Aside from the pompous posturing on healthcare and faux frenzy over climate change, nothing has captured more Capitol Hill ink than the economy.
With the first signs of a recovery beginning to take hold, policymakers are wrestling with whether more economic stimulus is needed to jumpstart our still flagging economy.
Former Fed Chair Alan Greenspan says no.
This is the same Alan Greenspan who set the stage for the housing and equity bubble in 2003 when he pushed interest rates to a half-century low of 1 percent, and he kept them there for more than a year.
This is the same Alan Greenspan who humbled himself before the House Committee on Oversight and Government Reform by admitting that he had put too much faith in the self-correcting power of free markets and had failed to anticipate the self-destructive power of wanton mortgage lending.
For years, lawmakers doted on the former Fed Chair as an economic sage. Congressional hearings with Alan Greenspan were marquee events. Markets rose and fell on his often enigmatic turn of phrase.
In My Opinion
Now Ben Bernanke, his replacement at the helm of the nation’s central bank has been dubbed “Man of the Year” by Time magazine, and Greenspan can’t stand the loss of the limelight.
This time, however, he may have a point.
Greenspan argues that while another round of stimulus spending may appear inevitable, it is inconsequential compared to the strength and power of the global increase in equities since March. In a recent interview Greenspan said, “Capital gains have proved a far greater stimulus than one can attribute to the $787 billion program that has been only partially spent.”
In an Economics 101 moment, Greenspan patiently reminded his interviewer that when stock prices go up, the equity in banks and other financial institutions also rise, making it more likely that they will recommence normal lending practices.
According to Greenspan, the level of household wealth is the most critical factor in consumer expenditures. As the individual perception of prosperity dips, consumer spending falls.
Where He Goes Wrong
From 1987 through 2006, during the period Greenspan presided over the central bank, the S&P 500 climbed more than six-fold, including dividends. This led to an unprecedented rise in consumer spending and precipitated an exponential expansion of consumer credit.
On a pure empirical level, Greenspan’s conclusions regarding the power of the equity markets to lift the economy are sound. But so were his assumptions in stimulating the housing and equity markets by keeping interest rates artificially low for more than a year from 2003 to 2004 following the crash of the tech markets. The result was the collapse of the housing market that led to $1.7 trillion in global banking losses and writedowns.
The flaw in Greenspan’s thinking is structural.
Consumer spending is driven as much by the psychology of economic well-being as it is by the reacquisition of wealth. As long as consumers feel insecure, they will be restrained in their spending.
Although the equity markets may be recovering, the job markets are not. The problem is that, of the nearly 8 million jobs lost during the most severe economic downturn since the Great Depression, many will not return.
Historically, we have learned that catastrophic recessions do more than dislodge wealth. They may also signal tectonic transformations in industry along with geographic shifts in production.
The Great Depression, for example, led to a mass exodus from the mid-section as workers fled the Dust Bowl in search of opportunities in the west. As a result, states like California became an economic Mecca.
Although the economic dislocation associated with this recession is not as pervasive as that of the 1930s, the lasting structural impact on the employment sector will continue to retard the outlook for a full-scale recovery among middle income wage earners. These workers will need to access currently unavailable resources to reorient their skills in accord with the industries that will invariably materialize.
Although the stock market is likely to continue its upward trend, the reacquisition of wealth will do little to address the structural problem.
In the aftermath of this crisis, investors will likely remain risk averse. Until these psycho-economic conditions abate, there will be little appetite in the financial marketplace to support new, untested business models.
In contrast to Greenspan’s admonitions, this then may be a legitimate role for continued government stimulus and spending. While this may involve more short-term deficit spending, the returns to the tax base should offset the liability. The nation’s banks already have access to more than $2 trillion of near-zero cost funds through the Fed’s discount window. Despite this massive infusion of capital, they still are not lending. Presently, the federal government has no lever to force them to do so.
This means that in the short run it will be up to the federal government to use its financial resources to expand this economic frontier. Without this narrow-range financial support, a potentially pernicious problem will persist even if the equity markets return to pre-recession levels.
John Cohn is a senior partner in the Globe West Financial Group based in West Los Angeles. He may be contacted at www.globewestfinancial.com
