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I know I know you're all greenspan h8rs here, but, nonetheless, I found this interesting and yes, I agree with Alan's analysis with the caveat that I believe more price extrapolation has occured abd been taken advantage of in the housing market than the fed wants to admit because it does not fit their do nothing about bubbles theory.
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BMO Financial Group was the title sponsor bringing Dr. Alan Greenspan to Calgary last week. On October 6th, 2100 people joined us for lunch at the Telus Centre, where some attended a VIP reception and photo op with the Maestro. He graciously received the ‘White Hat’ award from Dave Bronconnier, Mayor of Calgary. Those who sat with the Chairman at lunch found him witty, friendly and cheerful.
Dr. Greenspan prefers a dialogue rather than a formal presentation. Dr. Sherry Cooper, Chief Economist of BMO Nesbitt Burns and former Fed economist, had the honour of conversing with him for well over an hour. He was forthcoming, direct, and very funny. You never would believe he was the same man as the obscure and abstruse Fed Chairman.
Cooper: Mr. Chairman, it is a great honour to be with you here today for what I hope will be a far-reaching discussion. Given that many in the audience know little about your personal history, let’s begin with a bit of that. It is well known that you are from a musical family and that you studied the clarinet and tenor saxophone at Julliard, after which you toured in a band alongside jazz great, Stan Getz. What made you leave music for Economics?
Greenspan: I was a good amateur musician—but only an average professional. I realized this playing side-by-side with Stan Getz. What he could do, I couldn’t. So, after doing a mathematical calculation, I realized I stood a better chance of success as an economist than a musician.
Cooper: For 30 years, you were friends with, and a disciple of, Ayn Rand, whose novels (Atlas Shrugged, and The Fountainhead) portrayed capitalism as a moral force and successful business leaders as epic heroes. By that definition, there are many ‘epic heroes’ in this room today. How did her philosophy and work affect yours?
Greenspan (eyes lit up): I met her when I was very young, in my mid 20s. At that time I was a strong proponent of logical positivism, a philosophy that asserts the primacy of observation in assessing the truth of statements of fact and holds that metaphysical and subjective arguments not based on observable data are meaningless. I was an empiricist—if I couldn’t measure it, it didn’t exist. I believed that economics was simply an empirical field and that the economy could be forecasted econometrically.
Cooper: For those in the audience who are not economists…
Greenspan: The smart ones—unlike us.
Cooper: Econometrics is the analysis of historical data to predict the future. Given that so many new phenomena and unpredictable events affect economic developments, judgement is often better than what a computer model would spit out.
Greenspan: Lucky for us, Ayn Rand showed me that my views were self-contradictory. From her, I learned that the economy is driven by psychology, values, attitudes, trust and other often-irrational and immeasurable factors. Rand showed me that judgement is a key ingredient in all economic forecasting and analysis. One cannot understand society as a whole unless you deal with all of it. Economics is more than a technical field. It is based on the whole spectrum of human decision-making and action. Econometrics is only part of the game. A good example of this is that to complete economic transactions, people must trust the word of strangers. This works because it’s practical. I would likely have been a reclusive econometrician, spitting out bad forecasts, if it weren’t for Ayn Rand.
Cooper: We saw this point many times during your period at the Fed. Often, the data could not describe or predict what was really happening. In the second-half of the 1990s, the U.S. economy was booming, the unemployment rate was falling, but inflation continued to decline. You were correct in predicting this and understanding that the surge in productivity growth owing to technological advance would allow for continued disinflationary growth. Many disagreed with you. The long-enshrined Phillips Curve, which showed the inverse relationship between unemployment and inflation, no longer appeared to hold. You let the U.S. economy run, refraining from raising interest rates even when labour shortages were evident in many sectors and regions.
What do you tell people who accuse your Fed of creating the stock market bubble of the late 1990s? Despite your disparagement of ‘irrational exuberance’ with respect to tech stocks in December 1996, you aggressively increased the provision of credit in 1999 in response to Y2K fears. Many have argued that this fuelled the 86% rise in the Nasdaq that year which, of course, ended very badly in March of 2000. Don’t you think this easy-money policy contributed to the wild IPOs and the over-investment, further inflating the tech bubble? Why did you not respond with at least an increase in margin requirements or a tighter provision of credit?
Greenspan: We tried that in 1994/95 and failed. We learned that the Fed could not incrementally diffuse a bubble. We tried in 1994 when we raised interest rates—you remember—even by 75 basis points. It was highly disruptive.
Cooper: What I remember is the meltdown of Askin Capital Management, a mortgage-backed securities (MBS) hedge fund and the demise of Kidder Peabody.
Greenspan: And in the end, we failed. The stock market bubble had already been forming, and didn’t react to the tightening. We didn’t diffuse the bubble; we made it worse. The stock market was flat during the tightening period, and when the tightening ended in 1995, the stock market took off. We realized that unless we tightened aggressively enough to hurt the economy and profitability, the market bubble wouldn’t diffuse. Rates would have had to go up 10-to-12 percentage points (1,000 to 1,200 basis points) to break the back of the stock market, which would destroy the economy. Therefore, we realized we couldn’t diffuse the bubble, and decided to focus, instead, on dealing with the aftermath, not the bubble itself. We didn’t ease until 2001 because we wanted to be certain that the bubble was over.
