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The Yoda of capitalism sees a looming menace

by Peter A. McKay
Aug 1 2017, 3:57pm

Much like Yoda is former Federal Reserve Chairman Alan Greenspan. Old he is, at 91. And translation his words have often required.

But on Tuesday, Greenspan, who ran America’s central bank from 1987 to 2006, gave a pretty clear warning about the U.S. economy in an interview with Bloomberg News.

It’s not about the stock market bubble, despite the Dow Jones Industrial Average’s current flirtation with a milestone above 22000. (The index just missed the mark on Tuesday but still finished at a new all-time high, up 72.80 points at 21963.92. Year to date, it’s gained 11 percent.)

No problem with that, says Greenspan. But great danger he senses in a bond bubble overdue to burst.

“The real problem is that when the bond-market bubble collapses, long-term interest rates will rise,” Greenspan told Bloomberg. “We are moving into a different phase of the economy — to a stagflation not seen since the 1970s.”

Bonds are a form of debt issued by a government, company, or other entity. They can be traded as an investment, like stocks, and they also pretty much allow capitalism itself to work fluidly day-to-day. By selling bonds on the open market, issuers from the U.S. Treasury to General Motors to your local bank can effectively borrow money to fund new projects, expand operations, and so on.

Of course, the money has to be paid back with interest, which bond investors refer to as yield. The yield of bonds moves in the opposite of direction of the price as they’re traded each day.

When bond prices are elevated, like now, yields tend to be low. But at times when prices fall sharply, borrowing costs go up. In really extreme cases, like the historic crisis of 2008, the bond market can just freeze up entirely as participants either become too afraid to lend to each other at all or demand very high yields to cover their risk.

During the dark times of the ’70s that Greenspan alluded to in his Bloomberg interview, inflation was high, so the Fed raised its official interest-rate target sharply, to a peak of 20 percent in 1981. This was the path to higher borrowing costs for everything from mortgages to credit cards to business loans. Which led to slower economic growth overall. Which led to suffering for everyone.

In today’s economy:

—Growth is already weak. Most economists expect gross domestic product to grow about 2 percent this year, contrary to Donald Trump’s wild promises.

—The Fed’s current interest-rate target is pretty low, ranging between 1 and 1.25 percent. That’s a far cry from the ’70s peak, of course, but the central bank is likely to raise rates later this year.

—U.S. manufacturing activity is slowing, according to new data released Tuesday. The Institute for Supply Management’s monthly index of U.S. manufacturing activity fell to 56.3, slightly below analysts’ consensus expectation of 56.4, according to FactSet.

In other words, some pieces of the “stagflation” scenario worrying Greenspan are already in place. Only time will tell about the rest — and whether the economy can avoid a full-fledged turn to the Dark Side.