Monday Morning: Greenspan failed to quell ‘exuberance’

Alan Greenspan has taken a lot of flak for arguing that the Federal Reserve could not have headed off the stock market bubble.

Mr. Greenspan, the Federal Reserve Board chairman, argued that hiking margin requirements for stock purchases, or hiking interest rates, in 1999 would not have worked.

We’ll never know about the efficacy of raising margin requirements, but he may have a point about hiking interest rates. In fact, raising interest rates in 1999 might have been counterproductive.

Remember the environment in 1999. The dollar was strong because investors, shaken by the 1997 meltdown in the Asian economies and the 1998 Russian default, were flooding into the United States.

The U.S. economy was regarded as a safe haven. As a result, U.S. interest rates were driven down as foreign investors bought U.S.bonds, especially Treasury bonds. And foreign demand for U.S. equities helped push stock prices toward their peak.

What would have been the result if the Federal Reserve somehow had raised interest rates early in 1999 in the above environment?

Most probably, there would have been a short-term dip in stock prices. However, higher interest rates in the United States might well have sucked in even more foreign money. As the dollar strengthened, U.S. equities would have looked even more attractive to foreign investors, and some of the additional money would have flowed into U.S. stocks.

The additional flows likely would have quickly offset the Fed’s push for higher rates, and the increased demand for stocks would have pushed stock prices higher again.

At the same time, a stronger dollar would have inflicted even more damage on those economies around the world where the currency is tied to the dollar, such as Thailand and Argentina.

The Fed’s task would have been immensely complicated, politically and economically, if it had attempted to prick the stock market bubble in 1999, and it might have driven the rest of the world into a nasty recession, if not a depression.

Mr. Greenspan’s mistake, for which he rightly deserves criticism, was to wait too long to even think about removing the punch bowl from the party. He should have taken action not long after his famous remarks about “irrational exuberance” in the market in July of 1996.

Perhaps if he slowly but steadily had raised interest rates after that speech, the steady pressure would have prevented the Internet bubble and the other market distortions that accompanied it.

If done gradually enough, it might even have brought about a slow correction of the distortions in the Asian markets that led to the crisis late in 1997 rather than the ensuing sharp correction.

no action

Clearly, Mr. Greenspan and his fellow governors on the Federal Reserve Board saw signs of a problem in 1996. But perhaps they were lulled by the fact the U.S. economy was humming, and inflation was benign.

For whatever reason, the Fed took no action to follow up Mr. Greenspan’s words, and the exuberance became truly irrational in late 1999 and early 2000.

As Mr. Greenspan said in a speech to the American Enterprise Institute in December 1996: “Because monetary policy works with a lag, we need to be forward looking, taking actions to forestall imbalances that may not be visible for many months. There is no alternative to basing actions on forecasts, at least implicitly. It means that often we need to tighten or ease before the need for action is evident to the public at large …”

Unfortunately, Mr. Greenspan and his colleagues on the Fed’s monetary policy body were not forward looking enough in that instance. Though they perceived “irrational exuberance” in the market, they apparently did not foresee a bubble.

The failure cost millions of investors hundreds of billions of dollars and has damaged their faith in the equity markets. It will take many years of good stock market performance to win them back.

Mike Clowes is the editorial director of InvestmentNews and sister publication Pensions & Investments.