Greenspan in Jackson Hole

Today, Federal Reserve Bank Chairman Alan Greenspan spoke at the Fed economic conference in Jackson Hole, WY. Gathered to discuss the legacy of the soon to retire Fed chairman, central bankers and economists from around the world are diving the issues that the new chief will face.

In his speech, Greenspan himself pointed to the difficulties in store in classic Greenspeak, dense and elliptical:

"The lowered risk premiums--the apparent consequence of a long period of economic stability--coupled with greater productivity growth have propelled asset prices higher. The rising prices of stocks, bonds and, more recently, of homes, have engendered a large increase in the market value of claims which, when converted to cash, are a source of purchasing power. Financial intermediaries, of course, routinely convert capital gains in stocks, bonds, and homes into cash for businesses and households to facilitate purchase transactions. The conversions have been markedly facilitated by the financial innovation that has greatly reduced the cost of such transactions.

"Thus, this vast increase in the market value of asset claims is in part the indirect result of investors accepting lower compensation for risk. Such an increase in market value is too often viewed by market participants as structural and permanent. To some extent, those higher values may be reflecting the increased flexibility and resilience of our economy. But what they perceive as newly abundant liquidity can readily disappear. Any onset of increased investor caution elevates risk premiums and, as a consequence, lowers asset values and promotes the liquidation of the debt that supported higher asset prices. This is the reason that history has not dealt kindly with the aftermath of protracted periods of low risk premiums."

In other words, the new resiliency of the American economy is both a blessing and a curse. As Americans perceive an increase in welath, so they increase their spending. This in turn expands the economy in the short term, but long term savings (and thus stability) suffer. The bubble will burst when investors decide to slow investment, overvalued assets will be revalued, and markers will be called in, thus leaving a glut of debt, no new investment, and possible recession.

As Greenspan, who is viewed by many as the greatest central banker of modern times, established a new role for the Fed: risk mangement analysis. Acknowledging the rapid econmic changes precipitated by new technologies and globalization, Greenspan refused to follow any single model of economic analysis. Instead, the Fed attempted to predict probabilities and allow the economy to operate without interference. Monetary policy best serves to maintain ecenomic flexibility, not to predict specific problems and alleviate them before they happen (e.g. the housing bubble. As Greenspan said today:

"If we can maintain an adequate degree of flexibility, some of America's economic imbalances, most notably the large current account deficit and the housing boom, can be rectified by adjustments in prices, interest rates, and exchange rates rather than through more-wrenching changes in output, incomes, and employment."

The question for policy makers, including the new Fed chief, Congress, and the President, how does one encourage economic flexibility?