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The so-called “Great Moderation,” for which our fiat-currency central bankers gave themselves so much credit, turned out to be the Era of Great Bubbles. The U.S., in successive decades, had the Tech Stock Bubble and then the disastrous Housing Bubble. Other countries had real estate and government debt bubbles.
Presiding over the Era of Great Bubbles as Chairman of the world’s principal central bank from 1987 to 2006, was Alan Greenspan, a man of undoubted high intelligence and great talent with scores of subordinate Ph.D. economists to build models for him. He was then world famous as “The Maestro,” for supposedly being able to always orchestrate the macro economy to happy outcomes. The idea that anybody, no matter how talented, could really be such a Maestro is ridiculous, just as the idea that national house prices could never fall was ridiculous—but both were widely believed and expressed nonetheless.
The central bankers, working diligently for their concept of economic Moderation, presided over the Era of Great Bubbles. Is this coincidence? Or does the one cause the other?
Greenspan, in his highly interesting new book, The Map and the Territory (2013), muses:
“The near quarter century from 1983 to 2007 was a period of very shallow recessions and seemingly extraordinary stability [aka “The Great Moderation”]. But protracted economic stability is precisely the tinder that ignites bubbles”; and further:
“Central banks have increasingly been confronted by the prospect that their success in achieving stable prices has laid the groundwork for asset price bubbles.”
Let us begin by pointing out that the first part of the period Greenspan cites was not notable for financial stability. In the 1980s, the savings and loan industry infamously collapsed, taking its government deposit insurer (the Federal Savings and Loan Insurance Corporation) with it into irreparable insolvency. For the ten years from 1983 to 1992, 660 savings and loans failed. So did 256 savings banks, and so did 1,321 commercial banks. In all, this decade brought the failure of an appalling 2,237 U.S. financial institutions, an average of 223 per year for ten years. Oil and farmland bubbles collapsed in the 1980s, the government-sponsored Farm Credit Banks needed a bailout, numerous foreign governments defaulted on their debt to U.S. banks, and the early 1990s featured a massive commercial real estate bust.
All of the 1980s disasters represent the aftermath of the Great Inflation of the 1970s, when annual inflation rates got to double digit increases. This inflation was created by the Federal Reserve itself and its money printing exertions in the crises of those days. Greenspan provides a notable contemporary quote: “America is in the worst economic emergency since the Great Depression”—the date? 1975.
In the next decade, with some success and by imposing a lot of pain, the Fed undertook “fighting inflation”—the inflation it had itself caused. Presumably the Fed learned from this experience. So in the 2000s it performed a variation: the Fed first stoked the asset price inflation of the Great Housing Bubble and then worked to bail out the Bubble’s inevitable collapse.
To evaluate the Fed accurately, we have to confront how the Fed relates to bubbles not only through “economic stability,” as Greenspan suggests (although that does indeed play an important psychological role in bubbles), but through its money printing and financial market manipulations. These can and do bring about asset price inflations.
Sometimes this is intentional on the part of the Fed, when it is trying to bring about “wealth effects,” as it did with the housing boom in 2001-2004 and is now doing again with its so-called “quantitative easing,” including its $1.5 trillion mortgage market manipulation. Exaggerated asset inflations always end badly, needless to say, but those highly leveraged with debt are the worst. This is why, as Greenspan correctly says, the Housing Bubble was so much more destructive than the Tech Stock Bubble.
Fiat-currency central banks like the modern Fed are, among other things, in the business of money illusion—that is, trying to influence real resource costs and prices by depreciating the currency they issue at more rapid or less rapid rates. The business of money illusion often turns into the business of wealth illusion: bubbles create illusory “wealth” that will evaporate.
In footnote 3 to his Introduction, Greenspan importantly observes, “I believe asset price causation is underrepresented in most models” —he means macroeconomic forecasting models. He recognizes two problems here: the shortcoming of macroeconomic forecasting models, and the difficulty of knowing when asset price inflations become bubbles.
For example, “The model constructed by the Federal Reserve staff [recall those scores of economists], combining the elements of Keynesianism, monetarism, and other more recent contributions to economic theory, seemed particularly impressive.” But: “The Federal Reserve Board’s highly sophisticated forecasting system did not foresee a recession until the crisis hit. Nor did the model developed by the prestigious International Monetary Fund.”
With admirable candor, Greenspan relates that at the onset of the financial crisis in August, 2007, “I was stunned.”
In short, “leading up to the almost universally unanticipated crisis of September 2008, macromodeling unequivocally failed when it was needed most, much to the chagrin of the economics profession.”
Why did the models which seemed so impressive perform like Casey at the Bat?
For one thing, “models, by their nature are vast simplifications.” True even for extremely complex models. Moreover, they do not deal so well with discontinuities, like the shriveling of prices in the collapse of bubbles and panics. And: “a related obstacle for forecasting and policy setting,” Greenspan reflects, “is that we seek to identify in advance which assets or markets could turn toxic and precipitate a crisis. It was not apparent in the early 2000s, as many commentators retroactively assume, that subprime securities were headed toward being the toxic asset they turned out to be.”
