We noticed you're blocking ads.

Keep supporting great journalism by turning off your ad blocker.

Questions about why you are seeing this? Contact us

Font Size

- Aa +

Sat 1 Mar 2008 04:00 AM

Font Size

- Aa +

Greenspan on the greenback

Alan Greenspan, the longest serving US Federal Reserve chairman, delivers his verdict on the likelihood of US recession, the future of the dollar pegs and the threats facing the rise of sovereign wealth funds. Tamara Walid reports.

Alan Greenspan, the longest serving US Federal Reserve chairman, delivers his verdict on the likelihood of US recession, the future of the dollar pegs and the threats facing the rise of sovereign wealth funds. Tamara Walid reports.

Alan Greenspan talks about the US recession as though it has already arrived.

In the US we have been able to withstand significant shocks.

"We are at stall speed, and at a stall speed anything that goes low will get lower," he says with the assurance of an economist that has seen recessions come and go since he was first appointed US Federal Reserve chairman under Ronald Reagan in 1987.

The most striking thing about the former Fed chairman as he takes to the stage at the Abu Dhabi corporate leadership forum, is how frail the 82-year old economist has become. But as he delivers his health check of the US and Gulf economies, there is no doubt that his mind is as sharp as ever.

The talks kick off with the US economy; how bad is the US slowdown and will it be more severe than previous recessions.

"I suspect that it might be but not significantly so. There's an issue here of what you mean by recession and I use the term not in the view of two-consecutive quarters of negative growth, but rather that the actual economy will recede," says Greenspan, adding that the probability of this occurring is better than 50-50, attributing this to the fact that the country's "GDP is growing at zero" at the moment.

Greenspan, however, is still optimistic. He sees a good sign in the degree of flexibility that is beginning to reflect into the economic system in the US and a big part of the world.

"In the US we have been able to withstand significant shocks to our economy without the type of contractions that history suggests were supposed to happen," he says, recalling, in recent years, moving through deregulation to the opening up of markets to "essentially engaging significant globalisation thrust and creating flexibility".

This was the exact factor, Greenspan believes, that enabled the economy to withstand the stock market crash of 1987, which resulted in the market losing a fifth of its value in one day without any obvious consequences in gross domestic product (GDP).

"And then again the 9/11 shock created a very dramatic drop in GDP in just six weeks and then the economy stabilised and we came back," he says.

What's more, Greenspan believes that those same "forces" are still present today, but that current financial problems are much "deeper" than the US economy has experienced in quite a considerable time.

"I would not be surprised to see that we move lower than we did in the last... centuries. But I would be surprised if we had anything of a very serious dimension because our system basically adjusts fairly quickly," he reassures.

Greenspan discussed this same system lengthily in his book The Age of Turbulence: Adventures in the New World, where he lists the many reasons that make the US economy so resilient; one being financial regulation and securitisation that have made the economy better equipped to absorb shocks. The recent crisis, however, in banking securities and other financial instruments might have altered his view on financial liberalisation.

"It has changed my view in a sense that, what I found remarkable... is that very sophisticated professional investors; hedge funds, investment banks, bought all sorts of securities, which look extremely complex and difficult to judge with respect to their value," he says, adding that a good part of the valuations were not market valuations but model-based statistical valuations. Greenspan says he has always assumed that allowing markets to make value judgments will eventually lead to them "getting it right".

"I must say I was appalled by some of what went on, but the argument is not that we therefore should regulate, but fix it, because regulators know far less about risk and they are far less adept at dealing with risk valuation models than the people who are trying to preserve their institutions' equity. One of the mistakes that were made is that a full realisation of how significantly flawed some of these risk management valuation models are, is only now becoming evident," he says.
The issue at hand, says Greenspan, is not so much failing to measure what type of risks might occur but the "mathematics have been inappropriate" because the current models fail to fully capture what immigration does to US business. "We get into states of euphoria that builds up," he adds.

