2 September 2002, 08:54  Greenspan Says Fed Policy Can't Prevent Stock Bubbles

/www.bloomberg.com/ Jackson Hole, Wyoming, Aug. 30 (Bloomberg) -- Federal Reserve Chairman Alan Greenspan said he and his central bank colleagues couldn't have prevented the 1990s stock market bubble because raising interest rates to control share prices might have sent the economy into recession.
``No low-risk, low-cost, incremental monetary tightening exists that can reliably deflate a bubble,'' Greenspan said in a speech to the Kansas City Federal Reserve Bank's annual economic conference in Jackson Hole.
Greenspan's comments were his most extensive response to critics who have blamed the central bank and its chairman for failing to take action to prevent an unsustainable rise in stock prices, a ``bubble,'' from developing during the decade.
The Standard & Poor's 500 stock index rose 233 percent from the beginning of 1999 to its peak of 1527.46 on March 24, 2000. The economy boomed during the decade and the business cycle of expansion and contraction became less volatile, leading investors to pour ever-increasing amounts of money into stocks in the belief that earnings would keep rising, Greenspan said.
Yet, because business investment in computers and other technology was raising the level of worker productivity in the U.S., the Fed couldn't be sure a bubble was developing, he said.
Some investors said Greenspan was trying to distance himself from a situation his central bank helped create.
`Fed Is the Culprit'
``The Fed is the culprit -- they caused the bubble'' by keeping interest rates low and increasing the country's money supply, said Bill Fleckenstein, president of Fleckenstein Capital Inc. a Seattle investment firm, which has $90 million under management. ``Greenspan is now finally feeling the heat for the problems we are facing.''
The most widely watched measure of the U.S. money supply grew at an average 5.9 percent a year in the latter half of the 1990s, compared with 2.1 percent during the first half of the decade, Fed figures show.
Others defended Greenspan's argument. To pop a stock market bubble, the Fed would have to guess at the correct level of stock prices, said Allen Sinai, president and chief executive of Decision Economics. ``I would not fiddle with the workings of asset markets,'' said Sinai, who was attending the Jackson Hole conference.
Debate in 1996
While Greenspan has said repeatedly that the Fed didn't know a bubble was forming, Fed policy makers debated the question as early as 1996. Then-Fed Governor Lawrence Lindsey told Greenspan that ``either the market will stop rising or we will have to decide whether we are going to make it stop by injecting a little risk into the process,'' according to a transcript of the Nov. 13 meeting that year of the Fed's policy-setting Open Market Committee.
The Dow Jones Industrial Average had more than doubled between 1990 and 1996. During the November 1996 policy meeting, Lindsey said the Fed's approach to dealing with the rise in stocks would be ``our toughest decision in the years ahead.''
Three weeks later, on Dec. 5, 1996, Greenspan made an oft- cited speech in which he asked rhetorically how the Fed would know if investors had developed ``irrational exuberance'' about the potential for ever-higher earnings.
Today, Greenspan noted that he had also warned Congress in July 1999 the surge in U.S. productivity didn't necessarily justify inflated stock prices.
Productivity Changes
Recent historical revisions to U.S. productivity figures show that while the pace was slower than estimated at the time, productivity was accelerating during the 1990s. From 1996 to 2001, productivity rose an average of 2.3 percent a year. That compares with the 1.4 percent average of the previous 25 years.
While Fed officials were monitoring equity prices, ``it was far from obvious that bubbles, even if identified early, could be preempted short of the central bank inducing a substantial contraction in economic activity, the very outcome we would be seeking to avoid,'' he said.
While the Fed could raise interest rates incrementally, that's been shown to have little effect on stock prices during the past decade, he said. Stock prices rose after the Fed raised the benchmark overnight bank lending rate in 1989, 1994, and 1999 and 2000.
``Such data suggest that nothing short of a sharp increase in short-term rates that engenders a significant economic retrenchment is sufficient to check a nascent bubble,'' he said.
`An Illusion'
``The notion that a well-timed incremental tightening could have been calibrated to prevent the late 1990s bubble is almost surely an illusion,'' Greenspan said.
Raising margin requirements for stock purchases wouldn't have helped, he said. The amount of margin debt is small, no more than 1 3/4 percent of the market value of outstanding equities. ``Changes in margins are not an effective tool for reducing stock market volatility.''
That wasn't what Greenspan thought in 1996. A transcript of the Sept. 24 meeting of the Open Market Committee that year quotes the Fed chairman as saying raising the amount investors must have on deposit with brokerages in order to borrow money to buy stocks would raise ``major concerns'' in markets.
``I guarantee that if you want to get rid of the bubble, whatever it is, that will do it,'' Greenspan said at the time.
``How can he ignore that comment?'' in today's speech, said Paul McCulley, who manages about $90 billion in fixed-income funds at Pacific Investment Management Co.
Adjusting Margins
McCulley said Greenspan is also wrong in arguing that nothing the central bank could have done would have had an impact. ``He should have declared that the market was a bubble and backed up that declaration with a hike in margin requirements,'' McCulley said.
By ``getting off the pot and declaring that it was indeed a bubble'' Greenspan would have signaled investors that they were overestimating prospects for corporate earnings, he said.
Although the recent recession was ``relatively mild,'' other factors have now pushed stock prices down more than would have been expected, Greenspan said. The S&P 500 fell as low as 797.7 on July 23, a 47 percent decline from its peak.
``The tendency toward lower equity premiums created by a more stable economy may have been offset to some extent recently by concerns about the quality of corporate governance,'' he said.
Greenspan, who became Fed chairman in August 1987, called developments in the economy and financial markets during the 1990s ``particularly challenging'' for Fed officials. ``We were confronted with forces that none of us had personally experienced,'' he said. ``Aside from the then-recent experience of Japan, only history books and musty archives gave us clues to the appropriate stance for policy.''
Investor Mindset
To pop an asset bubble, the Fed would have to change the mindset of investors, he said. Yet, ``prolonged periods of expansion promote a greater rational willingness to take risks, a pattern very difficult to avert by a modest tightening of monetary policy.''
To try to move rates up ahead of a bubble would require the Fed to develop some method of reliably computing ``realistic'' projections for earnings, he said. ``Of course, if the central bank had access to this information, so would private agents, rendering the development of bubbles highly unlikely,'' Greenspan said.
After studying history and their options, Fed officials opted not to try to manage stock prices. Greenspan said he told Congress in 1999 that central bankers would instead focus on policies ``to mitigate the fallout when it occurs and, hopefully, ease the transition to the next expansion.''

© 1999-2024 Forex EuroClub
All rights reserved