Secrets of Success: Goodbye to Greenspan and easy money

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The Independent Online

What is the biggest issue facing investors in the coming year?

What is the biggest issue facing investors in the coming year? You don't have to look much further than the question of how Alan Greenspan, the chairman of the Federal Reserve, handles his last year in office. Mr Greenspan is due to retire at the end of the year, after three six-year terms as chairman of the largest and most important central bank in the world. How the Fed handles monetary policy has, for good and ill, become an extraordinarily influential factor in the way that the global economy and world financial markets behave.

Love him or loathe him, Mr Greenspan is an iconic figure and one who excites considerable controversy among professional investors. On the face of it, his time at the helm of the Federal Reserve - where he became chairman for the first time shortly before the 1987 stock market crash - has been an unalloyed success. This, after all, is the man who has negotiated a succession of potential crises (the 1987 crash, the 1994 bond market bust, the Long Term Capital Management affair, the Asian crisis of 1997, the technology bubble of 2000) with both aplomb and apparent success.

Since the 1990/91 recession, he has also presided over an almost unprecedented period of sustained economic growth and low inflation, to the satisfaction of three out of four presidents from different parties. Along the way, rather like Ronald Reagan, the first president under whom he served, Mr Greenspan has acquired a reputation for being a Teflon public figure, to whom no enduring criticism seems to stick, at least in the minds of the general public and private investors, who have profited greatly from his largesse.

Yet, will history record a similarly benign verdict when he finally steps down from office? Many in the professional investment community have their doubts. The argument of his critics is that his easy-money policies - no man has ever cut interest rates so far so frequently - are going to leave behind a potentially disastrous combination of economic circumstances, a mess that all of us will have to pay for in the near future, as the unprecedented pyramid of debt that has resulted from his policies starts to crumble.

It is true that Mr Greenspan does not act on his own in setting the course of interest rates. He is only one of several members of the Federal Open Market Committee, albeit the most influential, and there are subtle and complex political pressures that he has to accommodate in seeking to fulfil his dual mandate of fighting inflation and sustaining economic growth. Nevertheless, not only are his power and stature considerable, but the policy that the Federal Reserve has been pursuing in recent years is clearly his own.

The debate in the world's bond markets at the moment is whether Mr Greenspan has now embarked on a new shift in emphasis in the way that US monetary policy is set. It has been clear since last summer that the Federal Reserve was intent on starting to tighten policy once more, after several years in which it has repeatedly cut interest rates, in an effort to avoid a painful economic fallout from the collapse of the technology and investment bubble of 2000.

In a comment in November, just after the presidential election, for example, he said : "Rising interest rates have been advertised for so long and in so many places that anyone who has not appropriately hedged this position by now obviously is desirous of losing money." The Federal Reserve has also pointedly dropped its reference to "gradual" tightening of policy. The significance of this lies in the fact that it suggests that the US central bank now recognises (1) that a renewed period of inflation is now more likely than the deflation some had started to fear 18 months ago; and (2) the adverse consequences of the cheap money policy it has been pursuing for so long are becoming too severe and too risky to sustain.

The effects of that loose policy stance are certainly there for everyone to see, all around the world. Symptoms include the falling dollar, a yawning US current account deficit and evidence of a serious housing bubble developing in many countries (not just the UK). Consumer spending and house prices have both been driven ever higher by the lure of easy money, resulting in an unprecedented level of debt in the household sector of both the US and UK economies.

The cheap money diet has also acted like a drug to the world's financial markets. When short-term interest rates are kept unnaturally low, it provides an easy source of money for banks and traders - borrowing money at 1 per cent and buying a bond yielding 4-5 per cent is about as easy a way to make money as can be found in financial markets.

The so-called "carry trade" has been gorged on by commercial banks, investment banks and hedge funds alike, inflating profits in the financial sector to unprecedented levels. When what historian Edward Chancellor calls the "credit bubble" bursts, those left holding debt obligations could be badly hurt.

The bottom line is that there has to be a reckoning quite soon. When it happens, expect a period of some turbulence - possibly a recession, certainly an economic slowdown, and retreats by some of the markets that have done so well in the past couple of years.

That almost certainly will include stock markets, though not necessarily the oil and commodity markets, which seem to be at the start of a new long-term bull market, caused by a growing supply-and-demand mismatch which cannot be corrected without substantial investment in new capacity. The timing of this cannot be predicted, but what is certain is that Mr Greenspan will have a big say in the matter. For investors, however, the message is clear: we all need to be alert to signs that the next adjustment is beginning.

Don't believe that housing and equities will deliver good returns indefinitely; whatever happens, the 2000s are not going to be a re-run of the 1980s in those sectors.

jd@intelligent-investor.co.uk

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