Cooper: Some would argue that the housing market in the past few years was in a Fed-generated bubble until about a year or so ago. There was a dramatic trend towards sub-prime lending. The last research paper you penned at the Fed dealt with mortgage equity withdrawal. We have seen the U.S. consumer savings rate plunge to negative levels. People are spending more than they earn. Boomers seem unconcerned about their financial security in retirement, using their homes as a piggy bank to pay for housing and non-housing related expenditures. Has there been some “irrational exuberance” here? Doesn’t it reflect, at least in part, the fact that the Fed took the overnight funds rate down to a record-low 1%? How vulnerable is the U.S. economy to its unwinding?
Greenspan: I don’t think the boom came from a 1% fed funds rate or from the Fed’s easing. It came from the collapse of the Berlin Wall, the opening up of markets behind the Iron Curtain. We had assumed that living standards in East Germany were about half or a third of those in West Germany. In fact, we were shocked to discover that purchasing power and general living standards were hardly of third of those on the western side of the Wall. The collapse of Communism brought billions of cheap labourers onto the scene. This was highly disinflationary. Bond yields fell, real interest rates fell and real asset prices, like house prices, rose dramatically.
Central planning was proven to be a failure, and the world saw that open free markets were far superior. The only difference between the East and West Germany was the economy and the political system. Central planning disappeared, almost overnight, and former centrally planned economies in less-developed countries moved towards more market-based systems. China was a prime example of this. As workers in those markets became less isolated and more capitalistic, labour costs all over the world fell. This brought disinflation and lowered inflation premiums and long-term interest rates, creating a decline in real interest rates and equity-risk premiums. In consequence, the real market value of assets increased faster than GDP.
Housing is not a liquid asset; in order to capitalize the equity in a home, you have to sell it and move out. This is an impediment to wealth creation. Much of the acceleration in home prices came from the investment side. This can be seen in the big acceleration in housing turnover.
Then, the system ran out of steam as no one could afford houses anymore.
Cooper: Having nothing to do with the Fed tightening that began in June 2004?
Greenspan: (Ignoring the question) I suspect that we are coming to the end of this downtrend, as applications for new mortgages, the most important series, have flattened out. There is a good chance of coming out of this in good shape, but average house prices are likely to be down this year relative to 2005. I don’t know, but I think the worst of this may well be over.
Cooper: As you have said, the introduction of free-market private sector initiatives in China has had a profound effect on the global economy. Can China successfully adopt an increasingly market-oriented economy while continuing with the highly controlled and repressive political regime? Or, is democracy a key requirement for the success of a capitalist economy?
Greenspan: China cannot continue as an authoritarian regime indefinitely. The success of capitalism and economic freedom hinges on allowing creative destruction—out with the old and in with the new, more productive and profitable activities. This is what generates increasing investment and capital flows; but it also causes dislocation and job loss. Some people don’t find another job that pays as well. In Communist China today, the dislocated peasants and former State-owned Enterprise workers who cannot find jobs or homes are a time bomb ready to explode. The greatest fear of the central government of China is insurrection and so they refuse to revalue their currency in the hopes of continued surging job growth.
Cooper: They also generate enormous fear as the number of arrests and executions per 1000 people, without due process, is the highest in the world.
Greenspan: Safety valves in a democracy enable disaffected workers (those who lose jobs) to vote for a change in government. It may not help their economic plight, but it makes people feel more empowered. This keeps the working class from rising up. This safety valve does not exist in China, but the Communist regime remains in place, for now, because it is producing material welfare, and is working hard to do so.
I was astounded when Tiger Woods and others played in a golf tournament with enormous prizes in China, and no one commented on it. This is a sign of the times—culture in China has changed. Golf is a capitalist’s game. No Soviets ever played golf in the USSR.
We have been observing the erosion in the power of the Supreme Leader of China ever since Mao. Deng Xiaoping was less powerful than Mao. Zhu Ronghi, who is a good friend of mine and, in my view, the author of many of the most important reforms, had even less power, and so on with Jiang and now Hu. The president’s authority has been declining with each change in leadership. Ultimately, the Communist party will morph into a democratic socialist regime. There will be more than one party and people will have a vote.
Cooper: But will this be a bloodless revolution?
Greenspan: There is a good deal of unrest and the central government’s greatest fear is insurrection. They must keep the economy growing strong and therefore the currency must remain weak. An undervalued currency allows them to continue to export labour-intensive goods. They’re not ready to move up on the quality scale just yet. They are worried, and for good reason, that the people will rise up if that changes.
Cooper: What about the resulting threat of U.S. protectionism? Did you take the Schumer-Graham tariff bill seriously or is it just political sabre-rattling in an election period?
Greenspan: That threat has eased off of late, since the Schumer-Graham bill rightfully was pushed off the floor. Schumer never thought he would get the Congressional support he did. He was only trying to pressure China to revalue, not to actually slap on an inflationary 27.5% tariff on Chinese goods. In any case, the tariff would have been in violation of WTO rules. U.S. protectionist fervour has dissipated of late. Protectionism jeopardises U.S. prosperity. This will continue to be a risk in the future.
