<i><b>Take heed of Greenspan's last words</b></i>

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The Independent Online

This week, for example, it is worth paying a visit to the Federal Reserve's website (www.federalreserve. gov) to have a look at what Alan Greenspan, its chairman, had to say at this year's Jackson Hole summit, an annual gathering of central bankers and economic policy wonks. Greenspan's remarks (he spoke twice on different days) attracted many headlines, but the full text of what he had to say covered quite a lot of ground and, although a little dense in places, bears some study.

The headlines mostly focused on the threat that asset prices in general (and house prices in particular) will start to fall, with important - though much disputed - consequences for the behaviour of the world economy and its financial markets. Reading the text of his remarks underlines that he does, indeed, regard such a fall as a distinct possibility, but to say that he was giving a warning - implying he had gone out of his way to draw people's attentions to this risk - rather overstates the case.

What he had to say on this subject came in the middle of an extended discussion of what it is that he and other policymakers think they have learnt during his 18 years in charge of the world's most important central bank. Greenspan's central message, as I read it, was that those who argue for monetary policy to be driven primarily by explicit targets for specific variables - be that an inflation target, the money supply or asset prices - are misguided.

Greenspan's argument, by contrast, has always been that central bankers cannot afford to be anything but pragmatic. They need to look at a wide range of different indicators and proceed in a cautious manner, measuring the risk of different outcomes against the severity of the consequences, and not becoming a slave to any particular school of economic theory.

This attitude is perhaps the source of a famous cartoon that shows a worried-looking man standing on a window ledge in a skyscraper, apparently poised to jump. A would-be rescuer dashes into the room shouting: "Don't jump - at least wait until you have heard what Alan Greenspan has to say," to which the would-be suicide morosely replies: "But I am Alan Greenspan."

In fact, you might argue that the most interesting thing Greenspan had to say on this occasion was his admission that the fear of deflation that prompted the Fed's ultra-cheap money policy in the aftermath of the bursting of the internet stock market bubble was never really that strong.

In his words: "In the summer of 2003 ... the Federal Open Market Committee viewed as very small the ... probability that the then-gradual decline in inflation would accelerate into a more consequential deflation. But because the implications for the economy were so dire should that scenario play out, we chose to counter it with unusually low interest rates. The product of a low-probability event and a potentially severe outcome was judged a more serious threat to economic performance than the higher inflation that might ensue in the more probable scenario."

Greenspan's critics, of whom there a good number in the investment community, will inevitably see this as further evidence of his willingness to play fast and loose with the welfare of the economies in his care.

They argue, as I have noted before, that the cheap money policy pursued in the past few years has created a number of unhealthy and dangerous symptoms (the build up of consumer debt; housing market bubbles; the US trade deficit) that could well lead to dire consequences in the future.

Greenspan, it is clear, is not unaware of these risks (as, indeed, you would expect him to be). In another passage, he acknowledges that there has been a significant increase in debt-funded asset prices during the past few years - a development that he attributes to consumers and investors coming to think that good times can continue indefinitely.

In reality, they are becoming less and less aware of (or worried by) the risk in the positions they take.

"This vast increase in the market value of asset claims," says Greenspan in a key passage, "is in part the indirect result of investors accepting lower compensation for risk. Such an increase in market value is too often viewed by market participants as structural and permanent. To some extent, those higher values may be reflecting the increased flexibility and resilience of our economy.

"But what they perceive as newly abundant liquidity can readily disappear. Any onset of increased investor caution elevates risk premiums and, as a consequence, lowers asset values and promotes the liquidation of the debt that supported higher asset prices.

"This is the reason that history has not dealt kindly with the aftermath of protracted periods of low risk premiums."

This is a timely warning. What Greenspan is saying, in other words, is exactly what Jeremy Grantham, the fund manager I mentioned a couple of weeks ago, has also been saying - namely that good times don't always last forever. There is nothing wrong with enjoying them while they are taking place: the danger is in assuming that they can or will continue indefinitely.

Greenspan also made the valid point that it is unwise to rely on any single indicator, such as the interest rate yield curve, to warn you how markets will perform in the future. That said, the fact is that yield curve inversion - that is long-term interest rates falling below short-term rates - has traditionally been a good barometer of risks ahead.

After two and a half years of a strong recovery from the stock market lows of 2002-2003, don't be surprised to see some weakening soon, though these things can never be timed with precision - and it may still not happen until next year, when Greenspan has safely retired from his job.