How Alan Greenspan Finally Came to Terms with the Market
By JACOB M. SCHLESINGER Staff Reporter of THE WALL STREET JOURNAL
WASHINGTON -- On the morning of Dec. 3, 1996, having watched the Dow surge a dizzying 27% that year, Federal Reserve Board Chairman Alan Greenspan hosted a private meeting that became his own genteel version of the debate show "Crossfire."
On one side was Abby Joseph Cohen, the belle of the bull market, who came from her post at Goldman, Sachs & Co. to defend investor sanity. She methodically gave Fed governors a list of reasons why underlying economic changes justified such lofty prices in the market.
On the other side were two Ivy League economists, Yale's Robert Shiller and Harvard's John Campbell, who painted a much gloomier picture, though they didn't address Ms. Cohen's comments directly. They illustrated their message of portent in 10 pages of handouts showing trends going back to 1872. The markets were destined, at best, to tread water, and possibly to crash, they warned.
As unusual as that meeting was, it didn't compare to what would follow two days later. At a black-tie banquet at the Washington Hilton, Mr. Greenspan delivered a speech that would contain the most memorable utterances of his career: "How do we know when irrational exuberance has unduly escalated asset values? ... And how do we factor that assessment into monetary policy?"
Minutes after he spoke, stocks began tumbling in Tokyo, where the markets were open. That was followed by more carnage in Europe, then the U.S. Over the next few weeks, the Dow Jones Industrial Average slipped 4% from its then-record of 6400. Back at Yale, Prof. Shiller's wife penned a Christmas letter to friends: "Recently, Bob has been troubled by the thought that he may have caused a worldwide stock market slide."
But Mr. Greenspan hadn't picked sides. He had deliberately posed his thoughts as questions, not statements. And in subsequent years, America's most influential economist continued to agonize over the causes and consequences of the unprecedented surge in stocks.
Mr. Greenspan's conclusions are evident in his recent words and actions. He has backed away from suggesting the market is overvalued, yet feels that monetary policy should reflect the market's impact on the economy. The bull market's surprising endurance has driven the Fed into its first sustained drive to raise interest rates in six years. Friday's report that unemployment fell to a 30-year low of 3.9% means that campaign will continue, as the Fed is expected to raise rates again -- possibly by half a point -- at its May 16 meeting.
Mr. Greenspan's current strategy provides only a glimpse of his journey. It has been, as described in interviews with current and former Fed officials, an enlightening and humbling odyssey during which he has changed his opinions 180 degrees on some key issues.
Mr. Greenspan didn't undertake the quest lightly. Both he and his institution have a deep-seated belief in the logic of free markets and in the Fed's ability, given enough effort, to divine it. He spent hours at his cluttered desk poring over reams of memos and dog-eared statistical tomes, the overflow spilling onto chairs and an oval table near his fireplace. All the while, he monitored market movements on two computer terminals and a television tuned to CNBC. And with each thousand-point rise in the Dow mangling the old models, the Fed staff kept building new ones.
The very fact of Mr. Greenspan's stock-market focus has been controversial. For three decades, Fed chairmen considered the topic taboo. They worried about spooking investors and saw stock prices as largely outside their concern.
Many of those who make their living in the stock market felt much the same way. "Why don't you guys shut the f--- up?" one investor told an official of the Federal Reserve Bank of New York at a recent social event. A businessman suggested to another Fed official that Congress require Mr. Greenspan to hold a broad-based stock portfolio so he would personally feel investors' pain. (To avoid conflicts of interest, Mr. Greenspan's wealth is invested largely in short-term Treasury bills.)
Some legislators also think the Fed should just stay out of the way. One day last month, as the Nasdaq was melting down, Kentucky Republican Jim Bunning sternly confronted Mr. Greenspan in a Senate hearing room. "The role of the Federal Reserve is to set monetary policy," he said. "I didn't know it was to jawbone ... the securities markets."
Even some of Mr. Greenspan's Fed colleagues grit their teeth when they hear the chairman is at it again. In recent weeks, a few have suggested to his aides that he tone down his remarks. When pressed by a group of financial analysts earlier this spring, Philadelphia Fed President Edward Boehne said, "Any time central bankers get involved in the stock market, the potential for confusion is great."
Mr. Greenspan's focus on the stock market began long before he became a central banker. As a New York-based business consultant, he advised investment banks and brokerage firms on how economic conditions would affect the market, and vice versa. He worked extensively for clients trying to dissect the Japanese market's run-up in the early to mid-1980s, attempting to find -- in vain -- some justification.
He became Fed chairman two months before the 1987 crash, and his first major task was to pick up the pieces. He sought a way to predict at the beginning of each day how U.S. stocks would open, a precursor to the futures markets that have since evolved to perform that task. During volatile periods in the late 1980s, a Fed staffer would arrive at the office at 5 a.m., call Europe to find out trading activity and have that day's forecast on the chairman's desk by 7:30.
Mr. Greenspan's fascination with stocks was revived at the birth of the most recent bull market, when stocks began to seem impervious to traditional yardsticks such as growth, profits or dividends. In 1991, when the Dow was hovering around 3000, the Fed chairman directed one researcher to delve into a popular theory that investors' expectations of declining inflation could explain rising stock prices. The ultimate report was dubious.
