Stephen Roach (New York)
Nearly two years after the popping of the Great American Asset Bubble, the US economy is still sputtering. Whatever the outcome -- double dip or anemic recovery -- it’s a far cry from the froth of the Roaring 1990s. Of course, the post-bubble experience of the US pales in comparison with that of the Japanese economy -- four recessions in over a dozen years. Yet asset bubbles wreak havoc on any economy. If left unattended, their impacts spread like wildfire -- damaging financial institutions and, ultimately, infecting the real economy. The authorities know full well that such bubbles are to be avoided at all costs. The trick is to be early in identifying the bubble and then determined in taking action to pop it.
To this very day, the Federal Reserve denies its role in nurturing the US equity bubble. Sure, Chairman Greenspan warned of "irrational exuberance" in his now infamous speech of December 5, 1996. Yet it took the central bank another three months to act on those concerns. And when it did, all the Fed was able to muster was a mere 25 bp of tightening on March 25, 1997. That action unleashed a torrent of politically inspired criticism that sent the Fed quickly running for cover. Any further assault on the bubble was promptly shelved.
Chairman Greenspan then went on to compound the problem by embracing the untested theory of the New Economy -- in effect, setting out the conditions under which the exuberance might actually be rational, when the bubble might not be a bubble. After all, sharply accelerating productivity growth was the sustenance of sustained earnings vigor, went the logic at the time. Under those conditions, maybe the markets might have had it right all along -- lofty multiples made great sense in an era of ever-expanding profit margins. In any case, the Fed sent an important signal to financial markets -- that it was willing to be unusually passive in tolerating the rapid growth of a high-productivity economy. This then set up the delicious moral hazard that speculators quickly pounced on. With the Fed out of the game, there was no stopping the equity market.
Alas, if the Federal Reserve only knew what was to come -- the dot-com implosion, the excesses of telecom debt, a massive capacity overhang, an unprecedented consumption binge, a record debt overhang, and obfuscation of underlying corporate earnings growth. Had it seen such a perilous post-bubble future, maybe the central bank would have reacted differently. Easier said than done, of course -- hindsight is the ultimate luxury.
Yet it turns out that the Fed knew a lot more than it claimed at the time. Recently released transcripts of policy meetings back in 1996 -- verbatim reports of actual conversations rather than the sanitized minutes that are published approximately 45 days after each FOMC gathering -- leave no doubt, in my mind, that Chairman Greenspan and several of his colleagues appreciated the full gravity of the rapidly emerging US equity bubble. (Note: These transcripts are released with a five-year time lag and are available on the Fed’s Web site at federalreserve.gov. The problem was the US authorities lacked the will to act. Had the Fed taken actions based on its concerns at the time, the US economy and financial markets would undoubtedly have traveled a very different road.
History often has a way of catching up with you, especially if the real story comes out after the fact. For a central banker who publicly expressed great doubt over the very existence of a US stock market bubble, consider the following statement by Chairman Greenspan, taken from the transcript of the September 24, 1996 FOMC meeting: "I recognize that there is a stock market bubble problem at this point." For the record, the Dow Jones Industrial average closed at 5,874 on that date, about half the level it was eventually to reach in early 2000. Nor was Greenspan reticent in expressing his opinion back in September 1996 on what should be done to pop the bubble. Again in his words, "…it is not obvious to me that there is a simple set of monetary policy solutions that deflate the bubble. 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." But in the end, of course, the Fed refrained from taking any such actions, keeping margin requirements unchanged, as they had been since 1974 -- in effect, electing to sit on the sidelines as mere observers of the Great American Asset Bubble. The reluctance to make such a surgical strike on the equity market can best be summed in Greenspan’s admission, "My concern is that I am not sure what else it (raising margin requirements) will do." End of story -- beginning of the real bubble.
All this is not to say that Alan Greenspan and the Fed were lacking in insights as to how to proceed in dealing with this critical issue. Ironically, it turns out that the near hero in all this was then Fed Governor Larry Lindsey -- whose day job now turns out to be Assistant to the President for Economic Policy. The same transcript of the September 24, 1996 FOMC meeting says it all: In Lindsey’s words, "…the long-term costs of a bubble to the economy and a society are potentially great. They include a reduction in the long-term saving rate, a seemingly random distribution of wealth, and the diversion of scarce financial human capital into the acquisition of wealth. As in the United States in the late 1920s and Japan in the late 1980s, the case for a central bank ultimately to burst that bubble becomes overwhelming. I think it is far better that we do so while the bubble still resembles surface froth and before the bubble carries the economy to stratospheric heights." Lindsey’s analysis was prescient, to say the least. All Greenspan could offer in response was, "…I agree with Governor Lindsey that this is a problem we should keep an eye on."
Of course, in the end, that’s about all the Fed ever did -- keep an eye on the bubble. About 10 weeks after that fateful policy meeting in September 1996, the Dow had risen another 10% and Greenspan dared to speak of "irrational exuberance." Three and a half months later -- and another 7% gain for the Dow -- the Fed took its one feeble shot at the bubble with the March 25, 1997 rate hike. And that was basically it. After having put on a tightening bias back in July 1996 and maintaining that bias through June 1998 (except for two crisis-related exceptions in December 1997 and February 1998), the Fed was astonishingly timid. Then along came the full force of the Asian and LTCM crises, and yet another dose of even greater monetary accommodation was added to the equation. That set the stage for an even greater liquidity injection -- just what every asset bubble needs.
Particularly troublesome, in my view, was the Fed’s very public campaign against using margin requirements as a means to pop the asset bubble. It smacked of a central bank attempting to make the case that there was really nothing it could do to address a serious problem. I must confess that I’ve heard that one before. As a young Fed economist in the 1970s, I remember all too well when then-Chairman Arthur Burns claimed that there was little he could do to counter a deeply institutionalized inflation. How wrong he was. Ultimately, as Paul Volcker demonstrated with great clarity, it was just a matter of will.
Yet in direct contradiction to Greenspan’s own private views, as noted above and expressed at the FOMC meeting back in September 1996, the Fed made every effort to convey the impression that there was nothing it could do to tame the equity market. For example, only six months after that meeting, Greenspan publicly stated in congressional testimony in March 1997 that "Our authorities (sic) on margins is one, an anachronism and two, inappropriately positioned in the Federal Reserve." A few years later, in January 2000, he went further and claimed that "…the level of stocks prices (has) nothing to do with margin requirements…" Vice Chairman Roger Ferguson also took up the cause in February 2000 and put it succinctly, "I believe that the Federal Reserve should not foster the impression that we are targeting the equity market by adjusting our one tool in the margin area, namely initial marginal requirements."
A few lonely souls on Wall Street, of all places, lobbied vociferously to the contrary. Paul McCulley of PIMCO and Steve Galbraith, then an obscure financial services analyst from Sanford Bernstein, testified in front of Congress in early 2000 in favor of hiking margin requirements. I penned a piece in Barron’s around the same time making a similar argument (see "It’s a Classic Moral Hazard Dilemma," Barron’s, March 27, 2000). The Fed stonewalled this criticism, but alas, by then, it was far too late.
In the end, the lesson is painfully obvious. The asset bubble is one of the greatest hazards that any economy or financial system can face. From Tulips to Nasdaq, the record of economic history is littered with the rubble of post-bubble economies. It takes both wisdom and courage to avoid such tragic outcomes. Sadly, as the full story now comes out, we find that America’s Federal Reserve had neither. |