What is almost impossible to do is forecast such dramatic change in the economy, which is the main reason for the ongoing crisis, believes Greenspan.

I have advanced degrees in mathematics. I cannot understand what some of these products are doing.

"If we could forecast, it would be a problem but it doesn't create a discontinuity in the prices of assets and risks because what we do in these cycles is we underprice risk for significant periods of time and history tells us that the aftermath of that is usually very destabilising," he says.

What's worse is that there is no learning curve, says Greenspan. Seldom are the lessons learnt from these experiences, he points out, which in turn results in building up bubbles of all kinds.

"The thing that we have to invest in is this curve; it's not to throw out the whole process which in a way is of extraordinary value; economic flexibility, economic growth and indeed in the global model is taking hundreds of millions of people out of poverty. We shouldn't be throwing that out but should be saying: how do we fix it?" says Greenspan.

He is obviously against re-regulating the market, but strongly advocates fixing it. Re-regulating, he thinks, is equivalent to going back to "the euphoria period when finance was very restricted" and when there weren't as many bubbles and world economic growth was slower.

"The choice is not how to maintain this growth. We either have to accept the issue that we want open markets where risks are taken and if you don't have risks you can't create markets. But if you're taking risks, problems emerge and what one tries to do is to fix them but not go back to that hole, to old periods of highly-regulated economies."

Should Greenspan and financial regulators in the US have warned investment banks when the crisis in the US subprime mortgage market seemed imminent? Greenspan says he tried.

"For people who say we and the rest of the central banks should have raised flags, I say we did," he says, adding that he met with investment bankers who were buying the mortgage products as early as 2004, and expressed his concerns, but demand for these products and other derivatives was too strong.

He recalls meeting a number of bankers back in the year when he pointed out: "I have advanced degrees in mathematics. I cannot understand what some of these products are doing."

Greenspan's warning, however, fell on deaf ears. "When the markets are caught in the grips of euphoria, I don't care what you tell people, they don't want to hear it, they don't want to believe it," he says.

Furthermore, earlier in 1996, when Greenspan questioned the markets' behaviour, calling it "irrationally exuberant", his words of warning were neglected. The markets' reaction was limited to the next 24 hours, he says, adding: "Then they went on for another five years".

Today, the results of this on the US economy have been dramatic. The subprime mortgage crisis and housing oversupply has sent the economy to the brink of recession. The big question here is whether the US economy will drag the rest of the world down with it, as has been the case historically.
China and India as well as parts of the Middle East are clearly emerging as stronger and rapidly-growing economies, therefore accounting for bigger parts of the world economy. Economists believe there is a big chance that these emerging economies could help cushion the world as the US economy stumbles.

"If they maintain much of the policy orientation that they have in the developing world and emerging markets... I think that that would be the case. Indeed, one of the reasons why the US is not in recession technically already is the fact that a considerable part, for example of emerging corporate traffic is coming from abroad," he says, adding: "While there's a significant margin in the US, the share of corporate earnings, which is at least a third from affiliates abroad, is supportive of systems and cash flow."

So what does the US slowdown mean for the Gulf states and their dollar-linked currencies?

Inflation in the UAE has already reached a 19-year high of around 10% and is rising, however, there are no signs of any steps towards the depegging of the dirham from the dollar.

When the markets are caught in the grip of euphoria, I don’t care what you tell people, they don’t want to hear it, they don’t want to believe.

Inflation is a problem currently faced by most GCC countries, with Qatar reporting a 14% surge last year, followed by the UAE, Kuwait and other Gulf states.

In Saudi Arabia inflation reached a 27-year high of 7% at the beginning of this year. The GCC region's inflation average shot to 6.3% in 2007, compared to 0.3% in 2001, according to a Merrill Lynch report.

As the US dollar continues to weaken, GCC countries will continue to experience a constant depreciation of their real effective exchange rates and an increase in imported inflation. So should Gulf countries allow exchange rates to float? Greenspan says they should. He explains why he believes that floating is better than fixing or revaluation of the exchange rate against the flagging dollar.