Cooper: Another major consequence of Chinese growth has been the surge in commodity prices, particularly the price of oil. Where do you see energy prices going in the long-term? Is there a range of oil prices that would sustain a smooth ride through the economic cycle? How sustainable is an oil price increase?
Greenspan: I have a lot to say about this, and in the end, I doubt you will know what I conclude.
Oil consumption has been rising in line with the volume of proved reserves. But the problem is that reserves in the ground are not the same thing as above-ground crude. Excess capacity is not there anymore; therefore, if anything goes wrong on the supply side, prices can jump. There is also a significant terrorist premium and prices were also bid up by financial speculation.
Hedge funds and other private market players did us a great favour in buying oil contracts. Investors can only invest by buying inventories, so they buy from producers, and that means that those inventories are already committed and cannot be consumed. Record-high prices generate an increase in the growth of supply and a slowdown in the growth of demand. Higher crude prices have triggered an improvement in technology, both green technologies and better oil- related technologies.
Hedge funds now have the inventory they need, so the bids are disappearing and prices are now falling. Speculative positions have come down and prices have come down with it. Global demand for oil hasn’t slowed much, slowing only a little in the U.S. It is not slowing in developing countries despite reduced intensity of consumption. Even developing countries are becoming more efficient in oil usage per dollar of GDP; but, because developing countries are growing so quickly, it means that consumption continues to increase.
Refinery problems are also an issue; there isn’t enough refinery capacity, especially for heavy crude and demand pressure on light crude is pushing the whole oil market higher. So that is causing alternative fuel development and use. I do not believe the future is in ethanol derived from corn. There just isn't enough corn in the U.S. But, I am very impressed with the development of non-cellulose ethanol, made from agricultural scrap. The U.S. may finally start to be weaning off petroleum products; one-seventh of every barrel produced in the world is consumed on U.S. highways. That’s 11 million barrels per day, 20% of which is consumed by large trucks moving goods across the country. If even only this group adopted non-cellulose ethanol, it would have a huge impact on the consumption of oil—a downward impact.
Coming back to China, they are building a strategic petroleum reserve. No one is sure how large the reserve is—we are not sure where all of China’s imports are going, but some of imports must be going to these reserves.
Unfortunately, there are huge gaps in the petroleum data not only with regard to China but much of the rest of the world as well. We can only guess what OPEC produces.
Cooper: China is not the only factor affecting demand. Isn't the U.S. the number one consumer of oil in the world, representing twice the number of barrels as China?
Greenspan: The U.S. consumes not twice as much oil as China but six times as much. The very severe refining problems will take years to resolve. Another problem is that the huge amounts of cash flowing into national oil companies are not being used for exploration.
Cooper: The Prime Minister of Canada, Stephen Harper, has said that the Alberta oil sands will make Canada the next oil Super Power. Do you agree? And how do you view the oil sands and their economic impact?
Greenspan: Alberta will be an oil Super Power, because the U.S. trusts Canada. Canada’s signature is trustworthy… we don't think it's got a Russian signature on it. The U.S. will import increasing amounts of oil from Canada. The only concern is the enormous use of natural gas to create heat to extract crude from the oil sands. You could use nuclear power, but there’s always concern that something terrible might happen. But you could say that about any one of a number of potential dangers.
Cooper: I believe that Canadians are less averse to using nuclear power than Americans. Many in Canada are concerned about greenhouse gas emissions and global warming. I have spent a good deal of time studying the effects of the Kyoto Agreement and I do not believe it will achieve its intended purpose. Nor do I believe it is good for Canada. What is your view of Kyoto?
Greenspan: First, let’s agree that global warming is real, evident, and a given. The greenhouse gas argument is scientifically demonstrated. Kyoto is based on a naďve view of the way the world works. For example, if a small democratic country with its own environment (not one shared by others), tried to pass a reduction in greenhouse gasses, it may well succeed because while it would reduce the standard of living (because of reduced energy consumption, reduced employment, slower growth, etc.), the environment would be better off, benefiting everyone in that country. However, because in reality, the environment is shared by all, even if Canada were to become pristine, it would make no difference to global warming.
Many people only look at one side of the argument—reducing pollution. This is like single-entry bookkeeping. While reducing pollution, we would also be reducing economic activity and living standards. But if we were to put a cap on energy use—forgetting for now that caps never work—the result would be job losses and rising in prices, both of which hurt the economy. Taking this into account, we have double-entry bookkeeping, recognizing there will be a very strong public outcry when trying to reduce energy consumption. Carbon trading works in the EU for just this reason, because it doesn’t reduce energy use.
Cooper: As you have seen, thanks to the oil boom, Alberta’s economy is red hot, with no excess capacity and enormous labour shortages. Prices are rising here, especially real estate prices, and the surge in commodity prices has led to a surge in the Canadian dollar. This has been particularly tough on the manufacturing sector, especially the automobile industry in Ontario. Would Canada be better off with multiple currencies? Or with the U.S. dollar? If you were David Dodge, how would you conduct monetary policy with such a geographically and sectorally diverse economy?
