[PEN-L:33332] the great deregulator

["Ian Murray" <seamus2001@xxxxxxxxx>]

[ operation infinite preposterousness continues...]


Fed Defends Stock 'Bubble' Performance
Greenspan Attempts To Restore His Image

By Steven Pearlstein
Washington Post Staff Writer
Sunday, December 22, 2002; Page A01


Responding to criticism that it helped create and sustain the stock
market "bubble" of the late 1990s, the Federal Reserve Board has
recently launched a vigorous defense, arguing that it was better to have
boomed and busted than never to have boomed at all.

The campaign represents a determined effort by Fed Chairman Alan
Greenspan to restore the luster to his reputation as the maestro of
global economic policy that has recently been tarnished by the worst
stock market crash in 30 years and an economic slowdown that has still
not run its course. Greenspan, 76, is widely expected to step down when
his fourth four-year term as chairman expires in 2004.

More recently, there have been questions about whether the Greenspan Fed
has been ignoring another possible bubble -- this one in house prices --
that may be about to burst.

The Fed's defense is waged in the arcane locution of macroeconomics,
infused with free-market ideology and reflective of the sometimes narrow
viewpoint of central bankers. But essentially it boils down to this: The
economic dangers involved in trying to pop a stock market bubble are
greater than the risks of letting the bubble pop on its own and then
lowering interest rates to try to limit the economic damage after it
does.

Fed officials acknowledge that some individuals and companies may now be
worse off because of the boom and bust in stock prices. But overall,
they contend, the substantial social and economic benefits of the long
boom of the 1990s -- low unemployment, rising incomes, a boom in
innovation and productivity -- far outweigh the temporary economic pain
caused by the bust.

"In my view, somehow preventing the boom in stock prices between 1995
and 2000, if it could have been done, would have throttled a great deal
of technological progress and sustainable growth in productivity and
output," said the Fed's newest member, Ben Bernanke, in one of eight
recent speeches by Fed governors on the subject.

Alan S. Blinder, a Princeton University economist who stepped down as
the Fed's vice chairman in 1996, agreed.

"To those who say the Fed failed to prevent this catastrophe I say,
'What catastrophe?' " said Blinder, co-author of "The Fabulous Decade,"
a book about the 1990s economy. "As far as I can see, the damage to the
real economy and to the financial system has been somewhere between
little and none."

Still, even Greenspan acknowledged in a speech last week that the final
judgment on the Fed's handling of the bubble will have to wait until all
the financial damage has been tallied and the economy has fully
recovered.

"It is too soon to judge the final outcome of the strategy that we
adopted," he told the Economic Club of New York.

A Tarnished Legacy?
Most of the criticism of the Fed's bubble policies has come from Wall
Street, where the vaporization of $7 trillion in market value has been
keenly felt, as well as in the columns of a number of influential
newspapers, magazines and newsletters, where Fed-bashing is a
long-established sport.

"Pure and simple, save for the Fed, the stock market bubble could never
have reached the monstrous dimensions it did, and its bursting would
never have caused such a widespread and profound misery as it has,"
wrote Alan Abelson, whose weekly column in Barron's is read religiously
on Wall Street. "The Fed wasn't just relaxed through the better part of
the '90s -- it was out to lunch."

"If anyone had the legal, moral and intellectual authority to prick the
bubble, it was Alan Greenspan," John Cassidy wrote last year in his
book, "Dot.con," reprising earlier critiques published in the New
Yorker.

Journalistic criticism has come both from the left (Nation columnist
William Greider accused Greenspan of "gross duplicity and monumental
error") and the right (the Economist and the Financial Times, which
headlined a recent editorial "Mr. Greenspan's Tarnished Legacy").

"He seeded it, accommodated it, celebrated it and defended it from those
who believed they saw it turn into a bubble," declared Jim Grant,
publisher of a bearish investment newsletter easily given to Fed
bashing. "It was a terrifically costly lapse of judgment."

Grant's big complaint is that after giving a prescient warning about
Wall Street's "irrational exuberance" in 1996, Greenspan gave in too
quickly and instead launched into an enthusiastic embrace of the "new
economy" and the productivity revolution that lay behind it.

"He was a greater seducer than any of the big-money analysts," said
Grant. "Instead of doing what central bankers are supposed to do, which
was take away the punch bowl, he was busy spiking it."

