I customarily write a lengthy note to PIMCO's Investment Professionals on the day of major Greenspan speeches. It's usually both a professional and personal joy: analysis and commentary, hopefully crafted with a bit of levity, and even more hopefully, some exploitable portfolio ideas.

Last Friday, I did not write a lengthy note on Mr. Greenspan's major speech opening the Fed's annual Jackson Hole symposium. Instead, I simply e-noted the following three bullet points:

  • Absolutely fascinating; a thinking-out-loud exercise, with much referencing of garden- variety tools of security analysis, "confirming" that there was indeed an equity market bubble.


  • But with a defiant, if not belligerent, tone of self-granted exoneration for any culpability in the bubble's formation.


  • A must read; will be back with a more holistic assessment when I've more holistically digested the essay.

I spent all weekend trying to do that, reading the speech again and again. Yet I must admit that I still don't feel holistically full in my assessment. To be sure, I sent a longish note to my PIMCO colleagues this morning on what Greenspan had to say (they are very cool in encouraging me to think out loud, even when my thoughts are not fully baked!). I must confess, however, that I still don't fully "get" Greenspan's speech.

Not that I don't understand what he said, which was clear, and reported faithfully by the media:

  • Yes, there was an equity market bubble, which confirmed its existence by blowing up.


  • Yes, the Fed was suspicious that it was a bubble when it was bubbling, even though it couldn't, and didn't, know for sure.


  • No, the Fed was not wrong in deciding not to act on its suspicions, letting the bubble bubble; to have done otherwise would have required tightening monetary policy suffi- ciently to induce a recession.


  • And finally, yes, the Fed did do as it had promised to do, if the unconfirmed bubble confirmed itself by blowing up: the Fed eased massively.



Bubble Evidence As It Was Bubbling:
NASDAQ Lottery Tickets Go Parabolic As Margin Debt Soars


Figure 1 is a line graph showing the Nasdaq-to-Dow stock indices ratio superimposed with that ratio of total margin debt outstanding to the sum of NYSE plus Nasdaq market capitalization. The time period shown is 1992 to mid-2002. For most of the chart, the debt-to-market cap ratio, scaled on the right-hand vertical axis, trades above that of the Nasdaq-to-Dow, at around 1.35 in mid-2002, down from a chart-high of around 1.7 in 2000. The Nasdaq/Dow ratio, scaled on the left, is around 0.8 in mid-2002, well off its own high of about 2.4 around 2000. Both ratios start in 1992 at a base of 1. 

Figure 1
Sources: NYSE

Yes, I got all that. That's what Greenspan said. But what do the words say about the role of monetary policy in America's macroeconomic policy regime, dominated by monetary policy? Is that regime sustainable? Does it contribute to sustainable growth? Is it capable of producing macroeconomic outcomes consistent with America's framework of democracy? Does a macroeconomic "regime change" lie on the horizon? And if so, and in the context of America's framework of capitalism, how does an investor position portfolios to make some serious money?!?!

Yes, those are the Socratic questions demanding answers. Not that I have them. Nobody has them. But the search for the answers will, I believe, dominate the process of asset allocation for the years ahead. Which brings us back to Greenspan's speech, which was a tour de force, in that Greenspan explicitly addressed the nature of the macroeconomic policy regime that he has come to dominate. Three passages in the speech are most instructive. Let me address them, and then conclude with some suspicions about what lies ahead.

Micro Volatility Begets Macro Stability?
Greenspan's core analytical tenet is that entrepreneurial capitalism, which promotes creative destruction in the economy from a bottom-up perspective, actually brings stability to the economy from a top-down perspective. In his own words:


"Over the past two decades we have witnessed a remarkable turnaround in the U.S. economy. We resurrected the dynamism of previous generations of Americans. A wave of innovation across a broad range of technologies, combined with considerable deregulation and a further lowering of barriers to trade, fostered a pronounced expansion of competition and creative destruction.

The result through the 1990s of all this seeming-heightened instability for individual businesses, somewhat surprisingly, was an apparent reduction (Greenspan's emphasis!) in the volatility of output and in the frequency and amplitude of business cycles for the macroeconomy."

