Alan Greenspan and the stock market bubble
10 September 2002

Quite a lot has been written lately about Federal Reserve chairman Alan Greenspan's speech at Jackson Hole on 30 August in which he essentially disclaimed responsibility for the stock market bubble of the 1990s. Much of what has been written has been critical of the chairman. Some has been downright vitriolic.

In his speech, Greenspan had asserted that "despite our suspicions, it was very difficult to definitively identify a bubble until after the fact -- that is, when its bursting confirmed its existence". Furthermore, he asserted that "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".

Greenspan has been criticised for his assertion that it is difficult to identify a bubble. In fact, many bears had been writing about the bubble since the late 1990s. As Comstock Partners pointed out on 9 September on its website, "there is an existing body of scholarship on bubbles describing their specific characteristics, how they have occurred repeatedly throughout history, and how to identify them while they are happening…We at Comstock identified the recent bubble in reports we were writing for institutions at the time." And the irony is that Greenspan himself warned of "irrational exuberance" in his now infamous speech of 5 December 1996. That followed a Federal Open Market Committee (FOMC) meeting on 24 September 1996, in which Greenspan reportedly said: "I recognize that there is a stock market bubble problem at this point."

Apparently, Greenspan had a change of heart after that. In his Jackson Hole speech, he suggested that the rise of stock prices in the late 1990s "implies a significant fall in real equity premiums in those years". However, he went on to suggest that "[i]f all of the drop in equity premiums had resulted from a permanent reduction in cyclical volatility, stock prices arguably could have stabilized at their levels in the summer of 2000. That clearly did not happen, indicating that stock prices, in fact, had risen to levels in excess of any economically supportable base."

In other words, Greenspan suggested that lower equity premiums arising from lower cyclical volatility provided a plausible basis for higher stock valuations. It just happened to be incorrect. Greenspan's mistake was that he gave the stock market the benefit of the doubt. But as William Pesek Jr. pointed out in his Bloomberg column on 2 September: "He's supposed to be the curmudgeon in the room at all times, the one who fears the worst even when things seem grand. The old saying about the Fed being there to take away the punchbowl just as the party is getting started is true. In the 1990s, though, Greenspan seemed to forget that."

However, Greenspan did more than accept the high stock market valuations. He became a cheerleader for the New Economy. As Stephen Roach, chief economist for Morgan Stanley, wrote on 9 September in the Global Economic Forum: "The rhetorical flourishes of Chairman Greenspan took perceptions of the New Era to an entirely different level. He became almost evangelical in his passion. In a January 2000 speech before the Economic Club of New York, he maintained that 'the American economy was experiencing a once-in-a-century acceleration of innovation, which propelled forward productivity, output, corporate profits, and stock prices at a pace not seen in generations, if ever.'" Or as William Fleckenstein, the president of Fleckenstein Capital, wrote in MSN Money, "he not only didn't recognize the bubble, he grabbed the pom-poms and microphone, and cheered about productivity at every possible chance, as well as the glories of the Internet". Or getting back to Pesek's metaphor: "Far from hiding the punchbowl, he refilled it."

Greenspan's assertion that there was little that he could have done to prevent the bubble has also been questioned. Most commentators have pointed to his 24 September 1996 FOMC meeting remarks to highlight his inconsistency. In that meeting, he had said: "We do have the possibility of raising major concerns by increasing margin requirements. I guarantee that if you want to get rid of the bubble, whatever it is, that will do it."

On 3 September, in his column in The New York Times, Paul Krugman wrote: "He now says he could not have done more, but how does he know when he never even tried? What really happened, one suspects, was that in early 1997 Mr. Greenspan discovered that his tentative efforts to deflate the emerging bubble made investors furious, and lost his nerve."

The lesson to be learnt from the bubble is that central banks need to be vigilant against inflation in all its forms -- including asset inflation -- at all times, before they get to an extreme and become potentially destabilising to the economy. In this regard, it may be somewhat ironical that some of the same economists who blame the Federal Reserve for feeding the 1990s stock market bubble are criticising the European Central Bank (ECB) for keeping interest rates relatively firm.

For example, Morgan Stanley's Roach, in his 9 September article in the Global Economic Forum, wrote: "Europe's lack of pro-growth policy stimulus is disturbing, to say the least -- especially in the current environment. It's not just the ECB that may be wrong-footed. The recent strengthening of the euro -- and the likelihood of further currency appreciation to come -- in conjunction with an inflexible fiscal policy as dictated by the strictures of the Stability Pact, only adds to the region's deepening deflationary perils."

It is not yet clear, though, that the criticism is warranted. Would lower interest rates necessarily be beneficial? Just consider what has happened in the US. While low interest rates there have helped prop up consumer spending, it has done little for capital spending. Instead, it has caused housing prices to jump 7.6 percent in 2001 and 3.8 percent in the first two quarters of 2002 alone (based on the US Office of Federal Housing Enterprise Oversight House Price Index). So even as the Federal Reserve fights the effects of the bursting of the stock market bubble, it may be creating another bubble, this time in the housing sector.

Asset inflation is not quite dead yet.

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