My interpretation of Greenspan's speech:
Last Friday Alan Greenspan gave a speech in which he talked about how capital gains and the housing market create a "wealth effect" on consumer spending. It is important speech and signals a subtle shift in his Federal Reserve policy. One which means he is less likely now to cut rates to make the market go up. I'm going to quote you parts of his speech and follow with my interpretations:
"The rapid technological innovation that spurred the advancement of the "information economy" has resulted in some dramatic capital gains and losses in equity markets in recent years. These remarkable developments have attracted considerable attention from economists and from macroeconomic policymakers. At the same time, movements in the prices of some other assets in the economy--changes in house prices, for example--have been steadier, less dramatic, but perhaps no less significant. "
The rise of the stock market bubble made people more wealthy, but this bear market has made them poorer. Housing prices have also risen in the past decade and have not gotten the same notice as the stock market. As I've noted before consumer spending has so far been stable due to people taking out home equity loans and taking on more debt, an act that is tied to rising home prices. People have focused on the effect of stock prices on consumer spending, but in many ways the housing market is more important.
"But we must ask whether the aggregate ratio of net worth to income is a sufficient statistic for summarizing the effect of capital gains on economic behavior or, alternatively, whether the distribution of capital gains across assets and the manner in which those gains are realized also are significant determinants of spending. To answer these questions, we need far more information than we currently possess about the nature and the sources of capital gains and the interaction of these gains with credit markets and consumer behavior. "
The last line here is very important. Greenspan says that he does not know how capital gains and changes in net worth effect individuals' propensity to spend. What is important here is that he once based his entire Federal Reserve policy on a theory that rising stock market prices would create inflation. This was the reason he gave for raising interest rates back in 1999. Now he comes out and says that he has no idea whether or not his previous theory was true or not.
"In carrying out this analysis, we have been especially mindful of the possibility that the amount by which a capital gain affects spending may well be a function of whether or not the gain has been realized. On the buyer's side, when an asset is transferred, the acquisition cost is its new book value and, by definition, its market value. On the seller's side, the proceeds from the sale are available for asset accumulation, debt repayment, and consumption. In this way, a capital gain is realized and made liquid, with the potential to affect spending, assets, or debt. The capital gain in the process disappears as an element in the householder's balance sheet. "
"Unrealized gains, to be sure, can be borrowed against, and the proceeds of the loan can be spent or used for repayment of other debt. Alternatively, the unrealized gain could induce households to finance additional outlays by selling other assets or by reducing their saving out of current income. But unless, or until, this gain is realized or is extinguished by a fall in market price, it will remain on the asset side of the householder's balance sheet, exposed to price change and uncertainty. "
This is important. When Greenspan is talking about unrealized gains here he is talking about someone who owns a house whose value has risen from its purchase price. He use the extra value to take on more loans or to take out a loan to pay off credit card debt. This in turn can free up an individual to spend more money. But if home values were to drop than a person's debt level would increase as the value of their asset(house) dropped.
Greenspan then goes on to talk about the importance of understanding the "wealth effect" and making a call to arms for further studies on this subject. I want to make one main point about his speech. Like I said before, 2 years ago Greenspan based his policy or raising interest rates on a theory that rising stock prices would eventually create inflation by promoting too much consumer spending. In this speech he now recants that theory, saying that he has no idea how to measure the interaction of a persons asset values and his spending.
Greenspan constantly flip flops from month to month and creates his theories to justify the way he wants to move interest rates. The viability of the theory is not important to him. He just uses them to make it look like he knows what he is doing. That is why when he cut interest rates in 1998 to bail out international bankers and hedge funds - an act which hyperinflated the money supply, exploded the current account deficit, and create a stock market bubble - he used the theory of a "new economy" and "producitivity miracle" to shove aside any fears that the cuts would imbalance the economy. Once the 1998 world econommic crisis subsided he came under fire by the IMF and world press for keeping interest rates too low so he decided he had to raise them. He then invented the theory that rising stock prices create inflation to justify his rate increases.
In this speech he distanced himself from the notion that the Federal Reserve should try to influence the stock market or the housing market in order to manage the economy. Why is he saying this when he has been doing this all year by cutting rates on the drop of a hat when the market drops? With a falling dollar he simply can no longer cut rates with reckless abandon. He now thinks that he will stop cutting interest rates in the near future and is preparing people for that. This speech is a subtle hint that there will be no more panic interest rate cuts if the market makes new lows. He will no longer daytrade interest rates. Investors will have to now fend for themselves. |
