Central Banks Are Repeating Greenspan’s Mistake

Alan Greenspan
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Alan Greenspan

Did you read that headline right? Alan Greenspan, chairman of the U.S. Federal Reserve from 1987-2006 and the most celebrated central banker in modern times?

(Read More: No 'Irrational Exuberance' in Stocks Now: Greenspan)

Yes you did, but there is no need to take my word for it. Authors including Nobel-prize winning economist Paul Krugman and strategist George Cooper have highlighted the long-term impact of the "Greenspan put", and how the era of cheap money during 2000-2006 was one of the causes of the financial crash.

(Read More: Krugman Can't Admit He Was Wrong on Austerity: Latvia PM)

And we are in the same danger again, although this time it comes while much of the Western world, and Japan, is still struggling to come out of recession. Fancy building up a crash while still recovering from the last one!

Back in February, this column mentioned equity markets reaching new highs based on not-very-much and the trend has continued. Last week, the Dow Jones Industrial Average closed above 15,000 for the first time and the FTSE 100 traded above 6500, in sight of its all-time high of 6930, last reached in 1999. Meanwhile, the Nikkei has risen by more than 60 percent in six months.

(Read More: Moorad Choudhry's Blog Post From February)

So do economic fundamentals support this increase in valuation? Possibly in the U.S., where with each passing month's statistics, it appears the country has turned the corner. But in Europe the euro's problems haven't gone away and the U.K. is struggling with all sorts of problems. Japan has applied "Abenomics" to try to get out of recession.

But no-one is so gauche as to think that all this equity market froth is due to something as obvious as economic fundamentals.

The rise in equity prices is due almost exclusively to central bank action. Continuing low interest rates, quantitative easing and asset purchases have contributed to an environment where the equity investor has nothing to lose: prices rise on any sign of good news, but even if the news is bad there is no need to worry because the central banks will pump in more money and buy more assets. One can't lose.

But just as with any real-estate boom, price rises based on cheap money are as solid as a house of cards and what we are witnessing now is yet another financial asset bubble. It isn't just the Fed, Bank of England and European Central Bank either, the Bank of Japan is at it and central banks around the world are cutting rates and manipulating currency to assist exports.

We warned back in 2009 and 2010 that asset purchases and low rates are handy bits of medicine when the world is facing depression, but carry it on too long and they turn into a crutch that is harder to pull away with each passing month. The markets need to stand on their own two feet, but right now it feels like any hint of tightening monetary policy will bring the cards crashing down.

The paradox is that a central bank will only start tightening once it feels the economy has turned a corner. In other words, rising interest rates and a wind-down of quantitative easing are signs of market strength, not weakness.

But the day equity prices reflect economic logic is a long way off. So what we have is a vicious circle of cheap money, unsustainable market bubbles, continuing cheap money and then the bust.

(Read More: As Stocks Rally, Market Flooded With New Shares)

Just like the last time. The world's central banks are making the same mistake the Fed made in the years leading up to 2007. And the longer it goes on, the harder it is to withdraw monetary policy support for asset prices, and the worse the bust will be when equity prices do undergo their next "correction".


Professor Moorad Choudhry is at the Department of Mathematical Sciences, Brunel University and author of The Principles of Banking (John Wiley & Sons 2012).