan's sorry legacy. We are continuing to focus on these opportunities and are being blessed with excellent realized profits on our stock trades.
During the latter 2/3rds of Greenspan's reign, his highly inflationary easy-money policies led to enormous misallocations of capital into first tech stocks and then houses. With capital flowing into these counterproductive bubbles, industries that really needed this very capital starved and withered. This contributed to a massive structural undersupply of crucial commodities.
And this capital-starved commodities industry is highly physical, unlike information industries that can be wished into existence overnight. It will take more than a decade to find and deliver enough oil, natural gas, copper, gold, silver, and other key commodities to meet today's demand. And not only are commodities prices rising because their producing infrastructure was starved in the 1990s, but Greenspan's massive monetary inflation is also filtering into commodities boosting them directly too.
At Zeal we are zealously researching elite commodities producers and developing tools to time trades in these companies. While we have already been blessed with awesome gains since this commodities bull market launched, odds are the best is yet to come. Please subscribe to our acclaimed newsletter today and capitalize on some of the massive capital distortions that need to now be righted thanks to Greenspan.
The bottom line is Alan Greenspan, despite his huge fan club today, is no different from the Communist party bosses of Russia before the Cold War ended. Rather than sitting back and letting the invisible hand of the free markets determine the price and growth rates of money, Greenspan chose to play God and horribly messed everything up like all other would-be demi-gods in history. Price manipulators always fail in the end!
Greenspan's legacy is one of a failed market manipulator and price fixer, a dangerous enemy of free-market capitalism in sheep's clothing. In five or ten years from now once the full spectrum of the consequences of his highly-inflationary and moral-hazard-ridden policies become apparent, I suspect Greenspan will be remembered as a goat, not a guru, a blight on our great nation and economy.
Adam Hamilton, CPA
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