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Greenspan & The Conundrum Effect   (September 28, 2005)


Talk about macroeconomic conundrums. Poor Federal Reserve chief Greenspan has mentioned three himself. To paraphrase:

  • "I keep raising short-term interest rates to cool the housing bubble, oops, I mean 'froth,' but the darn long-term rates keep dropping. What's up with that? Don't people know that when the short-term rates rise above the long-term rates, it invariably signals a recession?"
  • "I keep telling people that the housing bubble, oops I mean 'froth,' is being pumped up by speculative buying, but they keep buying houses at absurd prices anyway. Idiots! How much simpler do I have to make it?"
  • "OK, so we've been remarkably successful in lowering everyone's expectation of inflation and other gyrations in the economy. So guess what? Now everyone feels safe to gamble on risky hedge funds, no-interest mortgages and other cockamamie schemes. Folks, I can't help you if you keep swallowing firecrackers."

    One term the Chairman never uses is the "wealth effect." Why? To paraphrase again:
    "Wealth effect? Are you nuts? That's like saying there's a housing bubble. People will panic in the streets if I admit that the wealth effect works great when housing is going up--everyone feels so rich they spend like there's no tomorrow. But the same mechanism works on the way down, too, after the bubble pops. People feel poorer than they actually are, and so they stop spending. Economic activity goes into a tailspin and then we've got the big R, recession, or worse. The bigger the bubble, the bigger the pop and then the bigger the drop in the wealth effect. But for goodness sakes, don't let on we know that. I retire in a few months and want to get out while the getting's good, before the whole thing blows up."

    Think I made this up? Please read today's Wall Street Journal article entitled Greenspan Says Fed's Success May Inflate Bubbles.
    "In perhaps what must be the greatest irony of economic policy making, success at stabilization carries its own risks," Mr. Greenspan said in a speech via satellite to a conference of the National Association for Business Economics in Chicago Tuesday.

    "Monetary policy -- in fact, all economic policy -- to the extent that it is successful over a prolonged period, will reduce economic variability," Mr. Greenspan said, which will lead investors to demand less compensation for lending to risky borrowers, or for long periods. In practice, this means yields on long-term bonds will fall, as is happening now, pulling down mortgage rates and supporting housing prices. A similarly euphoric response to higher productivity in the 1990s produced that decade's stock bubble.

    Eventually, Mr. Greenspan said, this reverses and asset prices fall, reflecting "the all-too-evident alternating and infectious bouts of human euphoria and distress and the instability they engender."
    In other words: Yikes! Look out below.

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    copyright © 2005 Charles Hugh Smith. All rights reserved in all media.

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