Greenspan: With difficulty. In the U.S., there have been many occasions when different parts of country needed different monetary policies. I remember when California was under strain. The President of the San Francisco Federal Reserve Bank suggested that California’s economy was as big as that of many countries. He argued that if California had its own currency, it would depreciate in value versus the U.S dollar. But having only the U.S. dollar, its currency was stronger than warranted by the pace of economic activity. California was suffering from the ‘Dutch Disease.’ Those sectors of the economy that were not strong were dying, drowned by the value of the currency. Similarly in Alberta and Canada, the commodity sector’s boom is drowning out the manufacturing sector, which was originally much weaker. Alberta should have a different monetary policy than Ontario in theory, but that is impossible in practice.
Cooper: So there is no “optimal currency area”?
Greenspan: It is a very interesting theory for economists, but it has no practical reality. Optimal currency areas, if they could be determined, do not coincide with national boundaries. Alberta should have a different policy, but that’s not realistic. If it had its own currency, it would appreciate and drive out everything but the energy sector. The EU has similar problem. Ireland is growing far more rapidly than Italy, for example, yet both have the same currency and the same monetary policy.
Cooper: Touching on another subject, when I left the Fed in the early 1980s, there were more than 14,000 commercial banks, 4,000 savings and loan institutions and a handful of mutual savings banks in the U.S. Since that time, there has been a massive wave of merger and acquisition activity in the U.S. financial services industry, some of it with foreign banks. This has resulted in far fewer and much larger financial institutions, many of which have nationwide branch networks and a multitude of product lines. There are even some banks among the largest in the world, with significant global reach.
In contrast, Canadian banks have fallen significantly, on a relative basis, in size and global capabilities. Those in this country who oppose bank mergers or foreign acquisition of more than 20% of domestic banks argue that it would reduce competition domestically and, therefore, hurt the consumer and small business. Do you agree and why was that not a concern of yours in the U.S.?
Greenspan: Canada, in the past, was renowned for having a few large well-run banks with national reach. On a relative basis, they are no longer so large.
The world now has two types of financial institutions: the big investment banks/hedge funds/investment banks, all looking for above-average risk-adjusted returns. The other type of financial institution is the collateral lender, especially the mortgage lender, which is often community-based. They might both be called banks, but they are two increasingly different kinds of institutions.
It is going to be increasingly difficult to separate banking from commerce. Larger banks will continue to emerge from continued M&A activity. But we will also see the proliferation of community banks; they have the local knowledge and the local people that the larger banks have trouble replicating. The big banks are trying to imitate them.
I see no reason to fear M&A activity in banking. New institutions will spring up to meet local and community needs.
Cooper: What is the role that gold plays in the financial system?
Greenspan: I love that question. Gold is not an indicator of inflation. When oil prices fall, gold prices fall; gold prices are positively correlated with oil prices. They both moved up with the Iran nuclear scare, and they both declined when the fear dissipated. Gold, instead, is an indicator of the market’s perception of financial chaos.
As a monetary asset, it is expensive to store, and pays no interest. Gold is an ultimate means of payment, in and of itself, accepted irrespective of who is giving it to you. So, for Germany in 1944, gold was the only means of payment to receive goods from other countries. Currencies are backed by government or credit instruments, and for those countries that have bad credit, gold is of value.
But the real use of gold today is a haven against chaos. A small proportion of the investing public is concerned about a major financial breakdown; they are purchasing gold. Because the gold market is so small, a very small segment of people are capable of driving up gold prices. Terrorism, especially nuclear or bio-terrorism has led to a rise in the price of gold, but it fluctuates with the perception of risk.
Cooper: Mr. Chairman, we have talked for quite a while now. What have I missed that is of concern to you?
Greenspan: So many things worry me.
Cooper: Choose just one.
Greenspan: What bothers me is the U.S. health system and the projection of entitlement costs. We are making promises we just can't keep. While we can estimate the costs associated with Social Security, we have no idea what the costs of Medicare will be. We know the number of people that will be entitled to Medicare, but we do not know how much money each will spend on health care, particularly as people are living longer. At this stage, since the labour force is growing at half the previous generation’s rate, Congress can issue entitlement, but we need hospitals, pharmaceuticals, doctors, and other health-care workers to deliver these services. I am worried we might be promising more than the U.S. is physically capable delivering. The growth in the labour force is slowing. Our dependency ratio will be rising (the number of very young or very old people relative to the number of workers) because of the aging of the population.
Cooper: Canada has an even greater problem, as our baby boom was proportionately larger than that of the U.S. The baby boom in Canada started earlier, and at its peak, the average fertility rate in this country was 3.7 children per woman. Fertility rates were well above those in the U.S. for a number of years, but then they plunged. Today, the average fertility rate in the U.S. is 2.1 children per woman.
Greenspan: Which is only replacement rate fertility.
Cooper: That’s right, but in Canada, the fertility rate is a mere 1.5. The growth in the labour force is declining and will fall to a mere 0.2% by 2020, compared to nearly 1% over the past decade. This means the potential growth rate of the economy will fall unless productivity surges, boomers stay on the job longer, outsourcing picks up and/or the immigration of young workers rises. The public health system could well be just as compromised as the Medicare system in the U.S. The public and private sectors will work hard to entice boomers to stay on the job well beyond today’s average retirement rate of 61, and even beyond the traditional retirement age of 65. Many will and should choose to postpone their government pensions until age 70. Dr. Greenspan, you have been an excellent role model in this respect.
