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Alan Greenspan Discusses The Fed’s Inability To See Bubbles, Is Confident There Is A “Bubble Waiting To Burst In China”

Tyler Durden
Zero Hedge
March 28, 2010

The maestro managed to run away from the old folks’ bent on monetary destruction home just long enough to carry this amusing interview with Bloomberg TV’s Al Hunt. Tomes (will) have been written about Greenspan’s dementia, just as books will be available on the Kindle one day analyzing his successor’s massive mistakes which are slowly but surely leading to an American day of reckoning, so we won’t comment much, suffice to point out some of the key highlights in Greenspan’s presentation. Most amusingly, note the escalating battle between Greenie and the Fed’s new vice-chairman Janet Yellen, who blatantly contradicted Greenspan’s that higher interest rates would have prevented a housing bubble. For all it’s worth, Alan’s response is actually quite interesting: “We tried to do that in 2004. We ran into a conundrum. For decades, every time the Fed raised its short-term rates, the 10-year note, which is really the proxy for mortgage rates, the yield went up with it. This time, it did not. And the reason it did not, is you cannot have the 10-year note determined both by arbitraged global finance and individual central banks. As a consequence of that…starting in the period where the sensitivity of the early stages of the bubble were building up, it was very clear that what was determining the rise in prices was movements in long-term mortgage rates going down, not the federal funds rate.” In English, this is quite intriguing: China, which at about this time started running up massive trade balances, essentially became indifferent about US monetary policy, as it gobbled up everything east of 5 Years, with a preference on the 10 Year. The reason for this is the US consumer became the one driving force behind the massive Chinese economic expansion. With the consumer out, and with China set to report its first trade deficit in 6 years, and the Fed pulling out its support of mortgages, and the Chinese National Bank pulling liquidity, the move in 10 Year over the next few weeks is now more critical than ever, which is why the 10 Year – 30 Year MBS spread is paradoxically pressured at an all time tight spread, as all the early MBS shorts are covered, forcing pundits to say MBS are cheap as fighting momentum in this market is professional suicide. To be sure, this technical push down will soon end. And when this last coiled spring blows out, watch out below, first in housing, then in rates, in corporates, and last, in equities.

Key highlights from the interview.

On the outlook for the economy:

“Ordinarily, we think of the economy affecting stock prices.  I think we miss a very crucial connection here in that this whole recovery, as best as I can judge, is to a very large extent, the consequence of the market’s bottoming last March and coming all the way back. You can see the whole blossoming of finance. Remember, it is the market value of equity in a financial institution that determines the ratings of its debt. It”s not the book value. As the stock prices have gone up, debt became far more valuable and you can see this huge issuance especially of junk bonds. It is affecting the whole structure of the economy, as well as creating the usual wealth effect impact.”

On the jobless rate at the end of 2010:
“I think the jobless rate will be ending up not far from where it is, because even though the economy is going to continue to rise, provided I might add that the stock market moves ahead of it, but if that happens, you”re going to get a significant rise in employment as we move into the year, but we will also get a rise in the labor force.”

“The rate will come down a bit. Those who are looking for sharp declines will be disappointed.”

On rising yields for treasury auctions:

“It is a canary in the mine at this stage. The way I would look at it, if the markets are working well, the short term outlook is one of increasing momentum.  You can see it developing.  But if the 10-year note and say the 30-year bond yields begin to move up, in other words, the10-year note begins to move aggressively above 4%, that is a signal that we are in some difficulty. There is basically this huge overhang of federal debt which we have never seen before.  It is going to have a marked impact eventually unless it is contained, on long-term rates. That will make a housing recovery very difficult to implement and put a dampening on capital investment as well.” 

“I am very concerned about the fiscal situation, not so much about the numbers, but the climate. One of the unfortunate fallouts from these huge amounts of money that we’re putting in the budget and the Fed is that $1 billion is not what it used to be. You cannot turn someone”s debt down who is requesting $20 million or $400 million when we are talking about trillions. That adds up. It”s the culture. We cannot cut expenditures. We could not even cut the C-17.”

