Friday August 27, 10:13 am Eastern Time
TEXT-Greenspan's speech on monetary policy
WASHINGTON, Aug 27 (Reuters) - Following is the full text of Federal Reserve Chairman Alan Greenspan's ``New Challenges for Monetary Policy' speech issued in Washington Friday before a Kansas City Federal Reserve Bank symposium in Jackson Hole, Wyo.:
"I should like as a backdrop to this conference on the challenges
confronting monetary policy to focus on certain aspects of one of the
issues that will be more broadly discussed later this morning: asset
pricing and macroeconomic performance.
As the value of assets and liabilities have risen relative to income, we
have been confronted with the potential for our economies to exhibit
larger and perhaps more abrupt responses to changes in factors affecting
the balance sheets of households and businesses. As a result, our
analytic tools are going to have to increasingly focus on changes in
asset values and resulting balance sheet variations if we are to
understand these important economic forces. Central bankers, in
particular, are going to have to be able to ascertain how changes in the
balance sheets of economic actors influence real economic activity and,
hence, affect appropriate macroeconomic policies.
At root, all asset values rest on perceptions of the future. A motor
vehicle assembly plant is a pile of junk if no participants in a market
economy perceive it capable of turning out cars and trucks of use to
consumers and profit to producers. Likewise, the scrap value at the end
of the plant's service life will be positive only if it is convertible
into usable products.
The value ascribed to any asset is a discounted value of future expected
returns, even if no market participant consciously makes that
calculation. In principle, forward discounting lies behind the valuation
of all assets, from an apple that is about to be consumed to a
hydroelectric plant with a hundred-year life expectancy.
On such judgments of value rest much of our economic system. Doubtless,
valuations are shaped in part, perhaps in large part, by the economic
process itself. But history suggests that they also reflect waves of
optimism and pessimism that can be touched off by seemingly small
exogenous events.
This morning, I plan to address some of the problems that arise in
evaluating the prices of equities. I should like to first focus on some
significant difficulties of profit accounting that impede judgments about
prospective earnings. In particular, there are some difficulties that
have become more severe as a consequence of the recent acceleration of
technologies, which, in turn, are markedly altering patterns of economic
organization and production. And then I will discuss a different set of
forces that mold the development of discount factors which, together with
earnings projections, produce estimates of market value.
First, the rapid shift in the composition of gross domestic product
toward idea-based value added is muddying our measures of current
earnings and, hence, our projections of future earnings.
The key definitional question that must be confronted is, What is a
capital outlay? Conversely, What is an expense that, by definition, is
consumed in the process of production and deemed an intermediate product?
This issue is most immediately evident in accounting for software
outlays, but it is rapidly expanding to a much broader range of
activities.
Software that is embedded in capital equipment, and some that is
stand-alone, is currently being capitalized and consequently amortized
against current and future earnings. But a substantial portion of
software spending is expensed, even though the equity prices of the
purchasing companies are clearly valuing the software outlays as
contributing to earnings over their useful economic lives--the relevant
criterion for capitalizing an asset.
There has always been a fuzzy dividing line between what is expensed and
what is capitalized. This has historically bedeviled the accounting for
research and development, for example. But the major technological
advances of recent years have exposed a wide swath of rapidly growing
outlays that, arguably, should be capitalized so that the returns they
produce would be more accurately reflected as earnings over time. Indeed,
there is even an argument for capitalizing new ideas, such as different
ways of organizing production, that enhance the value of a firm without
any associated outlays. Some analysts judge the size of undercapitalized
outlays as quite large.1
The important point, however, is that decisions about which items to
expense will have important consequences for reported earnings. In
general, if the trend of expensed items that should be capitalized is
rising faster than reported earnings, switching to capitalizing these
items will almost always accelerate the growth in earnings. The reverse,
of course, is also true.
But the newer technologies, and the productivity and bull stock market
they have fostered, are also accentuating some accounting difficulties
that tend to bias up reported earnings. One is the apparent overestimate
of earnings that occurs as a result of the distortion in the accounting
for stock options. The combination of not charging their fair value
against income, and the practice of periodically repricing those options
that fall significantly out of the money2, serves to understate ongoing
labor compensation charges against corporate earnings. This distortion,
all else equal, has overstated growth of reported profits according to
Fed staff calculations by one to two percentage points annually during
the past five years. Similarly, the rise in stock prices, which reduces
corporate contributions to pension funds is also augmenting reported
profits. These upward adjustments in reported earnings, of course, are a
consequence of rising stock prices and, hence, may not be of the same
dimension in the future.
