16 October 2008

Greenspan’s Close Encounter of the Third Kind

As he slowly regained consciousness, Alan Greenspan sensed a presence. “Who are you where am I, what’s happening to me” he almost shouted, his voice rising in panic. A strange voice, clearly synthetic, answered. “Don’t worry EZ Al, I’m not your Maker and you are still alive. I’ve been sent from my world to your planet to study your economic and financial system. The Earth has been on our ‘To Do List’ for a very long time; but my boss moved it up in priority… their system is melting down, you need to get over there now, he ordered me. So here I am and I’ve merely telekinetically transported you to my spaceship to ask a few questions.”

Relieved that he was still alive, and being reassured that the ET was not going to hurt him, EZ Al felt fear recede from his body. ‘Ah, just another dumb reporter. I should be able to handle this, no problem’ thought Greenspan. “And what if I don’t want to answer any question”, he said. No sooner had he said that, he felt a strange new sensation … like he was drowning. “Am I being ‘waterboarded’?” he wondered as he felt a sheer sense of fear and panic wash over him. “Okay, okay. I will talk.” He blurted. Immediately, the drowning sensation disappeared.

ET: I am glad you have seen the light Dr. Greenspan. May I call you EZ Al for short? You can call me ET.

EZ Al: I’d rather not, but given that I have no choice in the matter, go ahead.

ET: Explain to me how you manage economic activity on Earth. And please try to be clear and concise. I don’t have time for your usual long-winded, pseudo-sophisticated gibberish.

EZ Al: Economies on Earth are managed via two kinds of policies – Monetary and Fiscal. The former is decided by the Central Banks while governments are responsible for the latter. Some Central Banks have a degree of ‘independence’ from governments but as a practical matter they must ultimately bow to political pressure … after all they are chartered by the State. Monetary policy is executed by, essentially, changing the short-term interest rate, i.e., the price/cost of money. When goods and services price inflation is high and rising, we raise the interest rate to discourage borrowing. Conversely, when economic growth is flagging, we lower the cost of borrowing in order to encourage credit growth – which gets the economy humming again.

ET: That sounds simple enough. Tell me EZ Al, do Central Banks have other responsibilities?

EZ Al: Yes, they do. We in the U.S., for example, have two other responsibilities: (1) To regulate the banking system to ensure long-term safety and soundness, and (2) To be the ‘lender of last resort’.

ET: And have you fulfilled these responsibilities?

EZ Al: Well we fulfill the second every time there is a crisis. And we have these crises with some regularity. Examples during my tenure as Chairman include the Stock market crash of 1987 and the LTCM/Russian bond default of 1998. However, when it comes to regulation, we believe in ‘free enterprise capitalism as the best path to prosperity’. Specifically, we believe in ‘efficient markets’ … that free markets are perfect and the way to get there is through de-regulation. So while we pay lip service to regulation to keep the socialists in our country off our backs, we work very hard to de-regulate markets and fight new regulation proposals.

ET: So under your tenure, did you make progress towards your goal of ‘totally free markets’?

EZ Al: Yes we accomplished a lot. We undid all the Depression Era regulations like Glass-Steagall, we succeeded in creating a huge ‘shadow banking system’ which circumvented the old regulated banks and, most importantly, set-up a global process of packaging loans and their derivatives along with capital markets that enable investors to buy and trade these ‘bundles of risk’ with perfect freedom.

ET: Hmmm … wonder why your perfectly free capital markets are having such a massive coronary right now. Tell me EZ Al, as you manipulate interest rates to promote or restrict the flow of credit into the economy, what happens to the level of Debt in the system; and do you have any guidelines as to how much Debt the economy can safely handle?

EZ Al: Well, I can tell you what has actually happened in the US over the last quarter century. Non-Financial Sector debt has increased from about $ 5 T to $ 32 T and Financial Sector debt ahs gone from $ 0.8 T to $ 16 T. And if you want to know how this relates to GDP, the total Debt to GDP ratio has gone from 150 % to 350 %. As far as any guidelines on ‘safe and sound debt levels’ are concerned, we don’t have any. As I told you, we believe in the free market. If debt levels become more than the system can handle, free markets will take care of them. It Schumpeter’s ‘creative destruction’ in action – reckless lenders will go out of business and prudent lenders will take their place.

