Greenspan's 'exuberance' reveals a monetary mess
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by ANDREW SMITHERS Chairman of fund manager advisers Smithers & Co
Chairman of the Fed, Alan Greenspan, has surprised the world not only by cutting US interest rates, but doing so without a meeting of the Federal Reserve Board while the market was still open. The timing of the announcement, both the day and the hour, seemed designed to boost the stock market, which duly re-sponded.
Greenspan expressed worry about the "irrational exuberance" of the stock market when it was 30% below its current level. He is now trying to stop it falling. Nothing could un-derline so well the mess that monetary policy is in. He knows the market is dangerously high so he wants it lower, but he knows that a fall could undermine the economy so he wants it lower without falling.
The economy is threatened by the stock market, which is as high as it was in 1929. There is no satisfactory answer. It is a situation that should never have been allowed to happen. Monetary policy is trying to maintain the stock market's massive distortion, which monetary policy should have been used to prevent.
It is absurd to try to stop share prices falling if you are not prepared to put up interest rates to stop the problem arising. Had interest rates been put up in 1995 when Wall Street started to get out of control, it is unlikely that the world would now be in such a mess.
There are only two ways out of the current problems. Either share prices must fall or inflation must push up incomes and prices of goods. At the moment, falling share prices look more likely than accelerating inflation.
As the Fed's chairman has been trying to hold up share prices he knows are dangerously overpriced, it is important to know why. Is he worried about a short-term crisis, or does he think they can be held up indefinitely?
Truth will out, so common sense suggests the former. If so we must have been on the brink of a major crisis and it is interesting to consider what it might have been.
There are plenty of suspects. The New York Fed's anxiety to prevent Long-Term Capital Management from going un-der has drawn attention to the potential time-bomb in derivative markets. Long- term investors use these markets to reduce their risks, which means that somebody else has to take them on. The bodies in question are investment banks. While the hedge funds have borne the brunt of the adverse publicity, the stock market is clearly worried about the investment banks, many of whose shares have fallen 50% or more.
Investment banks are most likely to get into trouble if share prices fall sharply. They would make large losses. but they can protect themselves even against large falls if they are not too rapid.
The problem is that once the general public recognise share prices are falling persistently, panic is almost bound to set in. Trying desperately to keep share prices at absurd levels is un-likely to be either successful or even helpful.
The Japanese have been trying unsuccessfully to support their stock market for the past six years and Hong Kong joined in this year. As far as we know, the Fed's efforts have yet to extend to organising or financing share purchases, but we may yet see such follies extend.
© Associated Newspapers Ltd., 26 October 1998
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