Of all the critiques of the Fed's bubble policy, perhaps the most
serious and sustained has come from Stephen Cechetti, a former research
director of the Federal Reserve Bank of New York and now a professor at
Ohio State University.

Cechetti argues that the Fed should have begun to "lean against the
bubble" by raising interest rates in 1998, as soon as the economic
dangers had passed from the Asian financial crisis and the near-collapse
of giant hedge fund Long-Term Capital Management, the combination that
had required the Fed to pump money into the financial system. A series
of rate increases at that point, supported by warnings, would have sent
a clear signal to investors that the economic assumptions underlying
stock valuations were in question.

"To the extent that bubbles arise from unrealistic expectations of
future economic growth, interest-rate increases that moderate current
levels of growth can put a brake on them," he wrote recently.

Greenspan, who only two years ago was lauded for having delivered the
best economy in a generation, has clearly been stung by such criticism.
Associates say he decided to respond with a series of speeches designed
not simply to stimulate a debate about the bubble but, more broadly,
about the role of monetary policy and financial regulation at a time
when financial markets have become a powerful, sometimes destabilizing
force in the global economy.

The opening salvo was delivered at the Fed's annual economics summer
camp at Jackson Hole, Wyo., in August. There, Greenspan argued that it
would have been the height of arrogance and folly for a bunch of
government officials to substitute their judgment about the appropriate
level of stock prices for that of millions of investors interacting in
an open market.

Furthermore, while bubbles may be easy to identify after they've popped,
it's a lot harder when you're in the middle of one, Greenspan
asserted -- particularly at a time when a new technology, the Internet,
appeared to hold out the very real promise of huge returns to investors.

Finally, Greenspan speculated that even if the Fed had determined to
burst the bubble, investor sentiment was so bullish that it would have
required an increase in interest rates so swift and so sharp that it
almost surely would have thrown the economy into precisely the deep
recession that pricking it was supposed to avoid.

"Is there some policy that can at least limit the size of the bubble and
hence its destructive fallout?" Greenspan asked. "The answer appears to
be no. . . . The notion that a well-timed incremental tightening could
have been calibrated to prevent the late 1990s bubble is almost surely
an illusion."

Critics wasted no time in characterizing the Jackson Hole speech as
disingenuous and evasive.

Some noted that as far back as February 1996, minutes of Fed meetings
quoted the chairman as acknowledging there was a "stock market bubble
problem at this moment," but he had turned aside a suggestion that the
Fed try to let the air out of it either by raising interest rates or by
raising margin requirements -- the amount of their own money investors
must put up to borrow more to buy stock.

Others dismissed Greenspan's exaggerated deference to free markets,
noting that the Fed routinely substitutes its judgment for the market's
on the basis of uncertain information, including every time it raises
and lowers interest rates in an effort to fine-tune the economy's
performance.

A number of Fed governors have since acknowledged that they were well
aware a bubble existed by the time the dot-com craze was in full swing.
But one reason they backed off from trying to doing anything about it
was that earlier attempts to use monetary policy or the bully pulpit to
restrain the bull market had little, if any, impact. That was the case
back in 1994, when the market easily shrugged off a series of rate
increases. And it was true after Greenspan's "irrational exuberance"
warning in 1996.

In fact, the steepest increase in the Nasdaq composite index -- when it
soared from 2500 to 5000 in eight months -- occurred in the period after
the Fed began raising interest rates in June 1999 and after Greenspan
began to use congressional testimony to warn anew about stock prices
that had become "unwarranted" and "euphoric."

Summing up the Fed's defense last week, Greenspan said he still believes
the wiser course was to have let the stock market work out its own
imbalances, stepping in only after the bubble had burst with lower
interest rates to help cushion the fall and avert long-term damage to
the economy.

History may also be on his side. The one time in its history that the
Fed set out explicitly to pop a stock market bubble was in 1929, when it
raised interest rates by 2.5 percentage points over 20 months. According
to Bernanke, the consensus among economists is that it was the effect of
this harsh monetary policy on the economy -- not the impact of the stock
market crash -- that set in motion the chain of events that led to the
Great Depression.

The Great Deregulator
While much of the criticism about the Fed and the bubble revolves around
its monetary policy, there is an equally fierce disagreement about
whether the central bank's enthusiastic embrace of deregulation in the
1990s opened the door for banks and Wall Street firms to engage in
questionable financing schemes that contributed to the bubble and were
used to mislead and defraud investors. Many of these financing
arrangements involved Fed-supervised banks using complex new securities
traded on markets that the Fed insisted remain beyond the reach of other
federal regulators.