ET: Hmmm … wonder if the fact that the Debt/GDP ratio has surpassed the point that it hit early in your last Great Depression is significant. Tell me EZ Al, do you think that there are any ‘natural limits’ to this debt load … that there comes a point when, to use a nuclear metaphor, it reaches ‘critical mass’ – causing a ‘core meltdown’?

EZ Al: Well, if there is such a natural limit, we on Earth are unaware of it. Macro-Economic Science has no such concept. Yes there have always been jeremiahs, doomsayers, chicken littles – take your choice of labels – who have been warning that the sky is falling. But what can you do about people who cry wolf – and always there is no wolf and the sky is still intact above? You ignore them.

ET: And as you manipulated the price of money, what happens to the price of assets – stocks, bonds, real estate?

EZ Al: I consider it one of my greatest accomplishments that, during my tenure as Chairman, the growth in the value of assets far exceeded the growth of goods and services prices as well as incomes. Especially during boom times, which, not surprisingly, some Cassandras called bubbles, American Wealth galloped ahead impressively. And today, in spite of falling housing values, on the whole, Americans are richer than at any time in our history.

ET: Do you think asset value booms, or bubbles as your critics call them, could lead to problems for the economy down the road? And, if so, should you not prevent, or at least, ‘lean against’ their growth?

EZ Al: Yes, sometimes booms lead to busts. But (a) you cannot identify them until later (b) even if you could, you can’t do anything to stop them (c) and if you did, you could damage the economy. So its best to ignore them and if their fall-out tanks the economy, you could always ‘mop up’ the mess and revive the economy via liquidity and EZ credit.

ET: So you don’t view asset value booms as an inflation problem?

EZ Al: No, of course not. Our whole job is to increase wealth. That’s what asset price inflation represents. Why would we want to contain it? On the contrary, we want to encourage it.

This time when the ET spoke, EZ Al sensed a distinct change in the ET’s tone of voice. No more did he sound Socratic, even friendly. There was no mistaking the withering contempt in his speech. It made the hair on Greenspan’s body stand on end.

ET: EZ Al, you and your ilk are complete fools. You don’t even have the common sense off a not-too-bright ten year old child. And yet you strut about with great pride in your ‘Economic Science’. If you represent human intelligence, I fear for the survival of your race. Let me explain this in very simple terms because you are obviously not too bright.

Debt levels are central to the safely and soundness of a financial system. Left unchecked, they grow to a point when the debt service burden starts squeezing disposable income, which in turn curtails spending and what you call economic growth. If the ‘squeeze’ becomes a ‘shock’, as in rate resets of your Adjustable Rate Mortgages, the consumer defaults. If enough defaults occur, lenders get scared, pull in their horns and curtail credit. This sets off a chain reaction … lower spending, leading to lower business profit, leading to lay-offs. Now you have consumers experiencing painful shocks to both incomes and obligations … leading to more debt defaults … which repeats the cycle in a downward spiral.

So what do you do to avoid this vicious cycle? Don’t be so arrogant. Respect the accumulated wisdom of your race. Re-learn ‘An ounce of prevention is worth a pound of cure’ or ‘A stitch in time saves nine’. Apply this learning to debt. PREVENT Credit Bubbles. Safety, Soundness and Sustainability require Limiting Debt Growth. Any real banker knows that he cannot lend beyond the borrower’s capacity to repay – in good and bad times. And you have to prevent asset bubbles … because they enable rampant debt growth. And when the bubble bursts and asset prices fall, people find that they are, in your idiom, ‘upside down’ … which leads to their defaulting in droves.

EZ Al felt a chill go up his spine. No one had ever spoken to him in this tone before. And yet, he was intrigued. The scholar in him came out.

