The "Greenspan Put" and Excessive Risk Taking

This article argues that many people view the Fed as an insurance policy against financial market risk and believe that the Fed would not allow substantial asset devaluation.  My own view is that people ascribe all sorts of motives to the Fed that aren’t there.  The Fed is trying to tell us that it’s really simple (as are Kash at Angry Bear and Tim Duy in a Fed Watch).  Watch output and inflation relative to target and adjust accordingly.  We can argue about how to measure output, the target, and how to parameterize “accordingly” in the Taylor rule, but those are details, the essence is simple.  The Fed’s behavior is explained very well with a Taylor rule and reinterpreting it as an insurance program or something else is an entertaining exercise, but we probably shouldn’t take it much beyond there.

However, the broader question of whether the perception that the Fed will protect asset markets is causing overconfidence and excessive risk taking among investors is an interesting issue.  For some reason, I’ve been reminded lately of the overconfidence among policymakers in the early 1960s.  After the discovery of the Phillip’s curve and the belief that it represented a permanent inflation-unemployment tradeoff, policymakers were very confident in their ability to pick a particular point on the Phillip’s curve and it was widely believed that the stabilization problem was largely solved.  History teaches us that such overconfidence in any discipline is generally a bad idea, and the 1970s showed economists that humility is always a valuable trait.  Has a run of good luck caused a misperception of the risk of losses so that such overconfidence has emerged again?  This article argues there are reasons to believe it has:

Backstopping the Economy Too Well? - Some Experts Worry Greenspan's Success Bequeaths Risky Overconfidence, By Nell Henderson, Washington Post:  In financial markets, they call it "the Greenspan put" -- a belief that if stock or bond prices fall too much, the Federal Reserve will help prop them up ...  For many home buyers, it's the sense that house prices will keep going higher … thanks in part to Fed policies under Chairman Alan Greenspan.  For many lenders, it's the assumption that borrowers … will have no trouble repaying increasingly risky home mortgage and home-equity loans.  But according to some Fed observers, this confidence is … worrisome … Greenspan …and other Fed officials have expressed concern about increasingly risky financial behavior … The chairman even felt compelled to state recently that he cannot foresee the future and prevent all bad things from happening. … Investors have come to perceive the Fed's policies of recent years as "free insurance for aggressive risk-taking," said John H. Makin, an economist at the American Enterprise Institute. "Who doubts that a sharp drop in the market for housing or in the stock market would cause Fed [credit] tightening to stop or even to be reversed?" … People may be taking more financial risks because they reasonably expect the economic waters to remain calm, Greenspan suggested in his February report to Congress:  "In the United States, only five quarters in the past 20 years exhibited declines in [economic output] and those declines were small. Thus, it is not altogether unexpected or irrational that participants in the world marketplace would project more of the same going forward."   … Greenspan also said recently that the nation's housing boom is an unintended but acceptable side effect of the Fed's efforts to support the economy through difficult times. …

This article essentially asks if recent economic stability is due to good luck or good policy.  If you are interested in explanations for the decline in GDP volatility since 1984 such as good luck, good policy, and better technology (inventory management), see Ramey and Vine (2004).

Comments

[anne]

Alan Greenspan has been arguing for some time that our economy in particular had grown increasingly shock resistant or resilient since 1980. Investors seem to believe the same and have bid up asset prices correspondingly. Jeremy Siegel makes just this case for stock market investors, while his buddy Robert Shiller argues it is not so.

[calmo]

Shiller over Siegel any day.

[anne]

Shiller over Siegel, fine. Then, what of Alan Greenspan's sense that modern economies become more resilient to shocks? Inflation was controlled roughly but from then on from 1981. We managed a strong dollar to 1985 and a weak dollar after. We managed 1987 without a recession or even a negative stock market year. What of 1990, 1994, 1998, 1999, 2000...? Do reasources move faster in the wake of economic shocks? Of course, if America is resilient who is Japan not? The strong Yen from 1985 may have hurt the Japanese economy for the last 15 years. How could that be?

[anne]

When I note Shiller over Siegel is fine, by the way, I side with Shiller on housing and Siegel on stocks.

[anne]

Thinking of resilience and protection, Alan Greenspan according to Alan Blinder has spoken at times at Fed meetings of protecting asset values, not manipulating asset value just protecting against shocks or the effects of shocks. So, I would guess the Fed will try to raise a few more times but will be cautious not just of slowing growth but of signs the housing market has cooled.

[anne]

What the Fed will wish for when it finally happens is only a levelling of housing or real estate prices rather than a decline. Families will have to find another asset to build wealth with if housing prices level off for an extended period. The alternative again will be stocks, so I am thinking Siegel has the edge on stocks if the Fed is protective of asset values. Notice Britain is my advie to myself.

[anne]

A question that puzzles me is to what extent the Vanguard REIT Index can offer a sense of the strength of the housing market.

[anne]

http://www.calvorn.com/gallery/photo.php?photo=4785&u=133|11|...

Black-throated Blue Warbler
New York City--Central Park, Hallet Sanctuary.

[Mark Sullivan]

Anne,

have you looked into the composition of the Vanguard REIT index? I think it is more of a bet on commercial real estate than residential housing. Indirectly, they are a bet on the housing market (the retail industry is being supported by cash out refinancing and wealth effects. Incidently, there's an interesting article in Barron's this week about british retailers losing revenue as the british housing market slows). I think they also share an affinity for low interest rates with residential housing (all real estate concerns use leverage).

re: the stock market will go up when real estate investment is less attractive.

Yes, but maybe not the american stock market. Stock market value is ultimately tied to growth in the economy. Right now, the real estate industry (and related) is providing a lot of economic growth, new jobs, spending. Once people realize that their house isn't going to appreciate in value, refis go away, real estate jobs go away, consumer borrowing and spending goes down in a reverse wealth effect. That's not good for stocks in the short run, even if there's not an economic meltdown.

Also, even if you think Siegal is right about stocks in the long run, investing in the stock market at a peak could mean ten to twenty years before you get your money back. No one knows when the peak will be, but the penalty for bad timing can be pretty high.