Dwight Cass
12/01/2005
We’ll miss you when you’re gone. The Fed chairman who allowed two asset bubbles to attain disastrous circumferences—the Internet boom of the late 1990s and today’s ridiculous housing market—with little damage to his reputation as an economic wunderkind will soon have more leisure time to re-read Atlas Shrugged. His timing, as always, is excellent. Things are beginning to get messy.
The
Gulf Coast hurricanes and their immediate economic consequences caused many to
look to the maestro for guidance. In the weeks that followed, Greenspan
demurred, preferring instead to defend his failures to restrain the dot-com and
housing bazaars (policymakers cannot safely puncture bubbles, he argued, while
stoically ignoring the larger question of whether the liquidity his institution
provided helped to inflate them in the first place). “Hey,” he essentially said
of the dot-com era, “I told you so.” And he then recycled his famous turn of
phrase in a weirdly nostalgic moment and applied it to “exuberance” among
irrational housing market speculators.In a final flourish, Greenspan’s Fed raised its target short-term rates by a quarter of a percentage point, despite the skyrocketing price of gasoline and the other economic disruptions caused by the Gulf Coast catastrophe. Some applauded; others scratched their heads: If your car is burning at the side of the road, why apply the brakes?
In fact, the decision represented a significant compromise among Fed decision makers. Five of the members of the Federal Open Market Committee actually wanted—and have wanted for some time—to crank up the rate increases to half-point increments. Because the regions they represent have full employment, they fear that inflation is about to slip its leash. With national savings still negative and the rates of return on nearly all traditional investments only a few points above the current rate of inflation, any increase in that rate would be disastrous.
Katrina and Rita have not doused their concerns. Rather than being recessionary, these events, a number of Fed decision makers believe, will be massively inflationary, as huge volumes of public and private capital are invested in rebuilding efforts. But most investors are focused on the risk of a recession, not inflation, and a 50-basis-point increase by the Fed, with no preparatory jawboning, would be a catastrophe, both for the markets and for Greenspan’s reputation.
A Poisoned Chalice
Pity the next Fed chairman. He or she will take over
when the economy is dangerously dependent on housing bubble-related demand—last
year, home equity borrowings funded 2.5 percent of GDP—and the members of the
Open Market Committee are growing increasingly worried (and ever-more vocal)
over the need to head off inflation with substantial rate hikes. Long-term fixed
income investors, meanwhile, are signaling that they fear deflation more than
inflation. The yield curve has flattened to the point where banks can no longer
make easy money on leveraged carry trades and are therefore becoming less
enamored of growing their liabilities; tight investment-grade credit spreads and
widening junk spreads, meanwhile, make lending less attractive. And equity
price-to-earnings multiples remain too rich.
A corrective increase in
interest rates would have some cosmetic effect on inflation via expectations,
but capital flooding in from abroad (where else would it go; the other developed
economies remain antientrepreneurial basket cases) may offset the government’s
attempts to mop it up. It would also take the air out of the housing bubble, but
whether that leads to housing asset value destruction on the scale of 1979–1981
or 1987–1991, or a more modest downturn, is difficult to say.
Investors lucky
enough to have access to a diversified portfolio of well-managed accounts of
overseas assets and alternative investments such as private equity or hedge
funds may, if they hire smart people, ride through this period with positive
real returns. But it is difficult to escape the consequences of economic
turbulence entirely—the effects on the family business, on entrepreneurial
opportunities, on endowment performance and the capital needs of philanthropic
and cultural institutions can be significant. At the very least, they will need
to cull from their portfolios those institutions and companies that will not
survive when their cost of capital rises. Even these investors may find
themselves pining for Alan, after all.