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The Sins of Alan Greenspan

By       Message Richard Backus       (Page 1 of 2 pages)     Permalink

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  When Mr. Greenspan appeared on a recent BBC documentary and was forced to concede to major misunderstandings of certain market phenomena, he was being quite modest. He not only had misunderstood many economic factors, but had wittingly committed every single major blunder leading up to our current "great recession". He bet the future of the American working class against the interests of his supporters and lost. He kept his job and the country (and half the world) went belly up. He faced the same situation as Mr. Churchill when he, as Chancellor of the British Exchequer, had to reestablish the exchange rate for the British pound when Britain rejoined the gold standard regime after the First World War (in 1926). During the war Britain had suffered a major relative productivity loss via the rest of the world (to the U.S. in particular), and should have devalued the pound to preserve British wage rate competitiveness. But the rich, Churchill's major supporters, did not want that to happen. So he went with the rich and failed to devalue the pound, and the British economy went into a tailspin. Churchill had the decency to face the facts that he had blundered, calling this decision the second biggest mistake of his career (Gallipoli being the first). He was well aware of what he was doing but took his chances. Mr. Greenspan was also well aware of the chances he was taking, and chose to likewise support his rich backers. The only difference is that he has refused to admit his mistake and, worse yet, is continuing to encourage our current financial leaders to follow the same practices. This article covers each and every move he made and the consequences.

 

   It's all about the foreign exchange rate, and the desire of Mr.Greenspan's rich friends to maintain a high value of the dollar. The dollar has been maintained at a highly-overrated value for the last 30-some years in order that the rich could buy foreign luxury goods on the cheap, take inexpensive luxurious foreign vacations, and hire foreign labor at exploitative rates (to do the manufacturing work that American workers had previously been doing.) The exchange value of the dollar had been manipulation by the FED and foreign central banks for decades, and more recently by China, leading up to the dustup over China's meddling in exchange values! What hypocrisy! These manipulations had produced a wide and distorted difference in exchange values between Western currencies and the currencies of countries of Southeast Asia, virtually guaranteeing that all tradable goods would be produced overseas. Mr. Greenspan must share at least some small credit for this lamentable circumstance with the (uncontrolled) hedge fund traders who managed to further drive down the currency values of many otherwise financially-sound countries of Southeast Asia   These practices have led to the continuing and unaddressed mammoth U.S. trade deficits which will shortly impoverish America (except, or course, the very rich).

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   The major screw-ups started when George W. took office. During Mr. Clinton's presidency Greenspan had maintained interest rates at around 5 percent. A Democrat was in office and he did not want to make a Democratic president look too good, so he kept the interest rates relatively high. But in order to create a healthy economy under a clueless Republican president (who needed all the help he could get) he started in early 2001 to drastically lower interest rates, finally reaching 1-1 ? percent around mid-2001. Establishing this ultra-low rate was foolish. Bankers will normally not want to lend money to even the most credit-worthy businesses at a rate of, say, 4 percent (a reasonable 3-percent spread over the 1 percent cost of funds). This was amply demonstrated by our recent experiences with U.S. banks facing the same circumstances. At the then-current ultra-low interest rates they could make plenty of money simply by buying risk-free U.S. government securities. It would have been more responsible if Mr. Greenspan had lowered interest rates to, say 2 ? percent, but hey, anything to help a friend.

 

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The banks were not anxious to lent any money to businesses based upon a 1-percent interest rate considering that interest rates had nowhere to go from there but up, and an increase of just a few percent would quickly wipe out most profit spreads from most of their loans, and could very-well quickly lead to mammoth loses. But there was one exception, loaning money at ultra-low rates against real estate. It had no obvious risk because price increases would cover any shortfalls in interest payments even if the borrower was a flake. But even this contingency was covered. The banks, thanks to Wall Street's creation of mortgage-backed securities, were now able to lay off risk on these ill-considered loans to outside investors (as well as with other unsuspecting gulls like Fanny May and Freddy Mac). The rating agencies were also compliant, and all those risky loans blossomed. Now the stage was set for Alan to make his big bet.

 

   The problem with low U.S. interest rates, short term as well as long term, was that foreign investors would not be content with these returns, given their exchange rate as well as interest-rate risks. When foreign investors (individual and government) began to resist purchasing bonds and bills at these ultra-low rates (around late 2005), Mr. Greenspan feared that the dollar would fall on the foreign exchange markets, given the outlandish foreign trade deficits which needed to be resolved. Alan's employers, the rich, did not want the dollar to drop at all. When the dollar's exchange value went down, they called it "inflation". Of course it had very little to do with the type of stateside   "inflation" everyone worried about, that caused by too much money in the hands of the general public, driving up the prices of consumer goods. In order to prevent a fall in the dollar, Mr. Greenspan started raising interest rates to prevent a fall in the dollar, citing "inflation" as an excuse, pretending the inflation he was invoking was the kind leading to consumer price increases. That kind of inflation was nowhere in sight, evidenced by the market-driven low interest rates previously prevailing, and by the prevalent sluggish wages and stagnant money supplies experienced over the preceding decades. Proof that he was well aware that inflation was not really the issue was provided when he constantly mused at the time about whether the rate hikes would cause a recession! To worry about "inflation" and "recession" simultaneously is like a physician worrying that a bulimic patient he was treating might become obese. It's insulting and dishonest!

 

    But he went ahead and quickly jacked up interest rates in 2005-6 to the 5-6 percent level, well aware that it could very well push an economy already on the verge of recession into a full-blown one. This was a blunder of far greater impact than even Mr. Greenspan had expected. Raising interest rates have more consequences on the economy than just the cost of credit to businessmen. What Mr. Greenspan should have been aware of, as a banker, was that low interests rates were the driving force behind years of sub-par ("liar" as well as adjustable rate) loans whose owners could only survive if housing prices went up, and a rate hike would (and did) put a screeching halt on rising real estate prices. These rate hikes doomed these home-buyers, as he should have known it would.

 

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As a banker he should also have been well aware that as changes in the bank's cost of money (short term usually) went from 1 percent to 5 percent, as bank examiners forced the banks to value their loan collateral to "market", bank equity would immediately disappear and the balance sheet would show the banks to be insolvent (bankrupt). Even if the bank examiners refused/failed to do this, equity would be slowly siphoned off as money income derived from their loan portfolio would be more than consumed by the costs of funds. This would occur regardless of whether these loans were performing or not. There was no way out when banks were collecting even 6 percent on mortgage loans when their costs of funds jumped to 5 percent. What would they be paying their employees with? their oh-so-valuable executives? A margin of 3 percent would normally have been minimal (even for prime rates loans) to keep a bank viable.

 

    Perhaps Mr.Greenspan was not aware that when the value of the collateral backing any investment or loan instrument heads south, the value of the investment does as well. And many investors depend on the earnings of their investments for normal operations (endowments, brokerage firms, local governments, and insurance companies, et. al.). Those holding mortgaged-backed securities would not receive even reasonable dividends/interest on securities backed by non-performing loans, as well as experiencing the permanent loss of the principal. He should have known of the horrendous consequences to these entities as well. As one of the most trusted public servant he was irresponsible if not criminally negligent.

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Richard Backus is a journalist specializing in economics and politics.He has degrees in physics and engineering, and considerable experience in computer systems development. He is single, a good bridge player, and an enthusiastic tennis player.

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