Nonetheless, it is reasonable to surmise that undercapitalized expenses
have been rising sufficiently faster than reported earnings to have more
than offset the factors that have temporarily augmented reported
earnings. It does not seem likely, however, even should all of the
appropriate accounting adjustments to earnings be made, that such
adjustments can be the central explanation of the extraordinary increase
in stock prices over the past five years.
However we calculate profits and capital, shifts in the stock market
value of firms will doubtless continue to remain important influences on
our economies. It is thus incumbent on us to improve our understanding of
the process by which projections of future earnings are translated into
asset market value.
Even our most sophisticated analytic techniques have difficulty dealing
with the interactions among time preference, risk aversion, and
uncertainty and with the implications of these interactions for the risk
premiums that are embedded in asset prices. It is our failure to
anticipate changes in this discounting process that much of our inability
to accurately forecast economic events lies. For example, the dramatic
changes in information technology that have enabled businesses to embrace
the techniques of just-in-time inventory management appear to have
reduced that part of the business cycle that is attributable to inventory
fluctuations and, accordingly, may well have been a factor in the
apparent decline in equity premiums that has characterized the latter
part of the 1990s. Whether the decline in these premiums themselves may
foster activities that could result in wider business cycles, as some
maintain, is an open question.
As model builders know, all economic channels of influence are not of
equal power to engender growth or contraction. Of crucial importance, and
still most elusive, is arguably the behavior of asset markets. More
broadly, there is an increasing need to integrate into our macro models
more complete descriptions of the responses of households and businesses
to risk--behaviors that are generally modeled separately under the rubric
of portfolio risk management.
The translation of value judgments into market prices is, of course,
rooted in how people discount uncertain future outcomes. An individual's
degree of risk aversion may vary through time and possibly be subject to
herd instincts. Nonetheless, certain stable magnitudes are inferable from
the process of discounting of future claims and values.
One of the most enduring is that interest rates, as far back as we can
measure, appear trendless, despite vast changes in technology, life
expectancy, and economic organization. British long-term government
interest rates, for example, mostly ranged between three percent and six
percent from the early eighteenth century to the early twentieth century,
and are around five percent today. Indeed, scattered evidence dating back
to ancient Rome and before reflects the same order of interest rate
magnitude, not a one percent interest rate nor 200 percent.
This suggests that the rate of time preference underlying interest rates,
like so many other aspects of human nature, has not materially changed
over the generations. But while time preference may appear to be
relatively stable over history, perceptions of risk and uncertainty,
which couple with time preference to create discount factors, obviously
vary widely, as does liquidity preference, itself a function of
uncertainty.
The impact of increasing uncertainty and risk aversion was no more
evident than in the crisis that gripped financial markets last autumn,
following the Russian default.
That episode of investor fright has largely dissipated. But left
unanswered is the question of why such episodes erupt in the first place.
It has become evident time and again that when events are unexpected,
more complex, and move more rapidly than is the norm, human beings become
less able to cope. The failure to be able to comprehend external events
almost invariably induces fear and, hence, disengagement from an
activity, whether it be entering a dark room or taking positions in
markets. And attempts to disengage from markets that are net long--the
most general case--means bids are hit and prices fall.
Modern quantitative approaches to risk measurement and risk management
take as their starting point historical experience with market price
fluctuations, which is statistically summarized in probability
distributions. We live in what is, for the most part, a stable economic
system, where market imbalances that produce unusual outcomes almost
always give rise to continuous and inevitable moves back toward
longer-run equilibrium. However, the violence of the responses to what
seemed to be relatively mild imbalances in Southeast Asia in 1997 and
throughout the global economy in August and September of 1998 has
illustrated yet again that the adjustments in asset markets can be
discontinuous, especially when investors hold highly leveraged positions
and when views about long-term equilibria are not firmly held.
Enough investors usually adopt strategies that take account of longer-run
tendencies to foster the propensity for convergence toward equilibrium.
