The new millennium has not been kind to Alan Greenspan. The stock market bubble burst in 2000 wiping out $7 trillion in stock values and dragging the economy into one recession, or more likely two. Critics are lobbing crossfire salvos at the Federal Reserve Bank Chairman, some saying he raised interest rates too little too late to prevent the bubble, while others accuse him of provoking the recession by raising rates too much too soon. Edging toward the exit of an extraordinary tenure in office, Mr. Greenspan decided it was time to burnish his legacy.
In an address to his peers in Jackson Hole, Wyoming last week [August 30], the Chairman returned fire, saying, that it is “very difficult to definitively identify a bubble until after the fact – that is, when its bursting confirmed its existence,” and “it was far from obvious that bubbles, even if identified early, could be preempted short of the central bank inducing a substantial contraction in economic activity – the very outcome we were seeking to avoid.” In other words, the Fed governors couldn’t see the bubble coming, and even if they had, there’s nothing they could have done to prevent it short of clobbering the economy. That’s quite an admission from the oracle that questioned “irrational exuberance” in the stock market three years before the bubble burst. But more importantly, it’s another illustration of Chairman Greenspan’s penchant for masterful misdirection: focusing our attention on the debatable point of whether the Fed could have safely raised rates to prevent investors from bidding uPstock prices unreasonably, while diverting our attention from the Fed’s undeniable (yet generally unrecognized) complicity in creating the bubble in the first place, by force feeding investors a surfeit of new money with which to buy stocks.
It is axiomatic in economics that if you “print” new money faster than the economy grows, inflation results, be it in consumer prices or asset prices, as was amply demonstrated in the late 1990s. From 1995, roughly about the time the stock market bubble began to inflate, the Fed expanded the broader aggregates of the money supply (M2, MZM and M3) at or above the upper limit of its target monetary growth range between 1% to 5%, in response to various crises (see graph 1). In 1995 it was the Mexican Peso Crisis, prompting the Fed to boost the growth of the trailing 3-month average of M2 to an annualized 8% peak rate. Then in 1997 and 1998 it was the Asian Flu, prompting surges in M2 to 7% and 8%, respectively. In 1998 the Fed countered a slumPin U.S. stock markets with monetary expansion exceeding 11% at the peak. The bursting of the NASDAQ bubble in March of 2000 brought a monetary surge exceeding 10% and 9/11 prompted the Fed to kick the annualized rate of monetary expansion briefly above 14%! The various crises in 2000 caused the Fed to expand M2 at more than 10% for the year. Now in 2002, with the stock market flagging and the economy in danger of double-dipping back into recession, the Fed has again boosted monetary growth above 10%. If we examine the trajectory of the dark line, showing change in M2 growth for 12 months, we readily observe that M2 growth has consistently exceeded the 5% upper boundary of its target range since 1997.
Not surprisingly, given these extraordinary bouts of monetary expansion since 1995, inflation popped out right on cue, mainly in the form of asset inflation in stocks and real estate, rather than consumer price inflation (although the consumer price index did surge above 3% during all of 2000 and part of 2001). As the Fed’s Open Market Committee aggressively bought Treasury bills, notes and bonds from private investors, those same investors used their newly acquired cash to bid uPthe prices of real estate, and, most notably stocks, creating the bubble in question. Most notoriously, the NASDAQ composite index skyrocketed from 751 in January 1995 to a peak at 5,132 in March 2000, a gain of 580% in just five years! (See graph 2) Had the Dow Jones Industrial Average risen by that same percentage, it would have topped 26,000 at its peak in 2000, rather than a mere 11,722. During the same five years, the broader Standard and Poor’s 500 Index, slipped its moorings and climbed from 459 to 1553, a gain of 238%. 1995 was the last year in which we saw anything approximating reasonable fundamental valuations in the S&amP;P500, with a price-earnings ratio of 17 and dividend yield of 2.8% (see graph 3). At the peak of the mania, the S&amP;P500’s P/E ratio soared to 36 in 1999 and the dividend yield bottomed at 1.1% in 2000. These numbers, no doubt, would have astounded Messrs. Graham, Dodd and Cottle, yet the sages at the Fed found it “very difficult to definitively identify a bubble” despite having agonized about “irrational exuberance” three years earlier when the NASDAQ traded at a mere 1,158 in December 1996, and the S&amP;P500 yielded 2% and sported a P/E ratio of around 21.
