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Greenspan: trapped in ideology
by Stephen Roach

The blame game has reached epic proportions in this wrenching financial crisis. Alan Greenspan makes the most inarguable point of all in stating his case for the defense—that it is critical to get the lessons right. I couldn't agree more.

Unfortunately, Greenspan has been blinded by a dangerous combination of ideology and politics in his own search for those very lessons. And it was much the same during the 18 1/2 years he spent at the helm of the Federal Reserve. At the core of his principled stand is the belief that the US body politic demands rapid, albeit non-inflationary, economic growth. As a politically-compliant central banker, he has also stated that the independence of the Federal Reserve is not set in stone - implying that there is always huge pressure to keep the growth machine humming. And as a market libertarian, he has argued that regulatory intrusion impedes the speed of economic growth. Presto—the rest is history—and an increasingly painful one at that.

This combination of ideology and politics led to bad economics and to a succession of policy blunders—the severity of which are only now becoming evident in this most wrenching of crises. Unlike Martin Wolf, I believe that Greenspan's treatment of The Bubble is the smoking gun. The Greenspan-Bernanke mantra has long been steeped in the belief that markets know best—that central bankers should not attempt to override the verdict of millions of market participants in rendering the judgment that an asset bubble has formed. There are the costs to economic growth to consider. And why worry? After all, goes the script, the authorities always have the wherewithal to clean up any post-bubble mess. Maybe not. The mess this time is almost beyond the realm of comprehension.

Yet the problem has never really been the bubble in the narrow sense of the word. Unfortunately, this is one of the weakest links in the Greenspan defense and in Martin's defense of the defense—namely, a fixation on whether a serious bubble was forming in America's housing market. Never mind, his earlier arguments that housing markets are local, not national - and that it was highly unlikely that nationwide home prices could ever fall. Whoops. Never mind also his equally irrelevant point that there were lots of housing bubbles in the world at the same time&mdasy;and that America's property market excesses didn't look so bad by comparison. Even Martin Wolf buys the peer pressure rationale—every one's doing it—as exoneration for the Fed.

The problem with America's housing bubble was never its comparison with Ireland. The core of the problem lies in the distortions that asset bubbles created on the real side of the US economy. Courtesy of the most rapid rates of sustained US house price appreciation in the modern post-World War II era, in conjunction with innovative financing techniques that allowed American homeowners to extract equity with ease from their humble abodes, the new age of the asset-dependent consumer was born. Net equity extraction from residential property—ironically, based on a statistical framework developed by Alan Greenspan, himself—surged from 3 per cent to nearly 9 per cent of disposable personal income in the first half of the current decade.

And so it went in the Age of Excess. Increasingly supported by the confluence of both property and credit bubbles, American consumers spent well beyond their means—as those means were delineated by domestic income generation. Personal consumption climbed to an unheard of 72 per cent of real GDP in 2007—a record for America and, for that matter, for any leading economy in the modern history of the world. At the same time, household sector debt soared to a record 134 per cent of disposable personal income. America had the rapid growth that Greenspan felt the body politic wanted. But it was growth based increasingly on fumes. Unfortunately, the distortions of a bubble-infected US economy didn't stop there. With equity extraction from residential property viewed increasingly as a permanent source of income generation, consumers felt little pressure to save the old-fashioned way—out of their paychecks. As a result, the income-based personal saving rate plunged to zero for the first time since the Great Depression. Lacking in domestic saving, an increasingly asset-dependent US economy had to borrow surplus saving from abroad in order to keep growing—and run massive current account and trade deficits in order to attract the foreign capital. Greenspan and Bernanke turned this development inside out, as well—maintaining that America was simply doing the rest of the world a huge favor by absorbing its surplus saving. Serious dollar risks were always the catch to that favor, but they were typically couched as a problem for a distant day. Suddenly, that day doesn't seem so distant. In retrospect, the dollar bubble was the external face of America's penchant for asset-dependent growth and saving. The Greenspan defense completely misses the trees from the forest. His place in history will not be defined by a cross-country comparison of housing bubbles. What he missed repeatedly over the years—and still misses today—are the corrosive impacts this bubble had in fostering the imbalances and excesses of an asset-dependent US economy. Unprecedented consumer leverage is only part of the problem. So, too, is the failure of an aging US population to save at precisely the phase in its life-cycle when it needs to prepare for retirement. Global imbalances are also an outgrowth of this era of excess - underscored by America's massive external deficit and, by the way, the protectionist fires it stokes.

Alas, these fault lines were made all the deeper by the Fed's regulatory laxity in an era of unprecedented financial innovation—a laxity that, unfortunately, was accompanied by the cheap money that only a narrow CPI inflation targeter could justify. In retrospect, this was the most dangerous tactical blunder of all—a combination that created voracious investor demand for opaque and increasingly toxic financial products.

It didn't have to be this way. Saying no to asset bubbles—equity, property, or credit—was always an option. In contrast to Alan Greenspan, I concur with Martin Wolf and believe that could have been achieved by common sense—"leaning against the wind" when faced with the obvious asset bubbles of the past eight years. That would have allowed the Fed to use a variety of anti-bubble tools—the bully pulpit of jawboning, more disciplined regulatory oversight, and, ultimately, a tighter monetary policy than a narrow core CPI inflation targeting rule might otherwise suggest.

Yes, economic growth would probably have been slower as a result during the period when the Fed was leaning against asset bubbles. But that shortfall may well pale in comparison to the cost of the post-bubble carnage that is now unfolding. Yet trapped in ideology and politics, Alan Greenspan simply couldn't bring himself to follow the sage advice of one of his predecessors, William McChesney Martin, and "take away the punch bowl just when the party was getting good".