Greenspan, the Sheepherder

It is common knowledge by now that Federal Reserve Chairman Alan Greenspan oversaw, enabled and approved of, a major transition in the US economy. His infamous “Greenspan-put” in which his actions at the central bank would be driven, if not dictated, by the whims of financial markets, clearly led to higher asset prices. Investors obviously picked up on the strong bias in the Greenspan-Fed’s conduct of monetary policy as they slashed rates at the tiniest hiccup in financial markets, and kept them at low levels for much longer than what would be considered prudent by former administrations. Following markets on the escalator up and taking the elevator down together set a precedent that created a Frankenstein monster, which socialised losses through the printing press while privatizing profits. Such a system was and still is unsustainable as it more or less ensures valuations decouple from underlying fundamentals.

The monetary system in place since the gold-exchange standard that emerged from the rubbles of WWI clearly favours inflation over deflation, so we should expect values expressed in money to have an upward trend imbedded in them. However, a stable system would see nominal valuations rise more or less in tandem. In other words, we would expect a balanced sustainable system to see the price of apples, S&P500, cars, commodities and GDP grow more or less at the same pace.

Note, we are not saying certain markets will never experience idiosyncratic price movements due to their own peculiarities as driven by shifts in supply or demand. On the contrary, shifts in relative prices are the one thing that make a capitalistic system stable over the long run. What we are saying though is that the upward trend in prices is due to a diminution of the value of money per se ,driven by the inherent inflationary bias in monetary policy execution. With stable money, relative prices would change, but not the overall price level. This is important, as any comparative analysis of the pre-Greenspan era versus recent past must take into account the fact that prices do rise, relentlessly. We must thus examine financial asset valuations in relation to other markets to understand what the Greenspan put mean.

One way to do that is to look at equity values relative to GDP. As the chart clearly shows, right after Greenspan takes charge of the Federal Reserve equity valuations move to a completely new paradigm. Monetary policy implementation completely changed under Greenspan’s watch.