This defense of entrepreneurial capitalism has, of course, defined the ethos of the policy regime of the last two decades: creative destruction is wicked in real time at the microeconomic level, but blessed in the fullness of time at the macroeconomic level. To wit, if markets are allowed/encouraged to correct microeconomic excesses, they need not morph into macroeconomic excesses, thereby begging macroeconomic booms and busts. Rolling sectoral recessions are the prophylactic against economy-wide recessions.

Greenspan bought this proposition, and the data of the last two decades indeed supports the proposition: real GDP growth volatility has declined. What Greenspan didn't recognize or buy, at least until now , is that entrepreneurial capitalism's seemingly-free "externality" of lower macroeconomic volatility begets its own manifestly-costly "externality" of an equity market bubble, which with a lag , increases macroeconomic volatility. Hegel's dialectic lives. Or, in modern day terms, Soros's reflexi-vity lives!

Yes, It Was A Bubble
In matters of exuberance, Mae West once declared that "if a little is good and more is better, then way too much is just about right!" Last Friday, Mr. Greenspan acknowledged that the spirit of Mae West was indeed alive and well in the 1990s. Specifically, he said:

"As might be expected, accumulating signs of greater economic stability over the decade of the 1990s fostered an increased willingness on the part of business managers and investors to take risks with both positive and negative consequences. Stock prices rose in response to the greater propensity for risk-taking and to improved prospects for earnings growth that reflected emerging evidence of an increased pace of innovation. The associated decline in the cost of equity capital spurred a pronounced rise in capital investment and productivity growth that broadened impressively in the latter years of the 1990s. Stock prices rose further, responding to the growing optimism about greater stability, strengthening investment, and faster productivity growth.

Looking back on those years, it is evident that increased productivity growth imparted significant upward momentum to expectations of earnings growth and, accordingly, to price-earnings ratios. Between 1995 and 2000, the price-earnings ratio of the S&P 500 rose from 15 to nearly 30. However, to attribute that increase entirely to revised earnings expectations would require an upward revision to the growth of real earnings of 2 full percentage points in perpetuity.

Because the real riskless rate of return apparently did not change much during that five-year period, anything short of such an extraordinary permanent increase in the growth of structural productivity, and thus earnings, implies a significant fall in real equity premiums in those years.

If all of the drop in equity premiums had resulted from a permanent reduction in cyclical volatility, stock prices arguably could have stabilized at their levels in the summer of 2000. That clearly did not happen, indicating that stock prices, in fact, had risen to levels in excess of any economically supportable base. Toward the end of that year, expectations for long-term earnings growth began to turn down. At about the same time, equity premiums apparently began to rise.

Some decline in equity premiums in the latter part of the 1990s almost surely would have been anticipated as the continuing absence of any business correction reinforced notions of increased secular stability. In such an environment, the relatively mild recession that we experienced in 2001 might still have been expected to leave equity premiums below their long-term averages. That apparently has not been the case, as the tendency toward lower equity premiums created by a more stable economy may have been offset to some extent recently by concerns about the quality of corporate governance."










This is powerful stuff: Greenspan acknowledged that there was indeed a bubble, and he attributed it, in all but name, to "irrational exuberance," the phrase of infamy that he coined in December 1996. And while Greenspan noted the "relatively mild" recession of 2001 as further evidence of the stabilizing top-down properties of entrepreneurial capitalism, he also noted that the equity risk premium is now no longer below its "long-term average."

I have to admit that I am puzzled as to why Greenspan was so specific about his current estimate of the equity risk premium. One of (at least) two possible reasons: (1) he worries that the equity market may be discounting something more than the "relatively mild" recession already experienced - to wit, the dreaded double dip; and/or (2) he wanted to communicate that the equity market is, in his judgment, on the cheap side of "fair."

Regardless of which (or neither!) may be the case, Greenspan was honest in acknowledging that the putative stabilizing properties of entrepreneurial capitalism, if believed by the masses and embedded in equity prices, lose their stabilizing properties. Heady, heady stuff, borrowing (without saying so) from Hy Minsky's thesis 1 that macroeconomic stability itself can be de-stabilizing, if and when the widespread belief in macroeconomic stability begets unstable financial arrangements.

Despite this giant leap forward in both the analytical content and candor of Greenspan's public thoughts on the nature of bubbles, he remained resolute in his argument that his job description does not include prophylactic tightening action against bubbles, only morning-after easing.

