Hubris is a nasty disease, the mother’s milk of bubbles in asset prices. Hubris is also part and parcel of the human condition, as Fed Chairman Greenspan has repeatedly noted, most explicitly at Jackson Hole at the end of August, when he declared:

“ (the) 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 prices. This is the reason that history has not dealt kindly with the aftermath of protracted periods of low risk premiums.”

Bill Miller is one of today’s most renowned professional money managers.   He is Chief Executive Officer and Chief Investment Officer of Legg Mason Capital Management, Inc. and leads a team that manages $55.4 billion of assets as of 9/30/05.

His unique investment management philosophy and approach to undervalued stocks has also made him the subject of profiles in numerous books as well as publications, including The New York Times, Barron’s, Business Week, Kiplinger’s, Money, The Wall Street Journal, Fortune, and Smart Money.

Mr. Greenspan is surely right that humans tend to extrapolate the past into the future, often beguiling themselves into believing that what is too good to last will in fact last indefinitely. Such is the stuff of asset price bubbles, in technology and telecom stocks in the late 1990s and perhaps in some property prices at present.

Mr. Greenspan further bemoans that such trend-extrapolating investor behavior has been exacerbated by the Fed’s success in fine-tuning the economy. Specifically, he said a few weeks ago:

“In perhaps what must be the greatest irony of economic policymaking, success at stabilization carries its own risks. Monetary policy–in fact, all economic policy–to the extent that it is successful over a prolonged period, will reduce economic variability and, hence, perceived credit risk and interest rate term premiums.”  

Irony, indeed! Which brings to mind the powerful insight of the great Hyman Minsky that “stability is destabilizing.” Essentially, that is what Chairman Greenspan has been saying of late: bubbles aren’t my fault, but rather a consequence, or at least a manifestation, of how well I’ve done my job, perhaps too well.

‘Tis a curious defense, but perhaps not surprising, as Mr. Greenspan prepares to ride into the sunset, trailing charges of having been a serial bubble blower. Ironically, Mr. Greenspan has a great last chance to put that charge to rest and equally ironic, he can do so not by doing something but by not doing something!

What Mr. Greenspan can do by not doing, we submit, is to break his self-labeled conundrum of falling long rates in the face of rising short rates by stopping raising short rates, raising questions about whether he has gone soft on inflation, which would lift long-term interest rates.  

Yes, Mr. Greenspan could and should spend a little bit of his anti-inflation, stability-prYes, omoting credibility. An excess of such credibility, he seems to be saying, is to blame for excessively low long-term interest rates, which he argued in July, is the proximate cause of present bubble tendencies in the property market: 

“… the exceptionally low interest rates on ten-year Treasury notes, and hence on home mortgages, have been a major factor in the recent surge of homebuilding, home turnover, and particularly in the steep climb in home prices. Whether home prices on average for the nation as a whole are overvalued relative to underlying determinants is difficult to ascertain, but there do appear to be, at a minimum, signs of froth in some local markets where home prices seem to have risen to unsustainable levels. Among other indicators, the significant rise in purchases of homes for investment since 2001 seems to have charged some regional markets with speculative fervor.” 

Many years ago, Mr. Greenspan’s first political mentor, President Nixon, said that in matters of diplomacy, it is useful for your adversary to think that you might just be a little bit crazy. Ironically, the time has come for Mr. Greenspan to apply his mentor’s dictum.

It is time for the Fed to quit trying to force up long-term rates with anti-inflation hikes in short rates, which the market believes will indeed prove prophylactic against inflation, and opt instead for steady short rates, which would let rising inflation expectations lift long-term rates and temper speculative fervor in property markets.

During his tenure at the Fed, Chairman Greenspan has proven himself an able pragmatist in the best tradition of philosopher William James, who authored “Pragmatism” in 1907. In the mid to late 1990s Greenspan noted that economic models were failing to account for the economic environment then unfolding. Rather than being the slave of defunct models, he adopted a market-based approach to Fed policy, changing course when circumstances seemed to dictate.

That left him open to criticism and second guessing, yet the record of his 18 years as the principal architect of monetary policy, one that began with a stock market crash in 1987, encompassed a collapse of the savings and loan industry, emerging markets currency and debt crises, the failure of Long Term Capital Management, September 11, corporate scandals, and even the possibility of a deflationary spiral, has been an unqualified success as measured by the traditional metrics of production, employment, profits, and price stability.

The models are again failing him. Eleven successive rate increases have failed to budge intermediate and long rates, an unprecedented situation.

It is time again for a markets-based policy: if raising short rates is not working to raise long rates, stop raising short rates! Long rates will then rise, just as the doctor ordered.

Two things will happen when the Fed puts finis on the rate increases: the bond vigilantes will awaken like Rip van Winkle after his long slumber, and begin pushing up intermediate and long rates, and animal spirits will begin to stir in the equity market, which has been markedly depressed this year despite modest valuations and strong profits.

A rising stock market will also draw funds from bonds, putting further upward pressure on yields. Rising yields will lead to higher mortgage rates, which will finally halt the rise in home prices, accomplishing another of the Fed’s goals.

The solution to the conundrum of why rising short rates have not led to higher yields at the long end is this paradox: in order to raise rates, the Fed must stop raising rates.

The beauty of the policy of paradox is this: it is also riskless. If the Fed raises rates on November 1 and declares it has reached neutrality, or even better, does not raise rates at that meeting, and bonds yields fail to rise, it can always return to its previous policy of steady increase at the next meeting, with no harm done.

Hubris involves exaggerated self-confidence and a lack of restraint. The Fed was quite confident its policy of measured increases in short rates would deliver higher intermediate and long rates, it was wrong. Now is the time for restraint.

Paul McCulley
Managing Director
October 27, 2005


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