"In the Gulf states, energy is a dominant force of the economy and it's very evident that... what is pressing exchange rates very particularly is the extraordinary demand for oil as the price of oil goes up," he says.

This means that caution should be exercised when making judgments on allowing exchange rates to rise significantly, as this would place the competitive capability of the region's non-energy activity at a disadvantage in a global context, unless we expect energy revenues to be available indefinitely.

"If one can win that argument then the need to diversify is very questionable. Why bother if you have something as extraordinary as energy to supply the economy? But gas and oil are depletable reserves," he says.

This suggests, says Greenspan, the region's monetary bodies have to be careful about allowing exchange rates to rise.

Floating, suggests Greenspan, "is probably the most useful thing that can be done to stop the increase in the net depletion of foreign assets into the monetary system and therefore the monetary base, which is basically the major force in inflationary pressures".

Adding to the drumbeat of bad news, Greenspan also predicts that booming oil prices, which reached a record of more than US$101 a barrel two weeks ago, will continue to rise. He explains why.

"As a consequence of the shortfall in capital investment, we had a very serious problem that largely because of technological changes and new means of achieving increasing recoveries out of oil reservoirs the essential reserve position of the world has been rising very much in line with the level of consumption."
But the growth in capacity for crude oil production has simply not kept pace with this increase.

The reason for this, believes Greenspan, is that even though earnings, especially in national oil companies, have been very large, very few companies have been pouring back significant investment into expanding crude oil production capacity.

We now have enough liquidity to support more than one major currency.

"This means largely the oil companies, distributors and users in storage and as they sell the rights of ownership on their inventory to the financial centre they have to repurchase the oil, the real oil, not the paper claims, and this is pushing up prices quite significantly," he says.

Going back to the declining dollar - falling to a record low of US$1.50 per euro as Arabian Business went to press - Greenspan believes that the euro, which has been gaining power over the dollar, will continue to do so. He stresses, however, that this is not largely due to central banks moving to euros but the private sector.

"The euro has been gaining even after adjusting to exchange rate changes. What has happened in the world is in part because of this long-term decline in interest rates. The amount of liquid assets in the world is in excess of US$100 trillion and we now have enough liquidity in the world to support more than one major currency," he says, adding that he fully expects that there will be more than one.

As the dollar peg debate gathers pace across the Gulf, it seems that message at least is already well understood here.

Sovereign protectionismProtectionism and not national security may be the biggest threat facing the advance of sovereign wealth funds in the US.

The investments made by Middle Eastern and Asian sovereign wealth funds in American financial institutions have been depriving many US policy makers of rest. Not Greenspan, who says this doesn't worry him.

"I think we all have to recognise that there is a very considerable amount of ownership of assets across borders in the sense that within countries there is a great deal of ownership from one region to the other," he says. "I suspect that most of the negative response to sovereign wealth funds investments is driven by protectionism. In fact, I don't suspect it, I know it," he says, adding: "I think that is extraordinarily counter-productive because the United States has probably gained as much if not more from globalisation in the post World War II period."

At present, it is believed that sovereign wealth funds manage approximately US$2.5-US$3 trillion, with five countries managing about 70% of this.

The figures are also expected to rise to US$15-US$20 trillion during the next five years. Countries managing the funds include China, Kuwait, Singapore and the UAE, in addition to Russia and Norway.

A number of them made a US$60bn cash injection into Western banks struggling with the fallout of the US subprime crisis.

He says that the majority of foreign investors coming into the US will continue to thrive, but that a small number, which are related to national security issues have a problem succeeding.

Arabian Business: why we're going behind a paywall

For all the latest banking and finance news from the UAE and Gulf countries, follow us on Twitter and Linkedin, like us on Facebook and subscribe to our YouTube page, which is updated daily.