EZ Al: Sounds like you think we are complete idiots in economic matters. So how do you manage money in your world?

Economics in One Lesson

The ET’s tone of voice changed. It sounded friendlier … as if he was smiling. There was some hope for humanity after all. At least this specimen before him had a learning attitude. He proceeded to teach …

ET: Al, it all starts with really understanding what money is and how it should be treated or handled. Obviously, money serves two purposes (a) a store of value, and (b) a medium for exchange. It serves both these roles admirably as long as you treat or handle it with respect. Think of money as a person … if you abuse it, it will desert you. If you treat it with respect, it will always be your faithful companion.

Now you might accuse me of waxing philosophical. Maybe you are thinking all this sounds great but what does it really mean? You know what it means to treat a person with respect. But what does it mean to treat money with respect? Let me explain. There are four major ways of abusing money:

Spending more than you earn

Spending money in unhealthy (for the individual as well as society) ways

Borrowing/lending money for consumption rather than investment that improves societal productivity

Gambling/speculation … particularly with Other Peoples’ Money (OPM)

By these criteria, you will no doubt recognize, your society has been disrespecting and abusing money on a grand scale. All of your economic ‘players’ – consumers, businesses, and government have been spending far more than they earn …making up the difference with borrowing – hence the mammoth increases in debt. By the way, you should be ashamed of your appalling ethics. You claim to be the moral beacon for the whole world and yet you don’t hesitate to stick the tab for your gargantuan current consumption on to future generations of Americans. And yes, McMansions and SUVs are consumption and not investment – for they increase the ‘operating cost’ of households and are thus a drain on productivity. Why is it that your measures of economic growth make no allowance for qualitative differences – whether the money is being used to make bombs or feed the poor and hungry, to build yachts and private airplanes or medicines for the sick, to produce $5000 bottles of wine and $100 cigars for the ‘Masters of the Universe’ on Wall Street or to educate your children? And while I am at it, let me point out that all this mad waste, which you worship at the altar of GDP growth, is depleting your planet’s non-renewable resources while putting its fragile environment – and by implication your race, at risk.

Yes, all this constitutes disrespect of money. Of course, one of the worst abuses is what you do in your precious Capital Markets. While you justify their existence on the grounds that they facilitate the flow of capital from investors to entrepreneurs, let’s be honest about what they really are … a license to gamble, most often with Other Peoples’ Money (OPM).

However, let me point out the worst abuses of money on your planet. Real money or capital is a society’s savings. They are what is left over from income after deducting all expenditures. As such, they represent a voluntary restraint on current consumption in order to provide for an uncertain future. Savings are the true measure of character … the ability to postpone immediate gratification. These savings constitute the capital a society has to invest in production methods that increase efficiency and productivity. Over the last quarter century you have discouraged savings and encouraged borrowing and speculation. This you have done by driving down the returns savers can earn on safe bank deposits. So, to beat inflation they have to put their money into risky ‘investments’ – stocks, bonds, and real estate. And by reducing borrowing costs and encouraging asset bubbles, you have provided people huge incentives to gamble – often with other peoples’ money. Everywhere you turn on your planet, advertisers are trying to get you to buy stuff … even if they need to ‘help’ you buy it with no down, 0% ‘financing’. Your entire monetary policy is morally reprehensible and constitutes a profound abuse of money.

So there you have it – you have violated every principle of sound money consistently, and over a long period of time. Is it any wonder that money is now returning the favor by walking out on you?

EZ Al listened with rapt attention as ET unfolded this strange doctrine of sound, healthy money. Finally he said

EZ Al: ET, what you are saying is so diametrically opposed to what we do here on earth, it leaves me totally dumbfounded. Let me try a different tack. What would you do to solve the current problems? As you know, our financial system is totally frozen … as Bill Gross of PIMCO put it, it resembles a constipated owl. How would you treat this owl? Suppositories? Laxatives? Or do we need an enema?