But from time to time, this process has broken down as investors suffer
an abrupt collapse of comprehension of, and confidence in, future
economic events. It is almost as though, like a dam under mounting water
pressure, confidence appears normal until the moment it is breached.
Risk aversion in such an instance rises dramatically, and deliberate
trading strategies are replaced by rising fear-induced disengagement.
Yield spreads on relatively risky assets widen dramatically. In the more
extreme manifestation, the inability to differentiate among degrees of
risk drives trading strategies to ever-more-liquid instruments so
investors can immediately reverse decisions at minimum cost should that
be required. As a consequence, even among riskless assets, such as U.S.
Treasury securities, liquidity premiums rise sharply as investors seek
the heavily traded "on-the-run" issues--a behavior that was so evident
last fall.
History tells us that sharp reversals in confidence happen abruptly, most
often with little advance notice. These reversals can be self-reinforcing
processes that can compress sizable adjustments into a very short time
period. Panic market reactions are characterized by dramatic shifts in
behavior to minimize short-term losses. Claims on far-distant future
values are discounted to insignificance. What is so intriguing is that
this type of behavior has characterized human interaction with little
appreciable difference over the generations. Whether Dutch tulip bulbs or
Russian equities, the market price patterns remain much the same.
We can readily describe this process, but, to date, economists have been
unable to anticipate sharp reversals in confidence. Collapsing confidence
is generally described as a bursting bubble, an event incontrovertibly
evident only in retrospect. To anticipate a bubble about to burst
requires the forecast of a plunge in the prices of assets previously set
by the judgments of millions of investors, many of whom are highly
knowledgeable about the prospects for the specific companies that make up
our broad stock price indexes.
If episodic recurrences of ruptured confidence are integral to the way
our economy and our financial markets work now and in the future, it has
significant implications for risk management and, by implication,
macroeconomic modeling and monetary policy.
Probability distributions that are estimated largely, or exclusively,
over cycles excluding periods of panic will underestimate the probability
of extreme price movements because they fail to capture a secondary peak
at the extreme negative tail that reflects the probability of occurrence
of a panic. Furthermore, joint distributions estimated over periods
without panics will misestimate the degree of correlation between asset
returns during panics. Under these circumstances, fear and disengagement
by investors often result in simultaneous declines in the values of
private obligations, as investors no longer realistically differentiate
among degrees of risk and liquidity, and increases in the values of
riskless government securities. Consequently, the benefits of portfolio
diversification will tend to be overestimated when the rare panic periods
are not taken into account.
As we make progress, hopefully, toward understanding asset-pricing
mechanisms, we need also to upgrade our insights into the effect of
changing asset values on GDP--the so-called wealth effect.
Although many aspects of this issue deserve attention, let me cite a few
open questions of particular importance. Efforts to differentiate between
realized and unrealized gains, and the propensity to leverage both, may
afford a deeper understanding of the consequences of asset price change.
And differentiating between gains that arise from enhanced profitability
and those that reflect changes in discount factors may also be useful.
The former may be more likely to be sustained, given the tendencies of
discount factors to revert back to historic norms.
Moreover, it is evident that borrowings against capital gains on homes
influence consumer outlays beyond the effects of gains from financial
assets. Preliminary work at the Federal Reserve suggests that the
extraction of equity from housing has played an important role in recent
years. However, stock market values and capital gains on homes are
correlated and, hence, their separate effects are difficult to identify.
This is an area that clearly warrants further examination.
Finally, in the business sector, questions remain about the influence of
equity prices on investment spending. In particular, Do all equity price
movements--whether related to fundamentals or not--have the same effect
on investment spending?
In conclusion, the issues that I have touched on this morning are of
increasing importance for monetary policy. We no longer have the luxury
to look primarily to the flow of goods and services, as conventionally
estimated, when evaluating the macroeconomic environment in which
monetary policy must function. There are important--but extremely
difficult--questions surrounding the behavior of asset prices and the
implications of this behavior for the decisions of households and
businesses. Accordingly, we have little choice but to confront the
challenges posed by these questions if we are to understand better the
effect of changes in balance sheets on the economy and, hence,
indirectly, on monetary policy."
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