Ostensibly unaware of the bubble developing between 1995 and 1999, the Fed Governors did not simply fail to preempt it with higher interest rates, but instead actively fueled the mania with extraordinarily monetary stimulus: rapid monetary growth that pushed short-term rates down from about 6% to 4.5% and long-term rates down from around 7.25% to 6% during the period (see graphs 4 and 5). Only late in 1999, with an overheating economy on the verge of exhibiting troublesome consumer price inflation, did the Greenspan Fed begin to raise rates by sharply decelerating the growth of the money supply. Within six months, in the spring of 2000, the bubble burst, dragging the economy into recession by the first quarter of 2001.
The harmful aftereffects of the Fed’s monetary flood went beyond the stock market. As one might expect, banks awash in cash expanded credit at comparably prodigious rates, burdening consumers and corporations with record amounts of debt, raising the total debt as a percentage of gross domestic product to levels not seen since 1929. Not surprisingly, personal and corporate bankruptcies soared to unprecedented levels recently, raising the specter of a credit crunch and cascading defaults that could single-handedly drag the economy back into recession. (See graph 6.) In addition, the Fed’s unrelenting monetary deluge fueled an American spending spree on foreign goods and services resulting in record trade deficits, both in nominal terms and relative to gross domestic product (graphs 7 and 8). History tells us that mammoth trade deficits will eventually be cured by a devaluation of the currency (as we saw in the U.S. between 1985 and 1990) likely to undermine U.S. stock and bond markets and the economy in much the same way as the flight of capital from the U.S. did in 1987 and from Mexico and Asia did in the 1990s.
One might be tempted to argue that the Fed’s periodic monetary excesses were inspired by the worthy objectives of ameliorating various economic and financial crises at home and abroad, which might otherwise have dragged the U.S., and indeed, the world economy into recession. However, is the occasional recession such a bad thing to be avoided at all costs? If we truly believe in unfettered capitalism and free markets, we also believe in the accompanying recessionary discipline free markets impose on the economy to remedy the periodic excesses (“imbalances” in Greenspanspeak) – mounting inflation, too much debt, overvalued stocks and overpriced currency – that invariably accumulate during periods of economic expansion. It is this inevitable and salutary discipline that Mr. Greenspan seeks to short circuit with periodic surges of new money in pursuit of a policy of endless prosperity. In so doing he prevents the orderly rebalancing of the economy and financial markets through manageable recessions (and their moderate accompanying inflation abatement, debt reduction, stock market corrections and currency devaluations) that offer the best prospects for long-term economic growth. Unable to rebalance because of Mr. Greenspan’s well-meaning but misguided perpetual stimulus, the U.S. economy continues to accumulate potentially catastrophic imbalances. Consequently, we may find that Mr. Greenspan has traded off a series of small, manageable, naturally occurring recessions for one catastrophically big one.
Today the U.S. economy is barely being kept afloat by extraordinary “zero-percent” financing incentives offered by auto manufacturers, bargain mortgage rates and abundant liquidity fueling a housing market bubble, and frenzied military spending following 9/11. Meanwhile, the legacy of the Fed’s past and present monetary excesses increasingly weighs on the economy. Capital spending and consumer confidence sag dangerously – casualties of the bursting stock market bubble and excessive burdens of corporate and personal debt fueled by Mr. Greenspan’s monetary largesse. Federal budget surpluses disappear and deficits soar due largely to revenues diminished by stock market losses and recession. The early signs of flight from an overvalued dollar reveal a threat to undermine both U.S. capital markets and the economy. Consequently, Mr. Greenspan should not be faulted for inaction in preempting the bubble (the straw man he proffers to distract us), but instead be roundly chastised for fueling the stock market mania and other imbalances he has himself decried, the aftermath of which threatens to produce a “substantial contraction in economic activity – the very outcome [the Fed was] seeking to avoid.”
Who sees with equal eye, as God for all
A hero perish or a sparrow fall,
Atoms or systems into ruin hurl’d
And now a bubble burst, and now a world.
Alexander Pope, An Essay on Man
(Written in 1733-1734 after Pope experienced firsthand the folly of the South Sea Bubble of 1720 in England. Fortunately, he got out before the crash. Others he advised to do likewise did not, to their everlasting regret.)
