The Legends of Quantitative Easing

One of the expected advantage of buying stocks is to create, it is hoped, optimism in the future state of the economy.

In one of the greatest investment markets in the world, namely, New York, the influence of speculation (in the above sense) is enormous. Even outside the field of finance, Americans are apt to be unduly interested in discovering what average opinion believes average opinion to be; and this national weakness finds its nemesis in the stock market.

Fed Engineered Asset Price Bubble:

That is ill founded. Optimism in the economy is meant to make people who have money spend and invest. But you can spend and invest what is in your pocket. It is rare, I am told, that optimism will entice you to spend the money you don't have except in the case of the Irrational Exuberance of the bipolar in manic stage, which are statistically not numerous enough to jump start an economy.

The market will soon find out that there is no risk in buying stocks of established companies (mainly the companies included in the SP500) That will create a moral risk and some sort of irrational exuberance. With interest rate at 0% the present value of those stocks could reach stratospheric values in a very short period of time.

We know that Asset Price Bubbles are not Without Dangers:

Clearly, sustained low inflation implies less uncertainty about the future, and lower risk premiums imply higher prices of stocks and other earning assets. We can see that in the inverse relationship exhibited by price/earnings ratios and the rate of inflation in the past. But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade? And how do we factor that assessment into monetary policy? We as central bankers need not be concerned if a collapsing financial asset bubble does not threaten to impair the real economy, its production, jobs, and price stability. Indeed, the sharp stock market break of 1987 had few negative consequences for the economy. But we should not underestimate or become complacent about the complexity of the interactions of asset markets and the economy. Thus, evaluating shifts in balance sheets generally, and in asset prices particularly, must be an integral part of the development of monetary policy.

Thus, this vast increase in the market value of asset claims 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.

Our day-by-day experiences with the effectiveness of flexible markets as they adjust to, and correct, imbalances can readily lead us to the mistaken conclusion that once markets are purged of rigidities, macroeconomic disturbances will become a historical relic. However, the penchant of humans for quirky, often irrational behavior gets in the way of this conclusion. A discontinuity in valuation judgments, often the cause or consequence of the building and bursting of a bubble, can occasionally destabilize even the most liquid and flexible of markets. I do not have much to add on this issue except to reiterate our need to better understand it.

I made a mistake in presuming that the self-interests of organisations, specifically banks and others, were such that they were best capable of protecting their own shareholders and their equity in the firms,

Those of us who have looked to the self-interest of lending institutions to protect shareholders' equity (myself especially) are in a state of shocked disbelief.

Waxman: Do you feel that your ideology pushed you to make decisions that you wished you had not made?

Greenspan: Well, remember what an ideology is: it is a conceptual framework about the way people deal with reality; everyone has one; you have to; to exist you need an ideology. The question is, whether it is accurate or not. What I'm saying to you is, yes, I found a flaw. I don't know how significant or permanent it is. But I have been very distressed by that fact.

Waxman: You found a flaw in the reality? (!!!??)

Greenspan: I found a flaw in the model that I perceived as the critical functioning structure that defines how the world works.

Waxman: In other words, you found that your view of the world, your ideology, was not right, was not working.

Greenspan: Precisely. That's precisely the reason I was shocked because I had been going for 40 years or more [on this model] with very considerable evidence that it was working exceptionally well

Conclusion:

I pronounce officialy the death of the free market capitalist economy if not of the capitalist economy.

We have no hope that those eggheads at the Fed and at the Treasury will ever change their Ideology and lead a policy contrary to the special interest groups and vested interests they defend and understand that credit is the least critical systemic linkage of the economy. The most critical systemic disruption comes from the lack of consumption capacity of the ordinary folks. We know they will continue to deseperatly pump the liquidity pipe in order to try to revive investments when it is the last thing this economy needs: it is precisely why it is called a Liquidity Trap.

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