Insights from Former Fed Chairmen

CNBC’s Andrew Ross-Sorkin, March 15, 2013: “The question of the morning: Do you want to break out the phrase again, ‘irrational exuberance’?”

Alan Greenspan: “No, I don’t think it’s quite appropriate in this type of environment. In fact, a basic way of looking at this degree of exuberance or non-exuberance is to take a look at what we call the equity premium. As you know, it’s the extent of the measure of whether stocks are overvalued or undervalued. And right now, by historical calculation, we are significantly undervalued. The reason why the stock market has not been significantly higher is there are other factors compressing it lower. But irrational exuberance is the last term I would use to characterize what’s going on at the moment.”

Ross-Sorkin: “Is this a Fed-fueled rally?”

Greenspan: “I think you can fully explain the rally in terms of basically the issue of the removal of what economists call 'tail risk.' That is, what has been sitting out there virtually most of this year – and part of last as well – has been the European problems which have every characteristic of caving in the economies of the world as a whole, and that has been temporarily removed. The result is removing of that key factor has allowed the markets to move up. It’s not because earnings are moving all that well, as you know, earnings –expectations at least – have been either been flat or down for awhile. What’s basically been doing – the valuation structure and it still’s got a way to go as far as I can see.”

Paul Volcker, March 4, 2013, upon receiving the Lifetime Achievement Award for Economic Policy from the National Association of Business Economics (NABE):

“I have two other things on my mind, at least one of them may strike you as a bit unusual. But I think it is a too much neglected subject despite the fact that it seems to me to have been a major underlying ingredient in the financial and economic crisis we have. And what I’m talking about is the international monetary system. Of course you know it’s hard to call it a system. A system concerns itself with some interrelated parts and a mechanism that are working together to produce some stability and progress. That’s hardly a description of the international monetary system. And as many people have said, “international non-system.” The reason I say it – I’m not going to elaborate on it right now – just look at one characteristic of that system: in the first seven or eight years of this century, where the biggest characteristic of this system was a big surplus on the part of China, a huge accumulation and employing those surpluses into U.S. dollars. And, looking at the other side, the United States running the biggest deficits that it had run – in my memory anyway. The biggest economy in the world running current account deficits some years 5% or 6% of GDP, financing most of the large federal deficit by foreign purchases – so happy to lend at very low interest rates in a seemingly prosperous world. Now would anybody really design a system that would permit the Chinese to run cumulative surpluses – and Japan on top of it – in Trillions of dollars cumulatively over a few years? And we ran deficits of that size for a period of time without suspecting that something is going to happen in a serious way to upset the system. It’s all very nice to be able to finance your external deficits very easily while it happens. But sooner or later the world is giving you a lot of rope for this exorbitant privilege of the reserve currency. But at what point does the rope get to the point where it strangles you? And we’ve tried to avoid that. I’m not sure that’s true yet. But the lack of discipline in this system – which is replicated within Europe where deficits can go along more or less indefinitely in the euro zone until finally, finally something happens to interrupt the parade and we find ourselves with a degree of international indebtedness that is not easy to manage.”

From the NABE Q&A session moderated by CNBC’s Steve Liesman: “Let’s get to the subject you like talking about most in public: Monetary policy… When you were Fed Chairman – in that time period could you have imagined…”

Volcker: “No”

Liesman: “…purchasing…”

Volcker: “No”

Liesman: “…the amount of assets…”

Volcker: “No”

Liesman: “…the Federal Reserve has purchased today and ballooning the balance sheet to almost three Trillion dollars and buying $85bn of assets in a month.”

Volcker: “The answer to that question is clearly 'no…' When I first got involved with the Federal Reserve in the 1950s, the big issue in central banking was something called the ‘bills only doctrine.’ And the bills only doctrine was the central bank should only intervene in the money market in short-term securities, namely Treasury bills. Thou shall never touch a Treasury bond – or a mortgage bond. There was a big fight about it and the ‘bills only doctrine’ won. We’re a long ways away.”