By 1994, with the Dow nearing 4000, he asked researchers to dissect the popular explanations, such as the effect of globalization on profits, being floated on Wall Street. His staff was skeptical. "Bad science," and "Abby Joseph Cohen stories," the Fed staff called Wall Street's theories.
Throughout the mid-1990s, the staff prepared forecasts suggesting that the market would likely stop rising or suffer a 20% correction. Some of the economists told colleagues that they had personally gotten out of the market, and advised others to follow them into bonds.
Mr. Greenspan privately shared many of these doubts. When the Fed started raising interest rates at the beginning of 1994, the official explanation was that early signs of inflation were building. But behind the Fed's closed doors, Mr. Greenspan made clear that he was motivated by the stock market as well.
In February 1994, for instance, after the Fed made its first move to raise rates, the Dow dropped nearly 5% to about 3800. "We partially broke the back of an emerging speculation in equities," Mr. Greenspan contentedly told his colleagues in a conference call the afternoon of Feb. 28, according to transcripts. "We had a desirable effect."
Due in part to rising interest rates, Wall Street had a mediocre year in 1994. On Nov. 15, the Dow still was trading at about 3800. But Mr. Greenspan wasn't satisfied. At that day's meeting, the Fed chairman fretted that "the stock market, in my judgment, is still a little rich."
Then, stocks took off again. In 1995, the Dow soared by 33%; in 1996, 24%.
Mr. Greenspan kept asking questions. On Oct. 31, 1996, with the Dow at 6029, Fed researchers briefed him and some other board members on stock valuations. One aide explained that investors had been buying evermore expensive stocks, seeing double-digit returns, but that their purchases would make sense by historical standards only if they were willing to accept 2% returns in the future. Implicit in those remarks: Investors were nuts.
By late November, Mr. Greenspan decided to take his worries public. He was slated to receive an "eminent thinkers" award from the American Enterprise Institute, a conservative think tank, and chose that speech to launch his "irrational exuberance" project. The speech had already been written when the Wall Street vs. Ivory Tower debate was staged. Nothing said at that briefing persuaded the Fed chairman to retreat.
Nor did the red flags raised by colleagues who saw an advance draft of the text. One governor, Susan Phillips, an Iowan, says she wrote a note suggesting he make the point more subtle by citing an example of sharp price swings in corn prices rather than stock prices. Alice Rivlin, then the Fed's vice chairman, says she "went in to see the chairman and said, 'Do you really want to say that?' He said, 'I think I do.' "
Even after the "irrational exuberance" speech, Mr. Greenspan was mindful how risky, and difficult, it is for a central bank to pop a bubble. The two most determined efforts, by the Fed in 1929 and the Bank of Japan in 1989, succeeded only by destroying the rest of the economy.
So he put the burden of proof on the skeptics, not on the markets. It wasn't enough to say that he couldn't explain the Dow. He wanted to be able to prove that a sharp market drop was imminent. He had staffers repeatedly construct computer models of prior crashes, plugging in ever-changing variables: Returns on stocks vs. bonds. Public vs. private bonds. Short-term vs. long-term bonds.
No pattern emerged. The models, Mr. Greenspan has joked, predicted eight of the last three market plunges.
After 2 1/2 futile years, Mr. Greenspan dropped the project. To his 1996 question, "how do we know when irrational exuberance has unduly escalated asset values?" he finally gave this answer in 1999: It's impossible to know, except in hindsight.
Along the way, Mr. Greenspan came to another realization: The markets had been far more rational than he and his staff had suspected. The Fed's skepticism had rested in part on assumptions that the long-term potential for economic growth -- and thus corporate profits and stock prices -- was the same mediocre rate that had been in place since the early 1970s. Furthermore, the experts were convinced that a recession had to be imminent, simply because it had been so long since the last one.
Those assumptions turned out to be wrong, and Mr. Greenspan was among the first economists to see that. For years, he had suspected that productivity was rising, based on little-noticed trends like surging corporate investment in capital equipment and rising profit margins in spite of limited price increases. He tested his theories in his travels, asking executives what was happening in their companies. Convinced of the productivity trend even before the official data proved it, Mr. Greenspan began to argue that the acceleration in earnings growth justified a rise in price-earnings ratios.
He became more open, too, to notions that markets were working differently. In June 1998, the Fed again invited some outside experts to discuss the market. This time, Jeremy Siegel, a prominent bull and a professor at the Wharton School of the University of Pennsylvania, came to discuss the arguments in his influential book, "Stocks For the Long Run." The book asserted that investors understood the long-term stability of stocks, and that could explain higher values. Yes, he said, the market was "30% overvalued" by the old rules. But, he said in handouts, sometimes "historical yardsticks for valuation have been rendered useless in the past." Given that, market prices at the time "were not out of line."
