Weekend at Alan's

Back in late 1999, when Senator John McCain was running against then-Governor George W. Bush in the Republican primaries, he was asked whether he would reappoint Alan Greenspan as Federal Reserve Chairman if he was elected president. McCain replied, “Not only would I reappoint him, but if he died we’d prop him up and put sunglasses on him like they did in the movie Weekend at Bernie’s.”

Everyone had a good laugh.

With Mr. Greenspan's scheduled retirement next January drawing ever near, few people are laughing today, and for good reason.

The Issues

As discussed in this article from the Financial Times, there is great concern about the transition from the current Fed chairman to the next. The major issues the incoming chairman will have to deal with are:

1. Too much debt
   
2. Sustaining the economic expansion
3. Too much household debt
4. Too much carry trade debt
5. Too much debt
   

Honest!

Here are the issues, in excerpt form, from the article. You read 'em and see if the above summary isn't accurate:

1. "Although the US is outperforming most other industrial economies, it is borrowing heavily to sustain a massive wave of spending. This poses no immediate problem for the US, but when the economies of Europe and Japan return to robust levels of expansion, the Fed will have to decide how to respond to the likely increases in domestic inflation and a falling US dollar."

2. "Even before that happens, the new chairman must formulate a monetary strategy for an ageing economic expansion that, on the day he or she takes office, will be in its fifth year. While it is unlikely that the current expansion will end next year, the challenges of guiding the economy on a sustainable path can only grow in coming years, especially if oil prices continue to rise."

3. "The new chairman will need to make tough judgments on the housing sector. Unfortunately, the Fed does not yet view this with alarm. It has drawn attention to isolated instances of exuberance while publicly applauding aggregate data on housing activity and the financial strength of households. Nevertheless, household debt has risen sharply, and the grave risks this poses can be minimised only by low interest rates, rising household income or a combination of the two. For the new chairman the question will be: can households continue to serve as a stabilising force in the next recession or have they already been marginalised by the household debt binge?"

4. "This approach [measured rate hikes and transparency] has wrought several unintended consequences. For one, it has contributed to a massive carry trade - borrowing in low-yield funds to invest in higher-yielding ones. This is because investors have been conditioned to expect moderate and steady increases in money rates, which their quantitative analysis shows will pose limited risks, if any, along the yield curve. This, in turn, has led them to conclude that the carry trade can be the source of substantial profits. As a result, the yield curve spread has compressed significantly. Although spread compression typically yields smaller profits from carry trades, profits have remained high as investors have enlarged their positions."

5. "The second unintended consequence of the Fed's measured response policy has been the massive growth of debt. Investors have reacted to the assurance of a measured response by borrowing more. In highly securitised and innovative financial markets, which by themselves encourage entrepreneurial financial behaviour, rapid debt growth is a natural consequence of measured response policies. When uncertainty is reduced, risk-taking increases. Non-financial debt has increased at an annual rate of about 9 per cent during the past one-and-a-half years, while nominal gross domestic product rose 6 per cent over the same period. In the short run, this has buttressed economic expansion. But continuing to follow this approach will bring trouble down the road for the economy and for financial markets."

The Dream Team that Isn't

Lest anyone think that there may be some reason for concern when the current Fed chairman retires - that perhaps some little pin-prick somewhere will cause a snowballing loss of confidence in the absence of Mr. Greenspan - we refer back to one of our favorite articles from The Economist. This blunt assessment of how the Bush economic team might respond to a financial crisis may perhaps elevate what was a moderate level of concern into more of a panic:

"In theory, Mr Bush's economic team is headed by John Snow. The president was on the point of sacking his treasury secretary at the end of last year; he then pulled back—but only apparently to keep Mr Snow as a travelling salesman for his pension-reform scheme. The former railroad boss has recently visited such well-known global financial centres as San Antonio, Albuquerque and New Orleans.
...
Mr Bush clearly prefers businessmen and true believers to academics and Wall Street types.
...
There are two growing suspicions about Mr Bush's approach to economic policy. The first is that he sees it mainly as a question of salesmanship. Showing an admirable faith in markets, the president seems to think that economic policy will basically run itself; what you need is a bit of pizzazz to sell the president's reforms. Hence, the White House's enthusiasm for Carlos Gutierrez, the new commerce secretary, who made his fortune selling breakfast cereal at Kellogg.

The second suspicion is that loyalty is more important than knowledge. That was Mr O'Neill's problem: he said that more tax cuts were a bad idea. Larry Lindsey, Mr Bush's bumptious first chairman of the National Economic Council, was pushed out soon after he made the impolitic (but pretty accurate) point that the Iraq war could cost $200 billion.
...
In other words [in the event of a crisis], it would all come down to Mr Greenspan. But the Fed chairman is due to step down early next year. There are three front runners to replace him: Glenn Hubbard, who is well regarded but still seen as a fiscal rather than monetary expert; Ben Bernanke, a former economics professor from Princeton and now a Fed governor; and Martin Feldstein, a fiscal expert from Harvard and head of the Council of Economic Advisers in the Reagan era.

None of these men has recent experience of dealing with financial crises. That was true of Mr Greenspan once too; he earned his spurs by coping with the 1987 stockmarket meltdown. But given the lack of strength within the administration, the risks now are surely higher. Mr Bush should be crossing his fingers that nothing goes wrong."

Maybe we should heed the advice of John McCain - extend Mr. Greenspans term until he dies, then prop him up like they did to Bernie in the movie.