Liesman: “You’ve talked about various areas of potential instability from accounting to the banking system. When you look at the financial landscape here, do you see the Fed’s balance sheet and its monetary policy as a potential source of financial instability?”

Volcker: “It’s obviously a potential problem. The way I look at this, rightly or wrongly, I hope not too optimistically: they are obviously doing things that were beyond my imagination some years ago in response to their perception of a very unusual situation that I did not envisage some years ago. But they have a very large balance sheet - very large amount of excess reserves… It’s OK for the moment. We have no inflationary problem at the moment. They want to support growth in the economy and so forth. The crucial question for a central bank anytime – but it is going to come in spades this time: OK, have easy money when we have a recession or when there’s a lot of unemployment. But at some point when the worm turns and the party is getting under way – to use that old analogy – at what point do you begin retreating and you retreat decisively enough? You can make a mistake and go too quick. But the much more frequent mistake, in my judgment, it’s been that you go too slow. Because it’s never popular to take the so-called ‘punchbowl’ away – or to weaken the liquor. And there’s a lot of liquor out there now. Mechanically, sure it can be done. They can put it in; they can pull it out. Will it be done at the crucial time in a delicate kind of way that can be done without creating expectations in the other direction that will be harmful? It’s going to be a big challenge.”

Below are some of Paul Volcker’s comments from a March 13, 2013 economic conference sponsored by the Atlantic magazine:

“Obviously, the Federal Reserve has come to play an extraordinary role in maintaining the economic recovery. In doing so, it stepped out of the long-established but more limited institutional role of a central bank. Instead of confining its operations to intervention in the money markets and control of bank reserves, attention is today directed toward massive support directly and indirectly of capital markets – and most particularly the market for residential mortgages. What it amounts to is that the Fed has become the principal intermediator in American financial markets. It’s acquiring several Trillion dollars of securities of varying maturities on the basis of short-term monetary liabilities that it itself has created. In the common vernacular, that is termed ‘printing money.’ Those efforts are not unique in today’s world. In Europe and Japan, where recovery is weak and the possibility of renewed recession is evident, sweeping commitments have been made to do ‘whatever it takes’ to hold the euro together and to speed expansion. And, in Japan, even by explicitly seeking inflation. All of us in the United States and Europe and Japan – and indeed the entire world economy – have a large stake in the success of those really unprecedented steps toward monetary expansion. Clearly, there are obstacles and risks - those obstacles notably in the underlying imbalances within and among developed economies and the inevitably slow progress in dealing with the overhang of excessive indebtedness and the remaining dislocations in the financial system and the pervasive fiscal deficits. Those are matters, unfortunately, that are not easily corrected or corrected at all by monetary policy, however aggressively that policy may be managed. Indeed, extreme monetary easing and the suggestion that the approach will continue indefinitely could encourage elements of speculative activity undermining the very process of restoring sustainable growth and financial stability. And I make that point because I believe the Federal Reserve – or any central bank - must not minimize or neglect its responsibilities for oversight in the financial system as it devotes attention to the conduct of monetary policy. In retrospect, a heavy cost has been paid for failure to recognize the implications of behavior patterns and speculative excesses in the financial markets that culminated in the crisis. The complexities and opacity imposed by rapid innovation and financial engineering requires skills and depth of personnel beyond previous experience and the regulators have to be equipped to attain them…”

“Let me say a word about the independence of central banks, which I obviously think is important. When central banks depart from their more traditional role as they’ve felt forced to do during these difficult problems – if that was maintained over a period of time and then you really raise the question of the independence of the bank because they’re getting into the allocation of resources and the dominance of the markets in a way that isn’t really as intended when associated with independent central banks.”

Q&A with an astute question from iconoclast economist and author (“Debunking Economics”) Dr. Steve Keen: “To what extent should the mandate of price stability extend to the stability of asset prices when compared to consumer prices?”

