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The Checkers King Explains Why He Lost So Badly At Chess
by Mike Keilher

There he goes again ...

Alan Greenspan is back in the news. In January, presumably in efforts to push his book, Mr. Greenspan suddenly became a nearly daily commentator on his successor's policy actions and other economic matters. After a brief respite, Mr. Greenspan is once again in the headlines.

In his latest salvo, a March Financial Times editorial and April rebuttal to criticism of his original piece, Mr. Greenspan absolves himself of any responsibility for the global credit implosion currently unfolding. Collectively, the pieces display a puzzling contrast between his simplistic approach to monetary policy and his apparent lack of comprehension of fundamental economic consequences flowing from those policies. The articles reveal those polices as being a patchwork reactive morass from which naturally flowed the crumbling "structured finance" house of cards, which now threatens global economic stability.

Had these articles merely been the ramblings of a fading celebrity, it would be one thing. Instead, they ominously appear to be an insight into the reasoning underlying Greenspan's successor's moves in the current global financial chess match.

Greenspan's simplistic analysis is revealed by his claim that he is "puzzled" that "Federal Reserve monetary policy" is viewed as a cause of the U.S. housing bubble. He considers that housing bubble to be merely an average example of a global bubble caused by "a dramatic fall in real-long term interest rates." Fundamentally, he misses the point that the housing bubble is a symptom of irresponsible monetary policy, not the actual problem. The housing bubble is in fact another iteration of the tech bubble caused by irresponsible monetary policy in the late 1990s.

While Mr. Greenspan fails to grasp the connection between artificially low short term interest rates and what he refers to as the "core of the subprime problem . . . misjudgments of the investment community", it is pretty clear that Wall Street figured it out. There would never have been a housing bubble if Wall Street had not been able to strip the short term profits from long term loans and then pass along the risk that said loans would fail in the longer term. The market for the "subprime mortgage backed securities . . . [that were] seemingly under priced (high yielding)" was derivative of the artificially low yields on other fixed income instruments such as t-bills. Had free market rates of interest prevailed, investors would have been less inclined to abandon risk concerns in efforts to obtain higher returns. Further, the "Greenspan Put" and prior moral hazard-inducing behavior had lulled the investing community into an under appreciation of the risk inherent in debt instruments in general.

The fact that under priced capital induces over investment is Economics 101. Econ 101 students also learn that demand increases as prices drop. In this case, it was the price of buying homes (i.e. the lower monthly mortgage for a similarly priced house) that accelerated unsustainable appreciation. A further 101 lesson is that, in a growing lucrative market with few barriers to entry, competitors enter until the long term rate of return drops to a level of sustainable growth. Thus, it was as a direct result of Fed policies that unscrupulous lenders and mortgage salesmen rushed into this market.

Most puzzling perhaps is that there are no real "new" lessons to be learned from the structured finance debacle. Hazards from mismatching short term obligations with long term obligations were the lessons from the junk bond crisis and the Orange County losses in the 1980s and 90s . . . the dangers of overleverage were "quantified" when the Nobel laureates at Long Term Capital Management nearly took out the financial system in 1998 . . . the failure of risk distribution to "insure" against losses, a lesson from portfolio insurance and the 1987 crash . . . and, the certitude that artificially low interest rates do not fix bubbles they merely create new ones, the tech to housing bubble of recent vintage.

As noted at the beginning, it would be easier to discount Mr. Greenspan's ramblings as attempts to rewrite history if it were not for his institutionalization of bad policy at the Federal Reserve. The outcome of Greenspan's extended 1% rates is now clearly evident. Yet his successor has failed to learn from this costly lesson. Instead he is actually creating even more hazard by not only lowering interest rates but also engaging in direct subsidization of further capital misallocation.

It is a well worn adage that those who do not learn from history are condemned to repeat it. The lessons from the Greenspan Fed include that risk can not be eliminated, it can be merely be transferred and that economic cycles can not be regulated away. The current situation is analogous to irresponsible ecological policy, which dictates extinguishing small naturally occurring fires in forests. This leaves the forest exposed to complete devastation when a later fire can not be contained. We are now well past the point where a natural cycle of recession can clear out the dead wood of past excesses. Instead, we are in the midst of a raging credit inferno. The Federal Reserve's response has been to place its fire truck in front of the arsonist's house, while allowing the fire to roar toward the citizens who paid for their truck.

As exemplified by the Bear Stearns bail out, Wall Street continues to run a master's chess tournament. The Fed once again has sent a checkers player to represent our interests.