ET: Well Al, that’s the beauty of basing economic policy on eternal principles or values. That is the Value of Values. If you applied the Money Values that I have just outlined, not only is the solution clear and simple; most importantly, it is also fair and just … for in solving one problem you do not want to create a bigger mess down the road. Keep in mind the Hippocratic injunction – First, do no harm. Money Values provide you with a Moral Economic Compass to guide your policies … vs. the scatter-brained, ad-hoc approach you take. Here is what I would do.

Find out whether these frozen assets represent real money (somebody’s savings) or phony money, i.e., borrowings.

If it is the former, and it is ‘frozen’ in the system for some reason, step in and provide liquidity to ‘unfreeze’ it.

If, however, some entity is in distress because they cannot borrow any more money, you must tell them the truth … they were wrong to arrange their affairs to be so dependent upon ‘other people’s money’ and must suffer the consequences of taking undue risk. In good times these entities gambled and won spectacularly; it is only fitting that they experience the downside of leverage so that in the future they are discouraged from abusing money in this way.

In your society, unfortunately, the proportion of money abusers is large … consumers who live beyond their means – often borrowing on credit cards or against their homes or automobiles to squander on frivolous pursuits, businesses that expand beyond sustainable levels fueled by borrowed funds and, above all, investment banks and hedge/private equity funds who make jaw-dropping sums of money gambling with other peoples’ money. I am tempted to call your entire society ‘Opium (OPM – Other Peoples’ Money) Enterprises’ not withstanding your hubristic self-image of rugged self-reliance.

EZ Al: But ET, you don’t understand the problem. You see, our financial system is frozen … it is not extending credit – at least not in the copious quantities we need to drive economic growth. And the reason it cannot extend credit is because losses on previous lending are depleting the capital in the system. And believe it or not, we still have some rules on capital adequacy. The only way banks can start lending again is if they got new capital. And since private investors will not put in capital because they are afraid of losing it, the taxpayer is our only option.

ET: There you go again. You just don’t get it. You want the banks to lend more money. Have you stopped to ask yourself if that’s desirable? As I have demonstrated, the whole mess was created because you turned the economy into ‘Opium Enterprises’. Tell me EZ Al, does it make any sense to increase lending to consumers or businesses in the face of the deepening recession? Anybody who wants to increase leverage under these circumstances is either stupid or a fraud (because they have no intention to repay the debt). Either way, no responsible bank should lend to them.

You earthly economists are so blinded with Keynesian Fundamentalism, you can’t even think straight. You are like the physician who, examining the 300-lb patient who has been rushed to the emergency room due to a massive coronary brought about by years of over eating (of EZ credit) and no exercise (of self-restraint), prescribes more of the same regimen. Realize EZ Al, that EZ credit is like a drug … years of abuse has made your nation obese … literally as well as figuratively! So now you are fat, dumb, and unhappy. If you restore your country to respecting Money … in other words, recognizing the Value of Money Values, you can once again become lean, smart, and happy.

EZ Al: ET your medicine is a bitter pill – it will cause a nasty recession… may be even a depression.

ET: Well EZ Al, if you keep going on the current self-destructive path, it will merely postpone, while most likely exacerbating, the ultimate outcome. Wisdom is discernment … knowing right from wrong. And courage is the fortitude to follow the right path regardless of short-term consequences. I suggest it is time for your nation to display both.

So there you have it. If you deal with the crisis in this way you would be respecting money and avoiding violent injustice to those who acted responsibly and did nothing to contribute to the problem. You would also be ensuring both retributive and distributive justice for those who played major roles in creating this crisis.

Well, it was nice meeting you EZ Al – and please give my regards and best wishes to your fellow passengers on spaceship Earth. Got to run. Ciao!

And then, with that strange sensation at the base of his spine again, Greenspan blacked out.

* * * * *

Slowly regaining consciousness in his back yard, he realized the sun was high in the sky. “I must have dozed off,” he thought. And then he remembered very clearly the entire encounter with ET. “That could not have really happened – it must have been a nightmare”, he said to himself. “Thank God its over.”

America’s nightmare was only beginning.

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