As a long-standing admirer of yours, it has been a great honour to speak with you today. Thank you.
(Hand shake.)
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BMO Financial Group was the title sponsor bringing Dr. Alan Greenspan to Calgary last week. On October 6th, 2100 people joined us for lunch at the Telus Centre, where some attended a VIP reception and photo op with the Maestro. He graciously received the ‘White Hat’ award from Dave Bronconnier, Mayor of Calgary. Those who sat with the Chairman at lunch found him witty, friendly and cheerful.
Dr. Greenspan prefers a dialogue rather than a formal presentation. Dr. Sherry Cooper, Chief Economist of BMO Nesbitt Burns and former Fed economist, had the honour of conversing with him for well over an hour. He was forthcoming, direct, and very funny. You never would believe he was the same man as the obscure and abstruse Fed Chairman.
Cooper: Mr. Chairman, it is a great honour to be with you here today for what I hope will be a far-reaching discussion. Given that many in the audience know little about your personal history, let’s begin with a bit of that. It is well known that you are from a musical family and that you studied the clarinet and tenor saxophone at Julliard, after which you toured in a band alongside jazz great, Stan Getz. What made you leave music for Economics?
Greenspan: I was a good amateur musician—but only an average professional. I realized this playing side-by-side with Stan Getz. What he could do, I couldn’t. So, after doing a mathematical calculation, I realized I stood a better chance of success as an economist than a musician.
Cooper: For 30 years, you were friends with, and a disciple of, Ayn Rand, whose novels (Atlas Shrugged, and The Fountainhead) portrayed capitalism as a moral force and successful business leaders as epic heroes. By that definition, there are many ‘epic heroes’ in this room today. How did her philosophy and work affect yours?
Greenspan (eyes lit up): I met her when I was very young, in my mid 20s. At that time I was a strong proponent of logical positivism, a philosophy that asserts the primacy of observation in assessing the truth of statements of fact and holds that metaphysical and subjective arguments not based on observable data are meaningless. I was an empiricist—if I couldn’t measure it, it didn’t exist. I believed that economics was simply an empirical field and that the economy could be forecasted econometrically.
Cooper: For those in the audience who are not economists…
Greenspan: The smart ones—unlike us.
Cooper: Econometrics is the analysis of historical data to predict the future. Given that so many new phenomena and unpredictable events affect economic developments, judgement is often better than what a computer model would spit out.
Greenspan: Lucky for us, Ayn Rand showed me that my views were self-contradictory. From her, I learned that the economy is driven by psychology, values, attitudes, trust and other often-irrational and immeasurable factors. Rand showed me that judgement is a key ingredient in all economic forecasting and analysis. One cannot understand society as a whole unless you deal with all of it. Economics is more than a technical field. It is based on the whole spectrum of human decision-making and action. Econometrics is only part of the game. A good example of this is that to complete economic transactions, people must trust the word of strangers. This works because it’s practical. I would likely have been a reclusive econometrician, spitting out bad forecasts, if it weren’t for Ayn Rand.
Cooper: We saw this point many times during your period at the Fed. Often, the data could not describe or predict what was really happening. In the second-half of the 1990s, the U.S. economy was booming, the unemployment rate was falling, but inflation continued to decline. You were correct in predicting this and understanding that the surge in productivity growth owing to technological advance would allow for continued disinflationary growth. Many disagreed with you. The long-enshrined Phillips Curve, which showed the inverse relationship between unemployment and inflation, no longer appeared to hold. You let the U.S. economy run, refraining from raising interest rates even when labour shortages were evident in many sectors and regions.
What do you tell people who accuse your Fed of creating the stock market bubble of the late 1990s? Despite your disparagement of ‘irrational exuberance’ with respect to tech stocks in December 1996, you aggressively increased the provision of credit in 1999 in response to Y2K fears. Many have argued that this fuelled the 86% rise in the Nasdaq that year which, of course, ended very badly in March of 2000. Don’t you think this easy-money policy contributed to the wild IPOs and the over-investment, further inflating the tech bubble? Why did you not respond with at least an increase in margin requirements or a tighter provision of credit?
Greenspan: We tried that in 1994/95 and failed. We learned that the Fed could not incrementally diffuse a bubble. We tried in 1994 when we raised interest rates—you remember—even by 75 basis points. It was highly disruptive.
Cooper: What I remember is the meltdown of Askin Capital Management, a mortgage-backed securities (MBS) hedge fund and the demise of Kidder Peabody.
Greenspan: And in the end, we failed. The stock market bubble had already been forming, and didn’t react to the tightening. We didn’t diffuse the bubble; we made it worse. The stock market was flat during the tightening period, and when the tightening ended in 1995, the stock market took off. We realized that unless we tightened aggressively enough to hurt the economy and profitability, the market bubble wouldn’t diffuse. Rates would have had to go up 10-to-12 percentage points (1,000 to 1,200 basis points) to break the back of the stock market, which would destroy the economy. Therefore, we realized we couldn’t diffuse the bubble, and decided to focus, instead, on dealing with the aftermath, not the bubble itself. We didn’t ease until 2001 because we wanted to be certain that the bubble was over.
