Greenspan warns on dangers

Greenspan Warns on Dangers
Of Growing Acceptance of Risk

By JOSEPH REBELLO
DOW JONES NEWSWIRES
August 26, 2005 3:48 p.m.

JACKSON HOLE, Wyo. -- Federal Reserve Chairman Alan Greenspan, saying the recent rise of stock and house prices reflects an increased willingness by investors to accept risk, warned Friday that this inclination could end badly for financial markets.

"What they perceive as newly abundant liquidity can readily disappear," Mr. Greenspan said in a speech at an annual conference of central bankers. "Any onset of increased investor caution" could cause those prices to drop and force investors to liquidate assets to repay debts. "This is the reason that history has not dealt kindly with the aftermath of protracted periods of low-risk premiums." (Full text¹)

The comments amounted to one of the strongest warnings Mr. Greenspan has delivered about financial market risks in years. Ever since his speech about "irrational exuberance" among investors caused markets to swoon in 1996, Greenspan has been cautious about the way he has phrased such warnings. In 1999, at the same central bankers' conference, he warned that the rise in stock prices up to that point was both inexplicable and "extraordinary." The Dow Jones Industrial Average peaked a few months later.

In his speech Friday, Mr. Greenspan didn't discuss the current state of the overall economy or the outlook for monetary policy in the next few months. But he suggested he isn't particularly worried by the rise of crude-oil prices so far. Those prices have risen more than 44% over the last year, to about $67 a barrel.

"The flexibility of our market-driven economy has allowed us, thus far, to weather reasonably well the steep rise in spot and futures prices for crude oil and natural gas that we have experienced over the past two years," Mr. Greenspan said.

Mr. Greenspan said changes in the structure of the world economy in recent years have forced central bankers to pay increasing attention to asset prices. "Global economic activity in recent years has been influenced importantly by capital gains on various types of assets, and the liabilities that finance them," he said. "Our forecasts and hence policy are becoming increasingly driven by asset-price changes."

Household wealth, he said, has increasingly been fueled by increases in stock and house prices. The ratio of household net worth to disposable income, he said, had been stable for 50 years until the mid-1990s. It declined with "the collapse of equity prices in 2000," but has "rebounded noticeably over the past couple of years, reflecting the rise in the prices of equity and houses."

Mr. Greenspan said "it remains to be seen" whether that trend will continue in the long run. "But arguably, the growing stability of the world economy over the past decade may have encouraged investors to accept increasingly lower levels of compensation for risk," he said. "They are exhibiting a seeming willingness to project stability over an ever more extended time horizon."

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Mr. Greenspan also lamented what he called the recent decline of political support for free trade around the world, and the inability of the U.S. government to control spending. Those developments, he said, reduce the U.S. economy's ability to cope with a loss of confidence among international investors or a slump in house prices.

"The developing protectionism regarding trade and our reluctance to place fiscal policy on a more sustainable path are threatening what may well be our most valued policy asset: the increased flexibility of our economy, which has fostered our extraordinary resilience to shocks," he said.

"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."

"Understandable" fears about the effects of free trade on jobs should be addressed through education and training rather than trade barriers, Mr. Greenspan said. "A fear of the changes necessary for economic progress is all too evident in the current stymieing of international trade negotiations," he said.

Mr. Greenspan's speech at the conference, which has been organized since the late 1970s by the Federal Reserve Bank of Kansas City, is likely to be his last as Fed chairman. He has attended the conference for 17 of the last 18 years, offering opinions that shaped not only investors' expectations about the course of monetary policy but also the views of academic economists. His term at the Fed ends Jan. 31 and he is not eligible for reappointment.

Separately, the University of Michigan's full-month report on consumer sentiment was said to show its index for August at 89.1, compared to 92.7 in the preliminary report and 96.5 in July, according to reports. The median expectation of economists surveyed by Dow Jones Newswires was for a reading of 92.8.

The University's index for consumer expectations was said to have moved to 76.9 in August from 81.3 in the mid-month report and 88.5 in July. The current-conditions index for August was said to have shown a decrease to 108.2 from 110.4 in the mid-month report. The July level was 113.5. The report is released only to subscribers.

Write to Joseph Rebello at joseph.rebello@dowjones.com⁸