Greenspan’s Bubbles

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The Age of Ignorance at the Federal Reserve (2008)
By William A.Fleckenstein with Frederick Sheehan

In this book, the author makes it painfully clear that the financial troubles and the battered US economy is a result of Fed Chairman Alan Greenspan’s decision. He holds this position from 1987  to 2006.

Based on the book, it seems that all the faults lie with Alan Greenspan. However, you must note that he hold office for so long almost 19 years – hence he will have seen numerous ups and downs.

The year 1995 marks the start of the biggest stock market bubble that US has ever experienced. So what were the factors that create a financial environment so conducive to speculation?

1. Demographics
GreenSpan has always cut interest rate. The baby boomers’ awareness that investing for retirement was becoming critically important fostered a need to believe in the mind of the public. Wall Street did its part by supplying the rationalizations as well as the merchandise to the eager masses. The Securities and Exchange Act of 1934 delegated to the Fed the power to regulate broker loans – also known as “margin debt” – used to purchase stocks. The rules at the time, allowed speculators to borrow up to 50% of the value of their stock purchases.  Relative to GDP, margin debt was the highest it had been since 1929 and over 3X as high in Oct 1987. It was an unmistakable sign of rampant speculation.

 

2. Technology

The impressive technology improvements created the objects of speculation and fostered the giddy mood necessary for baby boomers to want to speculate.The internet also helped to supply the imagination necessary to get folks really excited about how rich they might become, which served to further intensify speculation.

 

3. Popularity of business and finance programming

Popularity of business and finance programming such as CNBC helped seduce the public into an overconfident state of knowledge bordering on arrogance. People become certain that they possessed the know-how to invest for themselves and thus had earned the right to be rich.

 

4. Creative expression of earnings and accounting

All throughout the 1995-1997 period, Greenspan threw his weight behind a move afoot to prove that the inflation rate was overstated. The Boskin Commission found that inflation rate was overstated by 1.1%. There was no pretence that its goal was to reduce the annual consumer price index (CPI). There was also the aim to reduce government costs.

The author describes 3 important changes that dramatically warped the inflation data.

1. Change period to period CPI calculations from arithmetic to geometric.

Based on geometric calculation, the price of a hog rises from $100 to $161 over 5 years, the annualized rise is 10% a year. But if you use arithmetic calculation, its annualized rise is 12%. Thus this resulted in the inflation rate to shrink.

 

2. Change to account for substitution effect was absurd

Let’s say the price of beef rises relative to the price of chicken. The Boskin Commission says you will substitute chicken for the beef you previously ate. Thus the rise in the price of chicken will be used in CPI calculations. The fact that you may not wish or choose to eat chicken instead of beef is not a consideration.

 

3. Hedonic adjustments

The author feels that this “hedonic adjustments” not only wildly distorted the CPI data, it also allowed plenty of mischief across the board. The Bioskin Commission advised that if a product went up in price, but improved in quality, then the increase in price need to be reduced by the amount of dollars that captured how much the object had been improved.

The price increase is a known fact, but the improvement in quality would be subjective.

The distortions caused by hedonics don’t stop there. When the price of a product actually declines and quality increased, especially in the cost of computing power in late 1990s, the hedonically adjusted price will collapse. For instance in 1998, only $95.1 billion was actually spent on business computers, the Boskin Commission concluded that after hedonic adjustment, it was as though the business had spent $351.8 billion, which by itself increased real GDP by over 2%. In short, the statistical techniques championed by the Boskin Commission are a cheat.

 

After reading this book, you will find that whatever statistical, accounting or professional qualifications are worthless, as one can easily distort statistics or data depending on how one interpret it .

Alan Greenspan was famous for cutting interest rate and printing money.  During Greenspan’s chairmanship, when a crisis arose and the stock market fell more than about 20%, the Fed would lower the Feds Fund rate, often resulting in a negative real yield. In essence, the Fed added monetary liquidity and encouraged risk taking in the financial markets to avert further deterioration.

During those years, many Baby Boomers lost their entire retirement funds or pension in the stock market during the dot com crash. This resulted in many hardship. John Makin of the American Enterprise Institute once says “A stock market bubble exists when the value of stocks has more impact on the economy than the economy has on the value of stocks.”

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History repeats itself with the housing mania, a dangerous credit bubble brought on by the financial innovations advocated by Greenspan, as there were lots of irresponsible lending practices.

 

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