Tuesday, July 31, 2007

Bye, Bye Greenspan Put. Hello Market Discipline.

You may recall that the Greenspan Fed had the tendency of acting preemptively, seemingly at the first sign of danger. Moreover, the Greenspan Fed was far more inclined to view nearly all difficulties experienced by financial institutions as a reason to step in and provide whatever liquidity was needed to avoid contagion from erupting. Both facets gave the impression that the actions of the Greenspan Fed relied heavily on the artistic judgment of the Fed chairman.

Contrast that with the Bernanke Fed, which appears to take a more deliberative and detached approach to action preferring collegial confirmation to prescient preemption. This is not to say that the Bernanke Fed will not act preemptively if it has to. No doubt it will. However, preemption does not appear to be first option taken. Then there is perhaps the single most significant difference of the Bernanke Fed versus the Greenspan Fed: it’s reliance on the principle of the “market discipline”.

Time and again, the market discipline mantra has been espoused. By Fed heads and Treasury Secretary Paulson. However, the implications of this point are often ignored by equity investors possessed with animal spirits, too much liquidity, and the pressure to perform (see prior comments on the issue of hedge fund and traditional equity managers and the pressure to perform).

Investment Strategy Implications

There is a two-fold difference between the Greenspan era and the current one under Bernanke. First, unless the circumstances warrant it, the Bernanke Fed is far less likely to act preemptively. Second, the Bernanke Fed is more likely to let the markets exercise a market discipline, which has been defined as the first line of defense against excess risk. In other words, there is no Bernanke put. You play, you pay.

The larger issue that remains to be learned is just how effective the new regime (both meanings) will work out when (not if) a major financial or economic crisis hits. Put differently, can the Bernanke Fed manage a crisis without resorting to a flood of liquidity, which has the unintended consequence of generating the next bubble? And that will be the mother of all tests for the professor turned Fed chairman.

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