Volcker: “When people talk about stability and when I talk about stability – I’m often thinking of price stability by some measure. But the word stability in my mind encompasses financial stability something more than price stability. The stability of financial relationships, institutional relationships and all the rest. And when you use the word ‘stability’ in that context, which I do, then I get worried about the excesses that might arise - and the Federal Reserve should worry about them. It doesn’t mean it’s easier to deal with them. It’s a big matter of judgment. First of all, when you identify some unsustainable boom in some sector of the economy, even if you identify it what do you do about it? They are both difficult questions and they are both questions I don’t think can be ignored. And I think the Federal Reserve now realizes it…”

“I do see a risk of what I consider a strange theory that these all-powerful central banks can play a little game. And when you want to expand – let’s have a little inflation that peps it up. But, of course, as soon as it gets a little big we’ll shut it off and then we’ll bring it down again. There is no central bank that I know of that has ever exhibited the capacity for that kind of fine-tuning. And if they lose sight of the basic role of a central bank is to maintain price stability, stability generally – the game will sooner or later be lost. That doesn’t mean you’re going to off in the next few years on some great inflationary boom – an inflationary process. But this hubris that somehow we have the tools that can manage in a very defined way little increases or decreases in the inflation rate to manage the real economy is nonsense. Did I say that strongly enough?”

Good stuff! A few years back when he began assuming a higher political profile, an inside-politics analyst suggested that Mr. Volcker was becoming “senile.” This saddened me, as I’ve been a long-time admirer of the former Fed Chairman. He was not only a tough and disciplined central banker demonstrating outstanding leadership in an unusually challenging environment. I respected him as a true statesman – in an era where statesmanship has, sadly, been in short supply. He is a man of impressive intellect and with a brilliant understanding of finance, qualities I value in individuals irrespective of their “left” or “right” political leanings. After listening keenly to his most recent speeches and Q&A sessions, I can state unequivocally that Mr. Volcker is as sharp – and deeply insightful - as ever. I hope very much that he takes an active role in the unfolding monetary policy debate.

And while Mr. Volcker raises the critical but somehow “too much neglected” issues of a dysfunctional global financial “system,” destabilizing market speculation and waning central bank independence, his successor talks about an equities valuation model and today’s significantly undervalued equities market. Demonstrating uncharacteristic restraint, I will only repeat my view that history will not be kind.

For me, there so much these days that’s pretty much déjà vu all over again. As stock markets again turn highly speculative and the latest and greatest Bubble enters a more euphoric (dangerous) phase, it’s increasingly back to New Age, New Era and New Paradigm-like news and analysis. There is this week’s cover story – and special report - from The Economist, “The America That Works – Luckily, dysfunction in Washington is only one side of the story.” The article notes recent encouraging data from the jobs and housing markets. “The stock market has just hit a record high…. Beyond the District of Columbia, the rest of the country is starting to tackle some of its deeper competitive problems.”

I dearly hope – we all do – that this is in fact an “America that Works.” Unfortunately, the truth of the matter is that no one knows at this point how the current economic structure is going to work out. After all, the underlying finance driving the U.S. economy is extraordinarily distorted and unstable. What are the future consequences from unparalleled deficits, monetization and market manipulation? And as Mr. Volcker noted, the global financial “system” is dysfunctional, hence inevitably unsustainable. The U.S. economy recorded a Q4 2012 Current Account Deficit of $110bn, the 86th consecutive quarterly shortfall. There’s no historical precedent for such massive and protracted deficits in a country’s external account. There is no precedent for such a consumption and services-dominated economic structure. And there’s no precedent for anything remotely comparable to the current fiscal and monetary policy regime.

Decades of unfettered global finance have, not unpredictably, fostered progressive financial and economic fragilities. These policy-induced deficiencies have incited increasingly desperate policy measures - and attendant market exuberance. Indeed, it’s all evolved into one epic experiment in unanchored international finance, unchecked speculation and financial leveraging, new paradigm economic structures, ballooning global imbalances and ever expanding monetary inflation. So I especially appreciate Mr. Volcker’s pertinent insights. And to see Greenspan on CNBC touting an equities valuation model and market undervaluation – well, it was just more of the ridiculous.

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