WASHINGTON – Asset bubbles fueled by "market exuberance" invariably burst and policy-makers cannot safely pierce them, Federal Reserve (search) Chairman Alan Greenspan (search) said Tuesday in what some economists took as a warning to bond market and housing speculators.
In a speech in which he once again defended the Fed's decision not to deflate the late-1990s stock market bubble (search), Greenspan said a successful monetary policy can be a victim of its own success — by reducing economic volatility that in turn fosters greater risk-taking.
He warned that protracted bouts of big risk-taking by investors are always followed by asset-price declines, and he said maintaining the U.S. economy's flexibility was essential to helping it weather the inevitable blows.
"History cautions that extended periods of low concern about credit risk have invariably been followed by reversal, with an attendant fall in the prices of risky assets," he told an economics conference in Chicago via satellite.
"Because it is difficult to suppress growing market exuberance when the economic environment is perceived as more stable, a highly flexible system needs to be in place to rebalance an economy in which psychology and asset prices could change rapidly," he said.
Prices for both U.S. stocks and government bonds rose a bit after his remarks as traders showed relief he had not signaled higher-than-expected interest rates ahead.
The Fed chief, who steps down at the end of January after more than 18 years, said the U.S. economy's ability in recent decades to weather a series of shocks — including the latest run-up in energy prices — offered evidence of its increased flexibility.
"That greater tendency toward self-correction has made the cyclical stability of the economy less dependent on the actions of macroeconomic policymakers, whose responses often have come too late or have been misguided," he said."
"It is important to remember that most adjustment of a market imbalance is well under way before the imbalance becomes widely identified as a problem," Greenspan added.
The comments reminded observers of Greenspan's now famous warning to stock market investors in a 1996 speech not to get caught up in "irrational exuberance (search)."
Some economists have criticized Greenspan for failing to stem the stocks bubble in the 1990s. He also faces criticism for an ultra-low interest rate policy in recent years that some argue has fueled speculation in housing.
As he has in the past, Greenspan defended the Fed's decision to wait for the "eventual exhaustion of the forces of boom" in the 1990s, saying acting aggressively to deflate the stock market could have led to a "significant recession."
"Whether that judgment continues to hold up through time has yet to be determined," he said.
He raised the prospect the economy's greater flexibility in recent years could mean a better economic performance.
"If we have attained a degree of flexibility that can mitigate most significant shocks — a proposition as yet not fully tested — the performance of the economy will be improved and the job of macroeconomic policy-makers will be made much simpler," he said.
Some analysts said the speech appeared in part a "victory lap," but one in which Greenspan seemed concerned about the potential for market stress once he leaves office.
"As outgoing Fed chairman, he's clearly concerned about the asset cycle and the prospect the low concern on credit risk is going to be associated with a decline in asset prices down the track," said Alan Ruskin, research director at 4Cast Inc.
Greenspan did not refer specifically to the low risk premiums evident in the U.S. bond market — a topic he and other Fed officials have addressed in recent speeches.
Those low risk premiums have kept long-term interest rates down, helping underpin swift housing price (search) gains.
In a speech Monday, Greenspan restated his view that "froth" was evident in some local housing markets, but said it was not yet clear if those speculative conditions would reach across the nation as a whole.
On Tuesday, he said "fostering an environment of maximum competition" was the best way to ensure economic flexibility.
In that regard, he said it was important to ward off misguided efforts to try to protect jobs through trade protectionism and other competition-inhibiting policies.
"Protectionism in all its guises, both domestic and international, does not contribute to the welfare of American workers," Greenspan said. "At best, it is a short-term fix at a cost of lower standards of living for the nation as a whole."