I just finished reading Alan Greenspan’s latest book on the financial crisis called The Map and The Territory. I really was hoping that the book would be his confession that flawed monetary policy led to a global financial crisis and how he learned all sorts of interesting things about interest rates in the process.. Unfortunately it reads more similarly to Hank Paulson’s memoir On the Brink for his unwillingness to take any responsibility for his decisions and for the absurdity of the excuses he offers.

In Paulson’s book he argues that it would have been illegal to have bailed out Lehman Brothers because they had capital rather than liquidity problems even though he had no problem bailing out AIG with bigger capital problems weeks later. Paulson’s memoir was at least so absurd that it was funny because it was filled with quotes like this:

“On October 30, I took the opportunity to deliver a pep talk to my staff , just before we began a lengthy strategy session in which I would lay out the assignments for the next few days. And of course everyone already expected they they were going to work all weekend. That’s what we did. I had to fly to Chicago with Wendy to babysit our granddaughter – but I, too, knew I would spend most of the weekend working.”

Greenspan didn’t even have funny tidbits about highly important babysitting gigs and fishing trips that required his attention in the height of the financial crisis. Greenspan directs most of the blame for the crisis on the chinese for saving too much money and driving down long term interest rates.

“In short, geopolitical events ultimately led to a fall in long-term interest rates and the mortgage interest rates which they were tied. That led, with a lag, to a global boom in home process”

Unfortunately he argues, there was just nothing he could have done about it.
“Some academics favored an incremental defusing of the bubble through a gradual tightening of monetary policy, but such incremental policies have never appeared to have worked in the real world. Even had we had the official data from 2005, there was little the Fed could have done to contain the rise in home prices”

It’s hard to imagine that higher short term interest rates wouldn’t have reduced the severity of the crisis. Much of the sub-prime mortgage mess is attributed to variable rate mortgages whose attractiveness was largely attributed to low short term interest rates. The share of adjustable rate mortgages in the total value of first mortgages sub-prime origination soared to nearly 62 percent by the second quarter of 2007. There is also the simple fact that low long term interest rates (which Greenspan says caused the housing bubble) are affected by the yield on short and medium terms bonds.

Greenspan should have rested his case with his hit track on Recession Sessions.

When the Fed launched its first episode of quantitative easing in November 2008 (1.25 trillion in MBS purchases and 175 billion in agency purchases), investors largely embraced it and considered it a necessary move given the ongoing panic in credit markets and the threat of deflation. The second round of Quantitative Easing (600 billion in long term treasury bond purchases) in November 2010 was more divided since financial markets and the economy had rebounded and deflation was no longer considered a major threat. The Fed justified its action by stating that core inflation (different from headline inflation which includes energy and food prices) was running below its desired levels and unemployment was still unacceptably high. This third round of QE (open-ended purchases of $40 billion of mortgage debt a month) has seen far more critics than supporters given that the majority sentiment among investors before QE3 was that monetary policy was already overly stimulative.

The tools that Bernanke has used to stimulate the economy have been very unconventional. Without any precedent it is very hard to tell if Bernanke is leading us down the road of recovery or high inflation but it is clear that there is a high degree of concern that it will be the latter outcome.
When the picture becomes clearer he will likely either be boasting as he did in our hit track QE2 or making excuses for providing excess liquidity like Greenspan did in Greenspan’s defense

I recently had the opportunity to hear Pistol Peter Schiff speak on the economy. His speech rehashed his major talking points over the past several years but it was fun seeing him in person. Here were some of his major points:

1. There is already substantial inflation that exists in most major developped economies. He believes that oil prices are the perfect example of this. The demand for oil is at a recent low while the supply has simultaneously reached a high but the price is still at $110 which has been entirely caused by his defintion of inflation ( the increase in the money supply). When pressed about why inflation hasn’t showed up in more tradional measures like the personal consumption expenditure index, he said that much of it has to do with the effect of subsitution. This means that if people were previously eating filet mignon, they might now be substituting towards a cheaper product like hamburger meat and thus PCE will not record inflation. He thinks that by the time measures like CPI, PCE start recording substantial inflation, that real inflation in the economy will already be out of control.

He also thinks that people aren’t more concerned about the inflationary impact of quantitative easing because the government created a good term from a marketting standpoint. He asserted that “Quantitative sounds smart and easing sounds pleasant”. He thinks if they called it what it actually is (debt monetization) people would be more concerned.

2. One conclusion from the inflation we are creating through low interest rates and quantitative easing is that interest rates are bound to rise. At that point he believes both the government and the banks will become insolvent. He says that the banks are borrowing money at practically zero interest rates and reinvesting in slighly higher yielding treasuries and mortgages. Once interest rates rise, the spread will turn negative and they will become insolvent. Concomitantly, the goverment will find it impossible to service the interest on their debt once interest rates rise.

3. He thinks that the dow and gold will converge to a 1:1 price ratio. He says this has already happened twice in history (in the 30’s and in the 80’s) and the economy wasn’t nearly as bad then. He didn’t want to speculate whether the prices will converage at the dow’s current price of 13,000 or gold’s 1,800 or somewhere in between. Other than his bullishness in commodities, he is much more bullish on emerging market stocks that pay a solid dividend. He thinks that the only thing that is worse than holding US dollars are US bonds (a promise to be paid US dollars in the future). He seems to be in agreement with Warren Buffet who recently wrote an op-ed on the toxic nature of US bonds.