More from Greenspan (the bottom is of special note):
"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.
At root, all asset values rest on perceptions of the future.
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.
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.
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."
Other quotes:
Greenspan said that although asset prices reflect “the economic process itself,” they sometimes move unpredictably.
“History suggests that they also reflect waves of optimism and pessimism that can be touched by seemingly small exogenous
events.”
Greenie also said that earnings valuations have been distorted by
changes in the economy. New technology coupled with gains in productivity and a bull stock market, are “accentuating”
accounting difficulties that “tend to bias up reported earnings” of U.S. corporations. “One is the apparent overestimate of earnings that occurs as a result of the distortion in the accounting of stock options.” Failure to properly account for the changing value of options “serves to understate ongoing labor compensation charges against corporate earnings.” That has resulted in an overestimate of two percentage points a year in the growth of reported profits. |
