A point of view.. Outlook: Why Greenspan should stay out of Wall Street
NEW YORK. 05:00 AM EDT—Less than a week after Fed chief Alan Greenspan hiked rates, financial markets are once again under the weather because of worries the central bank will squeeze an even tighter grip on monetary policy.
Just last week, Wall Street was confident that there would be no more monetary tightening in the foreseeable future. But now Greenspan himself has unnerved the market with his pledge to take a closer look at asset prices, stoking fears the mighty chairman will try to deflate a stock market bubble by increasing interest rates.
The market has every reason to worry about Greenspan's comments last week. Any attempt by the Fed to smooth out excesses in the stock market should be met with the skepticism it deserves. Greenspan didn't actually say he would use monetary policy to shave the froth off the market, but just the notion that he would consider such a move should set off alarms up and down Wall Street.
Greenspan should focus on his job, which is to walk a tightrope to keep the economy in its delicate equilibrium. He has no business trying to determine whether stock prices are fundamentally justifiable or not. In a free-market economy, such considerations should be left to the market itself, which will eventually correct itself if assets such as stocks and real estate become excessively expensive.
In theory, it's easy to see why the Fed would be concerned. Households now have a greater stake in the stock market than ever before. Economists worry that investments in the stock market will leave consumers with a false sense of security. American consumers still spend more than they earn. If the stock market crashes--and there's a reasonably good chance that it could happen soon--this shopping spree will come to an abrupt halt. Hence, stock market swings will reverberate throughout the economy, according to the theory of the "wealth effect."
The problem is that no one has really proved this theory to be true. From the onset, it makes very little sense. Heavy spending based on paper wealth defies logic. Most Americans have their money tied up in a 401(k) or similar pension plan that prohibits them from cashing in on the stock market's gains. And in the corporate world, balance sheets are healthier than ever. Few companies have tried to leverage their paper wealth by taking up excessive loans.
The Fed itself hasn't found any proof of the theory of the wealth effect. A study by two staffers at the Federal Reserve Bank of New York found no reliable correlation between stock market gains and future consumer spending. The study concluded that a lasting $1 increase in stock wealth leads to an increase in annual consumption of a mere 3 to 4 cents.
In fact, the negative savings rate is shrinking. If spending continues to decline while income rises, it will soon move into positive territory again.
Even if the link between stock market gains and spending were true--a big if--the impact of a stock market crash would most likely have a limited effect on the economy. Market bubbles have surprisingly muted effects on the overall health of the economy, even when they finally burst. The fallout from the most recent stock market crash, in 1987, was hardly noticeable at all. And the stock market crash in 1929 has unfairly been blamed for the ensuing Great Depression. A contraction of the monetary supply in the early 1930s--a patently absurd Fed policy given the economic hardship that was ravaging the U.S. at the time--was the greatest culprit, according to economist Milton Friedman.
What the Fed risks by elevating itself to the position of Big Brother of the stock market is much greater than what it stands to gain. Preemptive strikes can be fatal, as the Japanese central bank tragically proved when its new governor hiked rates with the intention of cooling off stock markets in 1989. That ill-timed maneuver helped send the stock market and the whole economy into a decade-long recession.
If the Fed really wants to protect investors against their own "irrational exuberance," it should consider a proposal by Henry R. Reuss at the Financial Markets Center think tank. Reuss has suggested raising the margin requirement on stock purchases to 60% from 50%. The margin requirement is the percent of a stock's price a buyer must put up to buy it--the balance can be borrowed. If the Fed raised the margin requirement, it could gently help cool down a debt-fueled, bloated stock market without hurting Main Street in the process.
Still, a libertarian such as Greenspan would be best off to listen to his heart and leave stock valuation to the market, where it belongs.
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