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July 01, 2005

A "Greenspan Put"?

Four years ago Barry Eichengreen and I wondered whether the "Greenspan Put" had been a powerful force pushing up lending to high-risk countries in the mid-1990s and pushing up stock prices during the dot-com bubble. But we found a problem: we couldn't find significant evidence that this was the case--indeed, we couldn't find that many mentions of the "Greenspan Put" in the financial press or the financial newsletters in the first place. If it was part of the Zeitgeist, it wasn't in any place very visible to us.

The idea of an important "Greenspan Put" lost plausibility as the Federal Reserve did not take steps to lower interest rates as the NASDAQ fell, but instead waited until it saw signs of slackening investment growth. How could anyone in the aftermath of the NASDAQ crash could speak--as John Makin does--of the Fed as providing "free insurance for aggressive risk-taking"?

Nevertheless, the Washington Post's Nell Henderson thinks it is back. But she rapidly gets badly confused between the effects of (i) good, stabilizing monetary policy which should make one optimistic about the future and cause appropriate rises in asset prices (which seems to be what James Grant is talking about), and (ii) the "Greenspan Put" proper--the belief that government rescues are in the offing--which would cause inappropriate rises in asset prices (which seems to be what John Makin is talking about).

And so the article dissolves into incoherence.

Backstopping the Economy Too Well?: Some Experts Worry Greenspan's Success Bequeaths Risky Overconfidence. By Nell Henderson: 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 with quick interest rate cuts to pump more cash into the system.... But according to some Fed observers, this confidence is a worrisome legacy after Greenspan's nearly 18 years helping to steer the economy through a variety of storms... people can take bigger financial risks because the chairman can and will save them if their bets go sour.

Greenspan... and other Fed officials have expressed concern about increasingly risky financial behavior, stepping up their warnings about exotic investment strategies, real estate speculation and loose lending practices. The chairman even felt compelled to state recently that he cannot foresee the future and prevent all bad things from happening. "The economic and financial world is changing in ways that we still do not fully comprehend," Greenspan told a bankers' conference in Beijing. "Policymakers accordingly cannot always count on an ability to anticipate potentially adverse developments sufficiently in advance to effectively address them."

Now you tell us.

"The essential Greenspan legacy . . . is the idea that the Fed will allow nothing to go really wrong," said James Grant.... 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?"

See also Mark Thoma: Economist's View: The "Greenspan Put" and Excessive Risk Taking.

Posted by DeLong at July 1, 2005 03:24 PM