Even when stocks soared beyond what could be explained by rising productivity, Mr. Greenspan became more willing to give investors the benefit of the doubt. The New Economy had ushered in tremendous ferment. Investors were gambling on the dot-coms, but that wasn't necessarily crazy. Disputing the assertion that the soaring Nasdaq was a bubble, he told a senator one day that stocks were driven largely by "very intelligent investors." He added, "That's not the same as saying that they're going to be right. But they are rational, informed judgments."
In August 1999, Mr. Greenspan formally announced his abandonment of "irrational exuberance" at the Fed's annual retreat in Jackson Hole, Wyo. He said the market reflected the "judgments of millions of investors, many of whom are highly knowledgeable about the prospects for the specific companies that make up our broad stock price indexes." The Fed had no business contradicting those investors, he concluded.
That didn't mean, however, that his concern with the market had gone away. He remained as preoccupied as ever, especially when the Nasdaq soared nearly 50% in the three months after Jackson Hole. But his line of his inquiry shifted from trying to understand why stocks were rising to the impact of rising stocks on the economy at large.
The buzzword inside the Fed became the "wealth effect" -- how riches generated by stocks and real estate were changing the psychology of consumers, leading them to spend more of their wages and salaries and putting a smaller portion into savings. In a presentation for the Fed chairman, forecaster Joel Prakken flashed a picture from his local paper, the St. Louis Post-Dispatch, with a dog in a spacious room under the headline, "Luxury boarding kennels are only one indication that people ... are spending more freely." Mr. Prakken inserted a caption that had the dog proclaim, "I sure enjoy consuming master's recent stock-market gains!"
Mr. Greenspan mixed and matched statistics to discern wealth effect patterns. His research indicated to him that, even if it were wholly rational, the bull market was hauling the U.S. economy into warp speed by generating greater spending.
Indeed, the more he and his colleagues believed that the New Economy and the stock market made sense, the more they worried that the economy was veering out of control. At policymaking sessions through late 1999 and early 2000, intense debates broke out as officials grappled with the ways that changing productivity affects the economy. It was a question the central bank hadn't confronted for four decades. Fed Vice Chairman Roger Ferguson literally dusted off his old macroeconomics textbook from college.
Fed officials were concluding that, contrary to popular belief, soaring productivity did not necessarily mean the central bank could afford to keep interest rates low. In debates, the more aggressive anti-inflation hawks, Fed governor Laurence Meyer and Richmond Fed President Alfred Broaddus in particular, argued that higher productivity could actually require higher rates. That's because the supply created by accelerating productivity takes time to build, but a stock market soaring in anticipation of that higher growth creates instant demand.
Mr. Greenspan found the case compelling and supported raising interest rates 1 1/4 percentage points over 10 months. "How the current wealth effect is finally contained will determine whether the extraordinary expansion ... can slow to a sustainable pace, without destabilizing the economy," he told Congress this past February.
Mr. Greenspan was comfortable with his new thinking, but he needed to sell it to the public. It was a difficult task. His evolution -- from contemplating targeting stock prices to countering the economic impact of stocks -- was subtle. And it was being used to justify an unpopular campaign of raising interest rates, a drive that made little sense by conventional logic since inflation, the Fed's main worry, remained low.
For all the effort that he put into pondering those questions raised in December 1996, he bungled the public-relations job.
The explanation put forth in his semiannual economic report to Congress in February was given in his trademark indirect jargon. In one sentence, he spelled out the likely consequence for bringing the economy back into balance: "This does not necessarily imply a decline in asset values -- although that can happen at any time for any number of reasons -- but that these values will increase no faster than household income," or roughly 6% per year.
Mr. Greenspan had hoped the passage would reassure investors that he wasn't contemplating driving down stock prices. He has told colleagues he was trying to send a signal that he was comfortable with a moderate rise in the market. But it became misinterpreted as an attempt to set a numerical "speed limit" for stocks, and a preference for stocks to go down.
To many observers, this was "irrational exuberance" all over again. House Banking Committee Chair Jim Leach followed up with a set of written questions, including, "Does the Fed have a proper role ... in 'jawboning' the market?" Cartoonists had a field day. One drew a bull labeled "Wall Street" standing on a window ledge while an impatient Mr. Greenspan asks: "Well, what are you waiting for?" The New Yorker showed him sitting impassively, Gandhi-like, surrounded by dancing nude women waving banners from dot-coms. The caption: "The temptation of Alan Greenspan."
That was the opposite of what the Fed chairman had intended to convey, and he became increasingly frustrated. He turned testy as normally deferential legislators tore into him during hearings. "Senator, I continue to deny and insist upon continuing to deny that our goal is to jawbone the stock market. It is not," he told one.
He scrambled to clarify his argument. Appearing at an early April White House seminar on the New Economy, he assured the audience that he believed "monetary policy should focus on the broader economy ... not asset prices."
To some in the Fed, Mr. Greenspan still doesn't get the point. The real lesson of the past three years, they believe, is that Fed officials shouldn't talk so openly about the market.
But Mr. Greenspan has remained unswerving in his basic belief, that one of the fundamental changes affecting the U.S. economy at the turn of the century is the impact of the market. "I could very readily stop talking about the stock market," he told a Fed staffer. "But if I do, I will not be explaining how the process is working... . There is no way to understand what is going on in this economy without reference to asset values."