THE SECOND MOST POWERFUL MAN IN THE WORLD
By James Grant
The Fed chairman did not get to where he is in life by forgetting to hedge. Yesterday, you'll recall, we posited that Greenspan contributed to the current bubble by heedlessly ignoring the risks of the technology boom.
"[L]arge voids of information still persist," Greenspan told the Boston College Conference on the New Economy on March 6, 2000, "and forecasts of future events on which all business decisions ultimately depend will always be prone to error."
Unfortunately, he neglected to point out that high-tech revolutions inflame the right portion of the brain even as they enable the left-hand side. They stir up the speculative juices, thereby introducing a new source of potential business error. It is an especially potent source as when, late in the 1990s, the chairman of the world's leading central bank lends his imprimatur to a supposed new age.
Many are the blessings of information technology, Greenspan proceeded. He mentioned the mapping of the human genome, the refinement of financial derivatives and the explosion of big-company mergers: "Without highly sophisticated information technology, it would be nearly impossible to manage firms on the scale of some that have been proposed or actually created of late."
Yet, he noted, "At the end of the day, the benefits of new technologies can be realized only if they are embodied in capital investment, defined to include any outlay that increases the value of the firm. For these investments to be made, the prospective rate of return must exceed the cost of capital.
"Technological synergies have enlarged the set of productive capital investments, while lofty equity values and declining prices of high-tech equipment have reduced the cost of capital. The result has been a veritable explosion of spending on high-tech equipment and software, which has raised the growth of the capital stock dramatically over the past five years."
Having climbed so far into a logical trap, the chairman pulled the door shut behind him. "The fact that the capital spending boom is still going strong indicates that businesses continue to find a wide array of potential high-
rate-of-return, productivity-enhancing investments. And I see nothing to suggest that these opportunities will peter out any time soon." At least, not for the next 96 hours (the Nasdaq peaked on March 10).
Here was a remarkable set of ideas. What drives a capital spending boom, said the central banker, was not - even in part - an excess of bank credit or an artificially low money-market interest rate. It was the cold and detached analysis of cost and benefit. Here the chairman was being unwontedly modest.
Fearful of a Y2K calamity, the Fed stuffed tens of billions of dollars of credit into the banking system late in 1999. Not for the first time in monetary history, excess credit raised speculative spirits, inducing a sense of optimism bordering on invincibility.
Greenspan spoke only 18 months ago, but it was an eternity in speculative time. In March 2000, B2B promotions commanded preposterous valuations, which the chairman proceeded to validate. "Indeed," he said, "many argue that the pace of innovation will continue to quicken in the next few years, as companies exploit the still largely untapped ootential for e-commerce, especially in the business-to-business arena, where most observers expect the fastest growth...Already, major efforts have been announced in the auto industry to move purchasing operations to the Internet. Similar developments are planned or are in operation in many other industries as well. It appears to be only a matter of time before the Internet becomes the prime venue for the trillions of dollars of business-to-business commerce conducted every year."
The Gartner Group had forecast that business-to-business commerce would generate $7 trillion of volume by 2004. Greenspan, a more experienced forecaster, gave no date and said only "trillions," but even that was wide of the mark. B2B stock prices crashed, and hundreds of Web sites went dark. He was, however, prophetic on one important detail: The potential for e-commerce remains "largely untapped."
The Fed was slow to raise the funds rate in 1999 and early 2000. It was slow to reduce the rate when, in the second half of 2000, boom turned to bust. The Austrian School economists who originated the theory of the investment cycle prescribed aggressive monetary ease in the bust phase, lest a depression feed on itself to become a "secondary depression."
Greenspan, having failed to call a bubble a bubble, was slow to recognize a bust as a bust. In his New Economy talk, he did acknowledge a connection between interest rates and technology investment. However, because information technology was an absolute and unqualified good thing, it followed that it could not be held responsible for a bad thing - for instance, the bottom falling out of capital investment and, therefore, out of the GDP growth rate. Blame for the downturn must lie elsewhere - with inventories or even the weather, as he proposed to the Senate Banking Committee on February 13, 2001. "[A] round of inventory rebalancing appears to be in progress," he told the senators.
"Accordingly, the slowdown in the economy that began in the middle of 2000 intensified, perhaps even to the point of stalling out around the turn of the year. As the economy slowed, equity prices fell, especially in the high-tech sector, where previous high valuations and optimistic forecasts were being reevaluated, resulting in significant losses for some investors...the exceptional weakness so evident in a number of economic indicators toward the end of last year (perhaps in part the consequence of adverse weather) apparently did not continue in January." However, he added, the FOMC "retained its sense that the risks are weighted toward conditions that may generate economic weakness in the foreseeable future." What portion of the future was "foreseeable" the chairman did not specify. He refused to waver from his previously established line, the transforming significance of new technologies. Productivity growth and the availability of real-time information would cut short this inventory and profits slump, he said.
Besides, Wall Street wasn't worried: "[A]lthough recent short-term business profits have softened considerably, most corporate managers appear not to have altered to any appreciable extent their longstanding optimism about the future returns from using new technology... Corporate managers more generally, rightly or wrongly, appear to remain remarkably sanguine about the potential for innovations to continue to enhance productivity and profits. At least this is what is gleaned from the projections of equity analysts, who, one must presume, obtain most of their insights from corporate managers. According to one prominent survey, the three- to five- year average earnings projections of more than a thousand analysts, though exhibiting some signs of diminishing in recent months, have generally held firm at a very high level. Such expectations, should they persist, bode well for continued strength in capital accumulation and sustained elevated growth of structural productivity over the long term."
Such expectations, needless to say, have not persisted, and the Wall Street analysts who held them have been scorned and mocked. Not only have earnings plunged, but sales have weakened, undercut by the unforeseen disappearance of demand. "Business sales," observes Moody's Lonski, "are down minus 0.7% in the second quarter of 2001 from the second quarter of 2000. This is the sum of retail sales, manufacturing and wholesale sales. Manufacturing got clobbered - it is down 4.5%. The last time business sales were down year-over-year was the three quarters from the first quarter of 1991 to the third quarter of 1991.
"Before that was the five quarters from the first quarter of 1982 to the first quarter of 1983. And before that, it was in the 1970s, when inflation made the numbers do funny things, but it was in the first quarter of 1970. All the previous declines occurred in and around recessions."
Alan Greenspan never understood the problem. This defect does not mean he will never hit on the solution. What it does suggest, however, is that he will come to it belatedly, and likely for the wrong reasons.
James Grant,
for The Daily Reckoning |