Not Our Job
While I was not surprised to hear Greenspan defend his record, which is exemplary on the inflation-control front, I was surprised to hear him declare that in the absence of an inflation "problem," which would justify nasty tightening action, the Fed is powerless in the face of an equity market bubble. Indeed, he implicitly argued, perhaps without recognizing that he was doing so, that the Fed's very success in controlling inflation was a source of ether for the equity market bubble. Specifically, he said:

"The struggle to understand developments in the economy and financial markets since the mid-1990s has been particularly challenging for monetary policymakers. We at the Federal Reserve considered a number of issues related to asset bubbles-that is, surges in prices of assets to unsustainable levels. As events evolved, we recognized that, despite our suspicions, it was very difficult to definitively identify a bubble until after the fact-that is, when its bursting confirmed its existence.

Moreover, 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 would be seeking to avoid.

Prolonged periods of expansion promote a greater rational (Greenspan's emphasis!) willingness to take risks, a pattern very difficult to avert by a modest tightening of monetary policy. In fact, our experience over the past fifteen years suggests that monetary tightening that deflates stock prices without depressing economic activity has often been associated with subsequent increases in the level of stock prices.

Such data suggest that nothing short of a sharp increase in short-term rates that engenders a signi-ficant economic retrenchment is sufficient to check a nascent bubble. The notion that a well-timed incremental tightening could have been calibrated to prevent the late 1990s bubble is almost surely an illusion.

It seems reasonable to generalize from our recent experience that no low-risk, low-cost, incremental monetary tightening exists that can reliably deflate a bubble. But is there some policy that can at least limit the size of a bubble and, hence, its destructive fallout? From the evidence to date, the answer appears to be no."










As a practical matter, Mr. Greenspan made an articulate case that secular victory against inflation - for which he can rightfully take his share of the credit - will ineluctably beget an equity market bubble, because the Fed cannot threaten to tighten enough - or actually tighten enough! - to induce a recession in the absence of nasty inflation. I happen to agree with Mr. Greenspan that draconian tightening is indeed politically verboten in America in the absence of a "credible" inflation-threat justification.

But to my mind, that exigency increases, rather than decreases, the duty of the Fed to contemplate means other than hikes in the Fed funds rate to temper irrational exuberance in stocks. To wit, regulatory tools, including most importantly, prudential constraints on credit creation for stock speculation. I'm talking about hikes in margin requirements, of course, which Mr. Greenspan once again on Friday categorically rejected as a policy avenue that he should have explored.

You, tolerant reader, already know how I feel about this, so I won't gag you with a spoon again on that issue. I stand by what I said on the subject in testimony before Congress on March 22, 2000; the graph on page 1 is taken from that testimony, which was reprinted as the April 2000 Fed Focus. 2 All I have to say here, as Paul Krugman said in his New York Times column yesterday 3 , is that Greenspan can't credibly argue that a hike in margin requirements would not have worked when he refused to try .

Bottom Line
Greenspan's speech on Friday marked the end of an era: Greenspan declared that the very success of entrepreneurial capitalism, turbo-charged by secular victory over inflation, is a prescription for an equity market bubble, which indeed America experienced. Mr. Greenspan also reiterated that, in his view, it was not the Fed's job to preempt bubbles, but only to deal with their deflationary aftermaths.

To me, this is a view that deserves - and more importantly, will get - a hearing in the democratic process. If bubbles are the natural consequences of the Fed's hegemony in the prevailing macroeconomic policy regime, and if post-bubble deflation risk is the long-tailed consequence of such a regime, I'm willing to bet that the democratic process will change that regime. And the easy wager is that the Fed will lose its hegemony.

The time is rapidly approaching when we must contemplate Mr. Greenspan riding into the sunset. Not because he failed, I hasten to conclude, but because he succeeded: in securing secular victory over inflation. By his own reckoning, that's all he was ever paid to do. And he did it, very, very well.

Bravo, Mr. Greenspan.

Paul A. McCulley
Managing Director
September 3, 2002

1 See "Capitalism's Beast of Burden," Fed Focus, January, 2001.

2 See "A Call For Fed Action: Hike Margin Requirements!," Fed Focus, April, 2000.

3 See "Passing The Buck," New York Times, September 3, 2002








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