Cooper: Some would argue that the housing market in the past few years was in a Fed-generated bubble until about a year or so ago. There was a dramatic trend towards sub-prime lending. The last research paper you penned at the Fed dealt with mortgage equity withdrawal. We have seen the U.S. consumer savings rate plunge to negative levels. People are spending more than they earn. Boomers seem unconcerned about their financial security in retirement, using their homes as a piggy bank to pay for housing and non-housing related expenditures. Has there been some “irrational exuberance” here? Doesn’t it reflect, at least in part, the fact that the Fed took the overnight funds rate down to a record-low 1%? How vulnerable is the U.S. economy to its unwinding?
Greenspan: I don’t think the boom came from a 1% fed funds rate or from the Fed’s easing. It came from the collapse of the Berlin Wall, the opening up of markets behind the Iron Curtain. We had assumed that living standards in East Germany were about half or a third of those in West Germany. In fact, we were shocked to discover that purchasing power and general living standards were hardly of third of those on the western side of the Wall. The collapse of Communism brought billions of cheap labourers onto the scene. This was highly disinflationary. Bond yields fell, real interest rates fell and real asset prices, like house prices, rose dramatically.
Central planning was proven to be a failure, and the world saw that open free markets were far superior. The only difference between the East and West Germany was the economy and the political system. Central planning disappeared, almost overnight, and former centrally planned economies in less-developed countries moved towards more market-based systems. China was a prime example of this. As workers in those markets became less isolated and more capitalistic, labour costs all over the world fell. This brought disinflation and lowered inflation premiums and long-term interest rates, creating a decline in real interest rates and equity-risk premiums. In consequence, the real market value of assets increased faster than GDP.
Housing is not a liquid asset; in order to capitalize the equity in a home, you have to sell it and move out. This is an impediment to wealth creation. Much of the acceleration in home prices came from the investment side. This can be seen in the big acceleration in housing turnover.
Then, the system ran out of steam as no one could afford houses anymore.
Cooper: Having nothing to do with the Fed tightening that began in June 2004?
Greenspan: (Ignoring the question) I suspect that we are coming to the end of this downtrend, as applications for new mortgages, the most important series, have flattened out. There is a good chance of coming out of this in good shape, but average house prices are likely to be down this year relative to 2005. I don’t know, but I think the worst of this may well be over.
Cooper: As you have said, the introduction of free-market private sector initiatives in China has had a profound effect on the global economy. Can China successfully adopt an increasingly market-oriented economy while continuing with the highly controlled and repressive political regime? Or, is democracy a key requirement for the success of a capitalist economy?
Greenspan: China cannot continue as an authoritarian regime indefinitely. The success of capitalism and economic freedom hinges on allowing creative destruction—out with the old and in with the new, more productive and profitable activities. This is what generates increasing investment and capital flows; but it also causes dislocation and job loss. Some people don’t find another job that pays as well. In Communist China today, the dislocated peasants and former State-owned Enterprise workers who cannot find jobs or homes are a time bomb ready to explode. The greatest fear of the central government of China is insurrection and so they refuse to revalue their currency in the hopes of continued surging job growth.
Cooper: They also generate enormous fear as the number of arrests and executions per 1000 people, without due process, is the highest in the world.
Greenspan: Safety valves in a democracy enable disaffected workers (those who lose jobs) to vote for a change in government. It may not help their economic plight, but it makes people feel more empowered. This keeps the working class from rising up. This safety valve does not exist in China, but the Communist regime remains in place, for now, because it is producing material welfare, and is working hard to do so.
I was astounded when Tiger Woods and others played in a golf tournament with enormous prizes in China, and no one commented on it. This is a sign of the times—culture in China has changed. Golf is a capitalist’s game. No Soviets ever played golf in the USSR.
We have been observing the erosion in the power of the Supreme Leader of China ever since Mao. Deng Xiaoping was less powerful than Mao. Zhu Ronghi, who is a good friend of mine and, in my view, the author of many of the most important reforms, had even less power, and so on with Jiang and now Hu. The president’s authority has been declining with each change in leadership. Ultimately, the Communist party will morph into a democratic socialist regime. There will be more than one party and people will have a vote.
Cooper: But will this be a bloodless revolution?
Greenspan: There is a good deal of unrest and the central government’s greatest fear is insurrection. They must keep the economy growing strong and therefore the currency must remain weak. An undervalued currency allows them to continue to export labour-intensive goods. They’re not ready to move up on the quality scale just yet. They are worried, and for good reason, that the people will rise up if that changes.
Cooper: What about the resulting threat of U.S. protectionism? Did you take the Schumer-Graham tariff bill seriously or is it just political sabre-rattling in an election period?
Greenspan: That threat has eased off of late, since the Schumer-Graham bill rightfully was pushed off the floor. Schumer never thought he would get the Congressional support he did. He was only trying to pressure China to revalue, not to actually slap on an inflationary 27.5% tariff on Chinese goods. In any case, the tariff would have been in violation of WTO rules. U.S. protectionist fervour has dissipated of late. Protectionism jeopardises U.S. prosperity. This will continue to be a risk in the future.
Cooper: Another major consequence of Chinese growth has been the surge in commodity prices, particularly the price of oil. Where do you see energy prices going in the long-term? Is there a range of oil prices that would sustain a smooth ride through the economic cycle? How sustainable is an oil price increase?