This is fair. The senior-subordinated structures and techniques used to design these securities were viewed as a major financial innovation and a creative advance, which in fact they were. But innovations, which are the creators of long-term growth, also create uncertainty and surprises, good and bad.
Greenspan quotes the famous dictum of Joseph Schumpeter that economic growth depends on “creative destruction.” This is his only citation of Schumpeter, but he might have quoted that illustrious economic thinker at greater length to illuminate the problems of why models, sophisticated or simple, may fail at the most important times. For example, Schumpeter wrote (in 1946):
The essential points about creative response are these…From the standpoint of the observer who is in full possession of all relevant facts”—say by hypothesis a Federal Reserve Chairman—“it can always be understood ex post; but can practically never be understood ex ante, that is to say, it cannot be predicted…. No deterministic credo avails against this.
Schumpeter considered “innovation, being discontinuous.” He sharply contrasted “the concept of equilibrium, the continuous curves and small marginal variations…the circuit flow of economic routine”—easier to model– with a real “theory of capitalist change,” which requires “the type and function of the entrepreneur, which will…destroy any equilibrium that may have established itself,” producing “cyclical waves which are essentially the form progress takes.” This applies to financial, as well as industrial and commercial, entrepreneurs.
Dipping into some classic financial wisdom, Greenspan considers “the ephemeral nature of market liquidity,” and the human “propensities related to fear [and] euphoria.” When mass euphoria turns to panicked fear, market liquidity vanishes. He considers the propensity for “herding.” Here we should especially add the dangerous propensity for cognitive herding, which affects the thinking and expectations of all kinds of actors in a financial bubble, central bankers and regulators, as well as investors, bankers and borrowers. Then there is “optimism” which “encourages entrepreneurial initiatives” and “probably assures greater successes, but certainly more failures as well.” And not to be forgotten is the famous Greenspan phrase, “irrational exuberance.”
The collective optimism which helps induce bubbles tends to flourish during periods of prosperity, success and stability, as in the Greenspan quote above: “the tinder that ignites bubbles.” This thought echoes Hyman Minsky, the theorist of the endogenous build-up of “financial fragility,” whose work has been summarized as “Stability creates instability.” In slightly longer form, the logic is: stability creates optimism, optimism creates speculative debt, and speculative debt ultimately creates instability. However, Minsky’s insightful work on financial psychology and cycles is not mentioned in this book.
Neither is Frank Knight’s famous distinction between risk and uncertainty, although it seems highly relevant to the conundrums of economic forecasting and central banking. It will be recalled that in his famous 1921 book, Risk, Uncertainty and Profit, Knight proposed that the unknowable future is characterized not only by risk, but more importantly, by uncertainty. With risk in Knight’s sense, you cannot know the outcome, but you do know the odds—like rolling fair dice or flipping a fair coin. But with uncertainty, you cannot even know what the odds are, so your ignorance of the future is more radical. Knight thought that the essential function of the entrepreneur, and the source of all economic profit, was bearing uncertainty. In other words, uncertainty is at the heart of economic growth. In contrast, many financial models which failed in the mortgage bubble thought their essential function was to deal only with risk, that they knew the odds—needless to say, they didn’t.
Greenspan reasonably observes that “Having been mugged too often by reality, we forecasters appropriately express less confidence.” Considering “the vagaries of human nature, forecasting will always be somewhat of a coin toss”—to quibble about the metaphor, it would be better to have something expressing uncertainty, rather than risk, here. But we get the point. “Euphoria will always periodically produce extended bull markets that feed off herd behavior [and herd thinking], followed by rapid fear-induced deflation of the consequent bubbles.”
In his concluding chapter, Greenspan poses a profound question. The enterprising market economy is “the most effective form of economic organization ever devised,” with the “remarkable gains in material well-being and life expectancy” which are obvious to all. Then the “but”: “But at its core is creative destruction.” Can the amazing record of economic progress happen without accompanying booms and busts? Or are booms and busts inevitably entwined in the energies which create the progress?
Greenspan’s thoughtful answer: “I see no way of removing periodic irrational exuberances without at the same time significantly diminishing the average rate of economic growth and standards of living.” For “rising standards of living require innovators who have unlimited expectation of success and perseverance no matter how many times they fail…. Exuberance (the propensity for optimism) is required—even if at times it runs to excess.”
All of us should ponder this, as well as pondering a further essential question which Greenspan, in spite of the many provocative ideas this book discusses, does not address. Do the constant efforts of central banks to promote moderation and stability, by money printing and interest rate manipulation, all the while facing ineluctable uncertainty, and using models which fail when most needed, result in making the booms and busts better or worse?
Alex J. Pollock is a Resident Fellow at the American Enterprise Institute in Washington, DC. He was President and CEO of the Federal Home Loan Bank of Chicago from 1991 to 2004.
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