On whether a consumption tax would work:

“I think it would be a short- term fix. It will work in the short run. The problem is very much of the type of issue that Greece has got.  Unless the underlying system contracts – the deficit contracts – it”s just delaying in the problem.  I am not convinced by any means that we can succeed in stabilizing this long-term outlook strictly from a value-added tax. Because unless we come to grips with the fundamental issue, which is the fact that we have promised in the ways of benefits for Medicare and social security, physically more than we have the assets to deliver with. The economy can only grow so far. Right now, the claims on the real economy – forget finance –are getting larger and larger. Social security, I might add, is money. You can always print money.  Medicare is not a defined benefit program.  It is one based on the physical needs of the population.”

On whether the current financial regulation bill would leave the Fed weaker or stronger:

“Weaker. [Al Hunt: Does that concern you?] It does indeed.

“My basic problem is that people don”t understand how important it is for the Federal Reserve banks in the districts, how important they are to the functioning of monetary policy supervision and regulation and all the aspects of the central bank. I am concerned that if the Fed loses that aspect of its structure, we are going to find that what was originally the notion that instead of centering the central bank in wall street, which was the argument leading up to 1913, it was decided to go geographically and spread it around. What is in the bills right now, in my judgment, reverses that.”

On whether there is a bubble waiting to burst in China:

“I think so. To be sure, there are significant bubbles in Shanghai and along the coastal provinces. Some of that is going back into the hinterlands as well.  Remember, the bursting of a bubble by itself is not a big catastrophe. We had a dotcom bubble, it burst and the economy barely moved. It is hard to tell when that bubble bursts, what the consequences are, because we do not have enough data on China.”

On the outlook for the Euro and the dollar:

“The unfortunate issue is that the dollar and the euro are both going down, if I may put it that way.  Since the exchange rate is a ratio, it is very hard to tell what the actual dollar-euro ratio will be. It went up this morning with the temporary agreement. Both sides have a problem. We have a long-term deficit problem. The Europeans have the obvious problem in that they are dealing with Greece and the other peripheral states.”

On whether we could have seen the crisis coming:

“I look back at our monetary policies and I see it could have gone wrong, it didn”t. The problem, as best I can judge on the fairly detailed analysis of the evidence, is that the roots of that crisis are very broad and geopolitical going back to the end of the Cold War and the massive changes in flows of finances that brought long-term, real interest rates down. And the consequences of that created a major expansion in capitalized values for real estate, especially residential real estate, across the globe. Certain aspects of monetary policy probably had some effect.”

On Fed President Janet Yellen”s remarks that higher-short-term interest rates probably would have restrained the demand for housing by raising home mortgage rates: 

“I think [that is wrong]. We tried to do that in 2004. We ran into a conundrum. For decades, every time the Fed raised its short-term rates, the 10-year note, which is really the proxy for mortgage rates, the yield went up with it. This time, it did not. And the reason it did not, is you cannot have the 10-year note determined both by arbitraged global finance and individual central banks. As a consequence of that…starting in the period where the sensitivity of the early stages of the bubble were building up, it was very clear that what was determining the rise in prices was movements in long-term mortgage rates going down, not the federal funds rate.  And indeed, when the federal funds rate was purposely put down in 2003, long-term rates did not come down. As far as I can say, the general notion is just not supporting. The general notion that the Fed was the propagator of the bubble by monetary policy, does not hold up to the evidence.”

Response to critics who say that a proposed systemic risk regulator (which Greenspan does not want) could hardly have done a worse job than the current system did:

 “They wouldn”t. But the problem is, that is not the answer to this issue. It is very evident to me that the underlying crisis was caused by what is clearly a once-in-a- century event. We have had almost no instances of short-term credit being withdrawn on a global basis the way it happened right after the Lehman bankruptcy. All of the individual evidence here is that this is a very rare occasion.”

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