Wednesday, October 17, 2007

Manias, Panics and Greenspan

In case you were thinking of reading the memoirs of former US Federal Reserve Chairman, Alan Greenspan, there are three things I can recommend:

1) buy it;
2) buy it on;
3) also buy a copy of Manias, Panics, and Crashes: A History of Financial Crises;


1) greatly improving your understanding of how policymakers react to economic and financial market volatility;
2) saving you some money;
3) suggesting to other people that they buy the same combination, potentially enhancing their (and your) understanding of how financial markets behave.

Reading both books will help sharpen your understanding of how financial markets and economic policy interact, helping to ensure you make more money when others are struggling to stay afloat or worse, living in fear of losing money of their own.

Luckily for you, the key messages contained within both of these books are summarised below.

For those of you with enough time to get through both books, you can stop reading here and go buy them now.


Memoirs often give famous people the first chance in their life to "come clean", revealing facts and tidbits that had until then remained a secret.

The first half of Alan Greenspan's "The Age of Turbulence" provides an unusual amount of information that was for the most part deliberately kept from the public during a period of almost 20 years.

One of the most important confessions that Greenpan makes about many of the issues he was presumed to be all-knowing is this:

"I really had no idea."

While Greenspan would (understandably) have been extremely reluctant to make this statement while Fed Chairman, he is now all too willing to reveal many of his inadequacies.

And even though we are being told this "after the event", much of what Greenspan says offer important insights into the way his successor, Ben Bernanke, is likely to be thinking about approaching the current turmoil in the financial markets.

A good example of Greenspan in honest, frank talk-mode, comes on page 156:

"Knowing when to start tightening [monetary policy], and by how much, and most important, when to stop was a fascinating and sometimes nerve-racking intellectual challenge... it didn't feel like "Oh, let's execute a soft landing", it felt more like "Let's jump out of this sixty-story building and try to land on our feet.""

Note these remarks were made in the context of the challenges facing the Fed during 1996, when the economy was cruising along nicely. During periods of financial market crisis, this uncertainty balloons. Being able to understand the mentality of policymakers in these circumstances is critical to formulating an investment strategy at such times.

And remember, the implications for monetary policy in reaction to certain events in the financial markets can be as important as the events themselves.


Greenspan's tenure at the Fed was marked by two distinct events, seperated by almost exactly 10 years: the 1987 stock market crash and the Asian/Russian financial crises of 1997/8.

Both of these events, as catalogued by Greenspan, both tell a story of a severe shock to the financial system coming at a time of a resilient economic expansion.

As a result, the emergency easing of monetary policy on both occassions were enough to prevent a pronounced and pervasive problem from becoming persistent. As Greenspan reflects on page 191, about the period following the Russian default in 1998:

"[the fear was growing that] after seven spectacular years... the US economic boom was coming to an end. That fear, it turned out, was premature. Once we coped with the Russian crisis, the boom would continue for another two years, until late 2000, when the business cycle finally turned."

A decade earlier, Greenspan, in his first year as Chairman, faced the biggest one-day loss ever in the stock market (-22.5%). But, as he reflects on page 110:

"Contrary to everyone's fears, the economy held firm, actually growing at a 2 percent annual rate in the first quarter of 1988 and at an accelerated 5 percent rate in the second quarter."

Two years later the cycle finally turned.


Two things should stick out a mile:

1) financial crises occur with odd regularity;
2) these crises occur at the late (though not final) stage of the economic cycle.

What's all that about then?

Well, this is what brings me to suggest reading Manias, Panics, and Crashes in conjunction with Greenspan's memoirs.

Manias makes two key observations:

1) economic theory is incomplete and thus incapable of explaining what, why and how financial crises occur;
2) all financial market crises are similar to each other.

While 1) is more of an academic point, 2) isn't. Not only is it consistent with the pattern of many historical crises of both the 19th and 20th centuries, it also makes perfect sense. As the economic cycle matures, much of what caused asset prices (i.e. equities) to rise will inevitably reach a point of saturation or obsolescence, bringing with it a costly transition to the "next phase" of the economic cycle.

This should also suggest the following likely scenario after the financial market crisis we have just witnessed this past summer:

1) The Fed will continue to provide additional liquity to the markets, thus avoiding any sustained downturn in the stock market;
2) the economic cycle will turn in 2 years;
3) at that point, there is little the Fed can do to prevent the stock market from falling, which it will likely do in an orderly fashion.
4) Ben Bernanke will start taking a bath each morning from now on.

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