The Greenspan Putsch

There is a cast of villains that led to the near-collapse of the global banking system and the crisis that ensued.

Republicans blamed Bill Clinton for 'relaxing' controls on Fannie Mae and Freddie Mac, encouraging dirt poor people to get their first mortgage on terms they couldn't afford. Democrats blamed him too, for signing into law the repeal of the Glass Steagall Act (sponsored by two Republicans). Lowly-geared retail banks could now purchase highly leveraged investment banks, with depositors wearing the risks. Others blamed the fraudsters that sold the mortgages and the bubble machine makers on Wall Street.

Almost all of them got away with it. After the Savings and Loans crisis of the 1980s, there were 2,000 prosecutions. The global financial crisis (GFC), a greater and more systemic collapse, has produced a parsimonious crop. Lee B. Farkas has been the only successful prosecution thus far.

The GFC wasn't Farkas's fault'. His role in a long running $2.9bn fraud was the GFC equivalent of stealing a Freddo from a newsagent. If anyone is to shoulder a greater burden, it's the man formerly known as the world's greatest central banker, Alan Greenspan.

The Greenspan effect

At every stage of the economic cycle, from crises in Mexico, Asia, Russia and Argentina, to the collapse of Long Term Capital Management in 1998, from the dotcom crash of 2000 to 9/11, Greenspan's response was the same: make money cheaper.

In the short-term it worked. Everyone could ride the various booms and, at the first sign of trouble, Greenspan would walk down the steps of the Federal Reserve waving cheap money to bail out the feckless and the stupid. Traders, brokers and fund managers rejoiced. There was now a floor to foolishness and no gate on greed. It was one helluva party.

This policy, known as the Greenspan Put, lasted from the late 1980s to 2006, coinciding with his term as Chairman of the Fed. Many also believe it was central to The Great Moderation when the previously resistant boom/bust nature of the business cycle finally succumbed to the policymaker's will. Keynes was dead. Monetary policy was king.

It was a false God, of course. In continually preventing crises over the short term, the inevitable long term crisis was made worse. Excessive risk taking wasn't curtailed; misallocation of capital wasn't punished; and salutary periods of slow or negative economic growth, which can rid the system of bad debts, didn't happen. The 'great moderation' became a giant IOU to the next recession.

‘Helicopter’ Ben rides in

When that IOU fell due during the GFC, Greenspan was gone. His replacement, Ben Bernanke, was better armed. Whereas Greenspan had one tool in his armoury Bernanke had two—interest rates and a giant US dollar printing press. In the form of a new administration, he also had a willing accomplice in using it.

These tools allowed the bankers to be bailed out on a scale hitherto unknown. The debt that the US banking system should have written off, through bankruptcies and defaults, was worn by less wealthy, recently foreclosed citizens, a growing army of unemployed and a reduction in public services. Private debt, and not just in the US but in Europe too, had been socialised. The profits of the boom had been kept largely for the exceedingly rich; the pain of the collapse was to be shared.

The bailout didn't just bring back from the dead zombie banks, it also exhumed John Maynard Keynes and the idea that government spending was again a useful economic tool. Interest rates, which by now were near-zero (see Chart 3 below), had lost their usefulness. Arguments for kickstarting failing economies with debt-financed programs were made, including Kevin Rudd and the Building Education Revolution. Trillions were spent. And much of that money was simply created with a rolls of paper and a printing press, conjured from thin air (see Chart 1).

The result is a more fragile environment than almost anyone cares to admit and a policy bind that is unlike any other in contemporary US economic history. In effect, two of the most powerful weapons in the US government's arsenal are a spent force.

Pushing the limits

US interest rates are now so low that borrowing costs are effectively free. Bernanke has also flooded the US economy with almost $2 trillion dollars. We've had Quantitative Easing I and II—which is how the Fed describes it's money printing—and QE3 looms.

Investment, in a textbook definition of a liquidity trap, remains unresponsive. Corporations are sitting on huge capital sums. If they are investing, they're doing so overseas. Individuals, worried about the future, are saving in an almost unamerican way. And yet the financial system is awash with cheap money. Bernanke's problem, and therefore almost everyone's, is that banks don't want to lend it out and customers don't or can't borrow it.

It was once thought that the idea of monetary policy, the foundation of Greenspan's wonder years, becoming utterly ineffective was fanciful, a distant, theoretical outpost of academia. The US proves it wasn't. 'Pushing on a string is all too real'.

The Keynesian weapon of government spending also faces challenges. Five years ago, US debt stood at 63% of GDP.  It's now above 93%, as you can see in Chart 2. The case that the US is at risk of default is weak—during World War II debt increased to 122% of GDP—but if enough people come to believe that view, financing the US deficit will become more costly, perhaps debilitatingly so. Bill Gross of Pimco and head of the world's largest bond firm recently sounded the alarm by selling out of US Treasuries entirely.

The political environment is such that cutting the deficit, rather than expanding it to help increase economic activity, seems a more likely course. Residents of the United Kingdom are getting a taste of how this can curtail a recovery and cause immense social damage.

Challenging future

The US may not have been here before but Japan certainly has. After the bursting of its property boom, the government reduced interest rates to near-zero and indulged in massive pump priming. The systemic bad debt was covered up, never expunged from the system. The result has been a 20-year recession. Government debt, at over 220% of GDP, is now the highest in the developed world and a recovery seems as distant as ever.

The US hopes to avoid that fate but in attempting to do so grapples with another risk: inflation. As the experience of Weimar Germany attests, flooding an economy with printed money rarely ends well. No one knows how China might react to its US$1,160bn of US foreign reserves being continually devalued by US policies either. The market reaction to an outbreak of inflation is also a great unknown, as is the commodity price boom.

Whether the US and Europe can chart a course between Japanese-style deflation and rampant inflation is guesswork. The authorities rarely get it right. What is clear is that this is an exceptional time. The economic policies that stretched from the early 1980s to the end of the last decade were of the same model. Your investment approach is almost certainly based on that model.

Right now, that model is broken. What got us here, as they say, won't get us there. The question is how you can prepare your portfolio for a time of sluggish economic growth, devaluations, currency wars, deflation and/or inflation.

The monthly Director's Cut feature will continue to address these questions, and help you distill our recommendations into a cohesive and intelligently diversified portfolio. Next month we are introducing another regular feature focused on broader economic and investing issues. We are yet to agree on a name, but this review is one example of what you can expect.

Many bottom up value investors have historically paid scant attention to broader economic issues. But investors need to be aware of external factors, as government and central bank policies will impact your portfolio's returns until the deleveraging process runs its course. As Seth Klarman warns, ‘Bottom-up value investors would not wish to bet the ranch on a macroeconomic view, but neither would they be wise to ignore the macroeconomy altogether. Disaster hedging – always an important tool for investors – takes on heightened significance in today's unprecedentedly challenging environment.’