The U.S. employment report for October 2008 was released that cold November morning, reporting a shocking 240,000 jobs lost along with a huge downward revision to the previous month. This data would eventually to be revised to 423,000 jobs lost, two months later.

After a number of weary weeks, many Bay Street participants were looking forward to this fully sold out luncheon sponsored by the Toronto Board of Trade and Toronto CFA Society. The audience was not disappointed.

You and Me and Two Thousand of Our Closest Friends

Seated facing each other on two comfortable leather chairs, reminiscent of a gentlemen’s pipe-smoking club, Alan Greenspan, U.S. Federal Reserve chief from 1987 to 2006, and Don Drummond, senior vice president and chief economist for TD Bank Financial Group, discussed several topics including recent economic news, world stock markets and possible solutions to the financial crisis.

“Don’t worry,” Drummond assured Greenspan. “Our conversation will be off the record, between you and me and two thousand of our closest friends.”

Are we there yet, Dr. Greenspan?!

Drummond started a conversation about the U.S. employment report and asked when we will see the end of this financial crisis. Greenspan said we needed to see two things stabilize: U.S. home prices and world equity prices.

Greenspan expects that U.S. home prices will bottom out by the first half of 2009. In fact, he believes we need to get to the point where home prices are predictable and stable so as to clarify the level of equity in homes⎯the ultimate collateral support for much of the financial world’s mortgage-backed securities. The assets of banks and financial intermediaries’ balance sheets could then be cleaned up and capital more freely allocated by investors.

Regarding world equity prices, much of the world’s equity prices had just bounced from multiyear lows. Many were asking, is this THE bottom? Greenspan suggested recent market action showed all the characteristics of a bottom, but this could just be another stage before going down again. Greenspan “frankly had no clue” whether world indices had bottomed. Drummond joked, “As the doctor says when a baby is born, all bottoms look the same but we cannot determine what this bottom will grow up to be.”

In terms of the economy, Greenspan suggested that based on early October 2008 indicators, the U.S. economy was close to a virtual free fall. However, “history tells us that markets stabilize long before the economy does.” Stabilization will feed on itself, encouraging investors to seek riskier assets and adding much needed capital to the financial system.

What to do. What not to do.

Drummond asked: “Will the U.S. sink under the weight of its excesses?”

Greenspan replied that the world’s largest economy is resilient and fortunate. Long-term mortgage rates had fallen on the belief that U.S. inflation would not be a problem despite a deficit approaching 5–6 percent of that country’s GDP; such was not the case in many emerging markets. The U.S. dollar retained its safe haven status in the global financial crisis.

He warned that the U.S. must be careful not to cause a flight from the dollar. Although Greenspan did not expect this, he could not be confident that it would not happen, adding “there’s nothing sacrosanct about the United States where we can do anything we want, and we can do it in any way we want without consequences.”

He cautioned against allocating sovereign capital to individual industries that do not have the risk associated with financial systematic failure (not coincidently making this statement as U.S. automakers were trying to secure short-term funding with government help). Any further action should consider the risk of moral hazard, which encourages inefficient allocations of private investment with long-term implications for future wealth creation and the standard of living.

Clearly bringing down the foreclosure rate would help, since the process benefits neither homeowner nor lender. In the past savings and loan crisis, lenders could meet with borrowers to do this; today it is more difficult to find who the lender is due to the securitization of debt. Keep focus on the macro banking system, Greenspan advised.

Also, he suggested governments avoid adopting protectionist policies, which are generally accepted to be economically inefficient.

In His Defence

Greenspan discussed his tenure at the Federal Reserve during which the United States resiliently pulled through many financial upheavals⎯the 1987 stock crash, the savings and loans crisis, and the technology bust. He answered his critics.

During the nascent boom in 1994, the Federal Reserve raised rates 300 basis points, which indirectly brought stocks down. However, the Fed found that as they stopped raising rates, markets surged higher⎯thinking if rising rates did not kill the market, nothing could. In terms of deflating asset bubbles, it was hard to argue with scant evidence to support it, that bubbles can be deflated until they break on their own.

Following the stock crash of 2000, the Federal Reserve took criticism for keeping rates low for too long. The Fed took insurance out against Japan-like deflation. Although not expected, the dangers were too great if it were to occur.

By 2003 when the Fed tried to raise short-term rates, long-term rates stubbornly remained low and at times fell; he called it “a conundrum” at the time. This was the first time in the post-war era that raising short-term interest rates did not affect long-term rates. Global forces were too great given that the developing world had accumulated a huge glut of savings.

Regarding the U.S. sub-prime problem, Greenspan pointed out that it first caught the attention of the Fed in 2000 and regulation was considered. Instead, the Fed chose to watch it first; delinquencies actually went down for several years. Only in 2005 did the quality of mortgages deteriorate as the demand for sub-prime mortgages, particularly from abroad, greatly exceeded supply. By 2007 almost half were under water (debt exceeded equity).

Any thoughts on Canada?

Finally on one topic “near and dear to you,” Drummond asked if Canada should look to expand beyond its borders given that our banking sector remained the prime beneficiary of not doing so earlier.

Greenspan replied that even having done “almost everything right,” being neighbours with the U.S., “you’ve got a problem.” When investing in undervalued assets, which by relative standards might describe Canadian assets–timing is imperative. Some experts specialized in this area but not him. Build your capital up to a point until demand for it arrives, he advised.

No matter how you judge Greenspan’s culpability in today’s crisis, there’s one thing we can agree on–he can sure fill a venue.