Greenspan's Fed has been aggressive in defending the deregulatory
paradigm. In recent speeches, Fed officials have said it was the new
powers granted to banks under deregulation, and the emergence of
unregulated markets in "derivatives" and "credit swaps" and "asset-based
securities," that allowed the U.S. economy to withstand the shock of a
stock market crash and the collapse of the telecom industry without a
financial crisis.

"These increasingly complex financial instruments have especially
contributed, particularly over the past couple of stressful years, to
the development of a far more flexible, efficient and resilient
financial system than existed just a quarter-century ago," Greenspan
said in a speech last month to the Council of Foreign Relations.

In the same speech, Greenspan cited Enron Corp., WorldCom Inc. and
Global Crossing Ltd. not as regulatory failures that contributed to a
bubble, but as success stories that prove the wisdom of deregulation.

Taking the somewhat narrow view of the bank regulator, Greenspan noted
that despite the rash of corporate failures and write-off of tens of
billions of dollars in bad corporate loans, no major bank has been
threatened with failure.

Greenspan went so far as to assert that it was the role of central
bankers to create an environment in which banks and investors are
encouraged to take the risks that lead to breakthroughs in innovation
and productivity, even if that same environment is also conducive to
investment bubbles and imprudent lending.

"We have responsibility to ensure that the regulatory framework permits
private-sector institutions to take prudent and appropriate risk, even
though such risks will sometimes result in unanticipated bank losses or
even bank failures," he told the Washington audience.

Such arguments strike some critics as perverse.

"It is hardly comforting to learn that deregulation helped the banks
strengthen their balance sheets by allowing them to operate unethically,
take risks they should not have taken and then pass them on to
unsuspecting investors," said D. Quinn Mills, a professor at Harvard
Business School who has just published a book on the bubble. "For the
Fed to claim credit for all the benefits of deregulation while denying
any responsibility for the negatives is, frankly, quite outrageous."

A New Bubble?
Even as the debate over the stock market bubble continues, another is
just beginning, this one over house prices.

Nationally, house prices were growing at the annual rate of about 8
percent through much of 2001, while in some metropolitan areas, such as
Washington, the average annual percentage increases were as high as the
mid-teens. Such increases were two and three times those in household
income, leading some analysts to argue that investors who had once
poured their savings into the stock market had now decided they could
get better, or at least more secure, returns by investing in new and
bigger homes.

Lending support to that notion were the Fed's own figures on household
wealth, which show an acceleration in the growth of mortgage debt
beginning in 2001. By the end of 2001, mortgage debt burden as a
percentage of disposable household income had reached its highest level
in more than 20 years.

A number of critics, including Ed Yardeni, an economist and chief
investment strategist at Prudential Securities, blame the Fed for
helping to create and fuel what they characterize as a housing bubble.
Keeping interest rates at their lowest level in decades, they argue, had
the effect of pushing house prices even higher while encouraging
households to allow their debt to grow faster than their incomes or
their wealth.

But Fed officials have repeatedly declared that there is no housing
bubble worthy of the name.

"We've looked at the bubble question and concluded it's most unlikely,"
Greenspan testified at a congressional hearing in July, noting that the
housing market by that time had already begun to cool. "We see no
evidence of it."

Indeed, rather than expressing concern about the increase in mortgage
debt levels, Greenspan and his colleagues have applauded the boom in
mortgage refinancings that allowed millions of homeowners to "cash out"
on some of the equity value of their homes. Consumers have used much of
that money to continue spending on new cars, furniture and other goods
right through the recession, Fed officials argue, helping to smooth out
the business cycle and make it one of the mildest in memory.

By contrast, Mervyn King, the new governor of the Bank of England, used
a speech last month to warn that the British economy had become overly
reliant on consumer spending propped up by increases in housing values
that reached nearly 30 percent in the past year.

"Even the optimistic Mr. Micawber would realize that this cannot
continue indefinitely," King said, referring to Charles Dickens's
character in "David Copperfield."

But King went on to acknowledge that he wasn't sure whether the central
bank should try to prick the bubble before it burst, or give it a chance
to deflate on its own.