Greenspan: I have a lot to say about this, and in the end, I doubt you will know what I conclude.
Oil consumption has been rising in line with the volume of proved reserves. But the problem is that reserves in the ground are not the same thing as above-ground crude. Excess capacity is not there anymore; therefore, if anything goes wrong on the supply side, prices can jump. There is also a significant terrorist premium and prices were also bid up by financial speculation.
Hedge funds and other private market players did us a great favour in buying oil contracts. Investors can only invest by buying inventories, so they buy from producers, and that means that those inventories are already committed and cannot be consumed. Record-high prices generate an increase in the growth of supply and a slowdown in the growth of demand. Higher crude prices have triggered an improvement in technology, both green technologies and better oil- related technologies.
Hedge funds now have the inventory they need, so the bids are disappearing and prices are now falling. Speculative positions have come down and prices have come down with it. Global demand for oil hasn’t slowed much, slowing only a little in the U.S. It is not slowing in developing countries despite reduced intensity of consumption. Even developing countries are becoming more efficient in oil usage per dollar of GDP; but, because developing countries are growing so quickly, it means that consumption continues to increase.
Refinery problems are also an issue; there isn’t enough refinery capacity, especially for heavy crude and demand pressure on light crude is pushing the whole oil market higher. So that is causing alternative fuel development and use. I do not believe the future is in ethanol derived from corn. There just isn't enough corn in the U.S. But, I am very impressed with the development of non-cellulose ethanol, made from agricultural scrap. The U.S. may finally start to be weaning off petroleum products; one-seventh of every barrel produced in the world is consumed on U.S. highways. That’s 11 million barrels per day, 20% of which is consumed by large trucks moving goods across the country. If even only this group adopted non-cellulose ethanol, it would have a huge impact on the consumption of oil—a downward impact.
Coming back to China, they are building a strategic petroleum reserve. No one is sure how large the reserve is—we are not sure where all of China’s imports are going, but some of imports must be going to these reserves.
Unfortunately, there are huge gaps in the petroleum data not only with regard to China but much of the rest of the world as well. We can only guess what OPEC produces.
Cooper: China is not the only factor affecting demand. Isn't the U.S. the number one consumer of oil in the world, representing twice the number of barrels as China?
Greenspan: The U.S. consumes not twice as much oil as China but six times as much. The very severe refining problems will take years to resolve. Another problem is that the huge amounts of cash flowing into national oil companies are not being used for exploration.
Cooper: The Prime Minister of Canada, Stephen Harper, has said that the Alberta oil sands will make Canada the next oil Super Power. Do you agree? And how do you view the oil sands and their economic impact?
Greenspan: Alberta will be an oil Super Power, because the U.S. trusts Canada. Canada’s signature is trustworthy… we don't think it's got a Russian signature on it. The U.S. will import increasing amounts of oil from Canada. The only concern is the enormous use of natural gas to create heat to extract crude from the oil sands. You could use nuclear power, but there’s always concern that something terrible might happen. But you could say that about any one of a number of potential dangers.
Cooper: I believe that Canadians are less averse to using nuclear power than Americans. Many in Canada are concerned about greenhouse gas emissions and global warming. I have spent a good deal of time studying the effects of the Kyoto Agreement and I do not believe it will achieve its intended purpose. Nor do I believe it is good for Canada. What is your view of Kyoto?
Greenspan: First, let’s agree that global warming is real, evident, and a given. The greenhouse gas argument is scientifically demonstrated. Kyoto is based on a naďve view of the way the world works. For example, if a small democratic country with its own environment (not one shared by others), tried to pass a reduction in greenhouse gasses, it may well succeed because while it would reduce the standard of living (because of reduced energy consumption, reduced employment, slower growth, etc.), the environment would be better off, benefiting everyone in that country. However, because in reality, the environment is shared by all, even if Canada were to become pristine, it would make no difference to global warming.
Many people only look at one side of the argument—reducing pollution. This is like single-entry bookkeeping. While reducing pollution, we would also be reducing economic activity and living standards. But if we were to put a cap on energy use—forgetting for now that caps never work—the result would be job losses and rising in prices, both of which hurt the economy. Taking this into account, we have double-entry bookkeeping, recognizing there will be a very strong public outcry when trying to reduce energy consumption. Carbon trading works in the EU for just this reason, because it doesn’t reduce energy use.
Cooper: As you have seen, thanks to the oil boom, Alberta’s economy is red hot, with no excess capacity and enormous labour shortages. Prices are rising here, especially real estate prices, and the surge in commodity prices has led to a surge in the Canadian dollar. This has been particularly tough on the manufacturing sector, especially the automobile industry in Ontario. Would Canada be better off with multiple currencies? Or with the U.S. dollar? If you were David Dodge, how would you conduct monetary policy with such a geographically and sectorally diverse economy?
Greenspan: With difficulty. In the U.S., there have been many occasions when different parts of country needed different monetary policies. I remember when California was under strain. The President of the San Francisco Federal Reserve Bank suggested that California’s economy was as big as that of many countries. He argued that if California had its own currency, it would depreciate in value versus the U.S dollar. But having only the U.S. dollar, its currency was stronger than warranted by the pace of economic activity. California was suffering from the ‘Dutch Disease.’ Those sectors of the economy that were not strong were dying, drowned by the value of the currency. Similarly in Alberta and Canada, the commodity sector’s boom is drowning out the manufacturing sector, which was originally much weaker. Alberta should have a different monetary policy than Ontario in theory, but that is impossible in practice.
