Greenspan and irrational exuberance The Federal Reserve's past reluctance to crack down on a runaway bull market raises questions about its remit, say Gerard Baker Published: March 6 2002 19:46 | Last Updated: March 7 2002 10:10
In the summer of 1996, while Bill Clinton was surfing to re-election on a wave of equity market euphoria and spreading national prosperity, the mood inside the Federal Reserve in Washington was anxious.
Policymakers on the central bank's federal open market committee (FOMC) were concerned that the stock market had begun one of its periodic bouts of financial amnesia and was pushing equity valuations to levels that required increasingly far-fetched intellectual justifications.
Alan Greenspan, the Fed chairman, and his colleagues pondered what to do. Should they direct policy explicitly towards the goal of knocking some of the wind out of the stock market? Or should they keep their focus instead on real indicators of overheated economic activity - goods and service prices, wages - none of which were flashing any warning lights?
By the end of the year, Mr Greenspan had seen enough. In December he delivered his famous "irrational exuberance" speech. The Fed, it seemed, was going to do what was necessary to stop the explosion of an asset bubble of the sort that had done so much harm to Japan's economy a few years earlier. Whether through verbal warnings, higher interest rates, or perhaps even more direct measures such as imposing margin requirements, the central bank looked ready to stop the party.
When the market quickly resumed its ascent after a brief decline following the chairman's remarks, the stage looked set for a battle between the Fed and exuberant investors. But then Mr Greenspan did an odd thing. To be precise, he did nothing. Despite his warnings, there was no concerted attempt to rein back equity prices over the next few years.
The Fed made one small upward adjustment in interest rates in March 1997. But it was not until more than two years later - when the Dow had clocked up several thousand more points - that rates began to rise sharply. Even then, Mr Greenspan made clear that was aimed at a broadly overheating economy of which the stock market was just one component.
This inaction has always been something of a mystery to Fed watchers. Why did the central bank signal such obvious concern about the equity market and then not follow it up? It is not only a matter of historical curiosity but an issue with critical implications for monetary policy in the future.
The mystery only deepened last month when the central bank released the full transcripts of FOMC meetings for 1996. For the first time, they reveal the scale of the Fed's concern about rising equity prices in those early days of the technology-driven bubble.
Early in the year, the transcripts show that Mr Greenspan was not certain that the equity market was indeed a bubble. But by September, he was explicitly referring to it in such terms: "I recognise that there is a stock market bubble problem at this point," he said at the September 24 meeting - the day the Dow closed at 5874.03.
The most forceful argument for the Fed to act came from Lawrence Lindsey, one of the Washington-based governors. Mr Lindsey, who is now President George W. Bush's chief economic adviser, had been arguing for some time that the equity market was overvalued. "As in the US in the 1920s and Japan in the late 1980s, the case for a central bank ultimately to burst the bubble becomes overwhelming," Mr Lindsey said in September.
Why, then, was no action taken? Mr Greenspan has expressed doubt about whether it was the central bank's job to second guess the decisions of millions of individual investors. But this does not fit well with the remit of the central bank to "take away the punch bowl just as the party is getting going," as one Fed chairman put it.
A more plausible explanation is that Mr Greenspan became less certain the market was overvalued. In late 1996, the US was only beginning to see the outline of the improvement in productivity performance in which Mr Greenspan - correctly, as it turned out - became such a fervent believer over the next few years.
But productivity improvements could only ever justify a small portion of the rise in prices. Mr Greenspan himself subsequently fretted that the market was overvalued, telling a Congressional committee in 1999 that it was not a question of whether equity prices would adjust, but when they would.
It is also possible Fed policymakers felt any policy designed to puncture the bubble would cause huge damage to the rest of the economy. Mr Lindsey argued in 1996 that it was important that the Fed act early in the asset inflation process precisely to avoid this problem. But this put the central bank in a bind - the Fed could not be sure that equities had become structurally overvalued until prices had risen a long way out of line with historical trends. By then, the risks of acting to deflate them could have been too high.
A more likely explanation for the Fed's inaction is that Mr Greenspan and his colleagues may simply have felt constrained by their public mandate. It is not at all clear that the Fed could actively engage in a policy designed to reduce the wealth of the American people. Reaction to Mr Greenspan's "irrational exuberance" speech was highly critical. He was attacked by politicians on both sides.
The Fed is highly sensitive to such political criticism. Though it is operationally independent of political control, it derives its authority from Congress, which dictates the goals it should pursue through legislation. The Fed has undertaken unpopular policies on many occasions, but this was different.
If this is the true explanation, then a broader public debate is necessary about the freedom of the Fed to use monetary policy to end a bull market that the central bank judges has run out of control.
( When I see valuable assets going for peanuts I have to wonder if bubbles aren't just financing mechanisms. How could globaloney work without some of the tech infrastructure paid for by investors, especially the late-comers? There would be no AOL TimeWarner without them. No fiber networks)