Cooper: So there is no “optimal currency area”?
Greenspan: It is a very interesting theory for economists, but it has no practical reality. Optimal currency areas, if they could be determined, do not coincide with national boundaries. Alberta should have a different policy, but that’s not realistic. If it had its own currency, it would appreciate and drive out everything but the energy sector. The EU has similar problem. Ireland is growing far more rapidly than Italy, for example, yet both have the same currency and the same monetary policy.
Cooper: Touching on another subject, when I left the Fed in the early 1980s, there were more than 14,000 commercial banks, 4,000 savings and loan institutions and a handful of mutual savings banks in the U.S. Since that time, there has been a massive wave of merger and acquisition activity in the U.S. financial services industry, some of it with foreign banks. This has resulted in far fewer and much larger financial institutions, many of which have nationwide branch networks and a multitude of product lines. There are even some banks among the largest in the world, with significant global reach.
In contrast, Canadian banks have fallen significantly, on a relative basis, in size and global capabilities. Those in this country who oppose bank mergers or foreign acquisition of more than 20% of domestic banks argue that it would reduce competition domestically and, therefore, hurt the consumer and small business. Do you agree and why was that not a concern of yours in the U.S.?
Greenspan: Canada, in the past, was renowned for having a few large well-run banks with national reach. On a relative basis, they are no longer so large.
The world now has two types of financial institutions: the big investment banks/hedge funds/investment banks, all looking for above-average risk-adjusted returns. The other type of financial institution is the collateral lender, especially the mortgage lender, which is often community-based. They might both be called banks, but they are two increasingly different kinds of institutions.
It is going to be increasingly difficult to separate banking from commerce. Larger banks will continue to emerge from continued M&A activity. But we will also see the proliferation of community banks; they have the local knowledge and the local people that the larger banks have trouble replicating. The big banks are trying to imitate them.
I see no reason to fear M&A activity in banking. New institutions will spring up to meet local and community needs.
Cooper: What is the role that gold plays in the financial system?
Greenspan: I love that question. Gold is not an indicator of inflation. When oil prices fall, gold prices fall; gold prices are positively correlated with oil prices. They both moved up with the Iran nuclear scare, and they both declined when the fear dissipated. Gold, instead, is an indicator of the market’s perception of financial chaos.
As a monetary asset, it is expensive to store, and pays no interest. Gold is an ultimate means of payment, in and of itself, accepted irrespective of who is giving it to you. So, for Germany in 1944, gold was the only means of payment to receive goods from other countries. Currencies are backed by government or credit instruments, and for those countries that have bad credit, gold is of value.
But the real use of gold today is a haven against chaos. A small proportion of the investing public is concerned about a major financial breakdown; they are purchasing gold. Because the gold market is so small, a very small segment of people are capable of driving up gold prices. Terrorism, especially nuclear or bio-terrorism has led to a rise in the price of gold, but it fluctuates with the perception of risk.
Cooper: Mr. Chairman, we have talked for quite a while now. What have I missed that is of concern to you?
Greenspan: So many things worry me.
Cooper: Choose just one.
Greenspan: What bothers me is the U.S. health system and the projection of entitlement costs. We are making promises we just can't keep. While we can estimate the costs associated with Social Security, we have no idea what the costs of Medicare will be. We know the number of people that will be entitled to Medicare, but we do not know how much money each will spend on health care, particularly as people are living longer. At this stage, since the labour force is growing at half the previous generation’s rate, Congress can issue entitlement, but we need hospitals, pharmaceuticals, doctors, and other health-care workers to deliver these services. I am worried we might be promising more than the U.S. is physically capable delivering. The growth in the labour force is slowing. Our dependency ratio will be rising (the number of very young or very old people relative to the number of workers) because of the aging of the population.
Cooper: Canada has an even greater problem, as our baby boom was proportionately larger than that of the U.S. The baby boom in Canada started earlier, and at its peak, the average fertility rate in this country was 3.7 children per woman. Fertility rates were well above those in the U.S. for a number of years, but then they plunged. Today, the average fertility rate in the U.S. is 2.1 children per woman.
Greenspan: Which is only replacement rate fertility.
Cooper: That’s right, but in Canada, the fertility rate is a mere 1.5. The growth in the labour force is declining and will fall to a mere 0.2% by 2020, compared to nearly 1% over the past decade. This means the potential growth rate of the economy will fall unless productivity surges, boomers stay on the job longer, outsourcing picks up and/or the immigration of young workers rises. The public health system could well be just as compromised as the Medicare system in the U.S. The public and private sectors will work hard to entice boomers to stay on the job well beyond today’s average retirement rate of 61, and even beyond the traditional retirement age of 65. Many will and should choose to postpone their government pensions until age 70. Dr. Greenspan, you have been an excellent role model in this respect.
As a long-standing admirer of yours, it has been a great honour to speak with you today. Thank you.
(Hand shake.)
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