(Reprinted from testimony before The House Subcommittee on Domestic and International Monetary Policy on March 21, 2000)

My name is Paul McCulley, and I am an Executive Vice President and Portfolio Manager at Pacific Investment Management Company (PIMCO) in Newport Beach, California. We manage over $180 billion in assets at PIMCO, where I lead the Short-term Desk.

I thank you for the opportunity to be here today, and want to commend Congressman Bachus for calling this hearing. Both Congress and the American people deserve an open and frank discussion of the role of the stock market in monetary policy formulation. In this connection, some of Chairman Greenspan’s comments on this issue at his recent Humphrey-Hawkins testimony are not easily reconcilable with his previous comments.

On the one hand, he argued forcefully that the so-called wealth effect is contributing to excess aggregate demand relative to aggregate supply, and that the Fed will tighten sufficiently to curtail growth in household net worth to that of growth in household disposable income. On the other hand, he maintained that the “wealth effect is not all that closely linked to the stock market.” Yet, last November, he argued that “only about one-sixth of the so-called wealth effect—that is, the impact of capital gains on consumer spending—stems from equity extracted from the stock of existing homes.”

Thus, it seems to me, it is reasonable for this Subcommittee to ask Mr. Greenspan where the other five-sixths of the wealth effect originates, if not in the stock market. As the following chart (Figure 1) vividly displays, household net worth to disposable income and the S&P 500 are fellow travelers. It is simply wrong for Mr. Greenspan to argue that the two are not “closely linked.”

What Mr. Greenspan seems to want is an immaculate correction in the wealth effect, without being named the father of a bear market in stocks. This is just not a credible proposition. If Mr. Greenspan indeed believes that the wealth effect is the skunk at the aggregate demand picnic, and that he should scotch it, then logic demands that he set his sights on the stock market.

Fellow Travelers: Household Net Worth vs. S&P 500
Figure 1
Source: Goldman Sachs

The Stock Market Bifurcates:
NASDAQ / Dow Index, 1980=100
Figure 2 
Source: Credit Suisse First Boston

The question before us today is whether those sights should be adhered exclusively to the short-term interest rate gun, or whether Mr. Greenspan should un-holster the Regulation T margin weapon as well. I believe strongly that Mr. Greenspan should reach for the second gun.

Wealth creation in the stock market is not a democratic process. Indeed, capitalism demands that the stock market be a very discriminating place. It is a machine of “creative destruction,” where the frontier of growth is funded, while the pillars of yesterday are essentially liquidated. This is as it should be, as I am sure Mr. Greenspan would agree.

The problem, as Mr. Greenspan sees it, is that the equity market, by creating wealth as it dis-counts the future profits from the frontier of our economy, is stimulating aggregate demand before the frontier can add to aggregate supply. Thus, Mr. Greenspan feels compelled to apply restraint to aggregate demand. Indeed, he argues that the need for such restraint can be ascertained without having an opinion as to whether there is “an irrational surge in stock prices or speculative imbalances which are threatening the economy.”

I do not think Mr. Greenspan actually believes that. Or, at least, I certainly hope he doesn’t! Given the tight link between the wealth effect and the stock market, it is incumbent on the Fed to recognize the fundamental bifurcated character of the stock market. Not all stocks are going up. Quite to the contrary, stocks of the so-called Old Economy are going sideways, at best. It is the stocks of the so-called New Economy that are propelling the wealth effect.

The chart above (Figure 2) showing the relative performance of the NASDAQ and the Dow Jones speaks volumes: The equity market-driven wealth effect is increasingly a New Economy affair. And over a year ago, at the February 1999 Humphrey-Hawkins hearings, Mr. Greenspan himself presented a fascinating framework for evaluating New Economy stocks, using the analogy of a lottery. Bear with me while I quote directly:

“…you wouldn’t get ‘hype’ working if there weren’t something fundamentally potentially sound under it. The issue really gets to the increasing evidence that a significant part of the distribution of goods and services in the country is going to move from conventional channels into some form of Internet system; whether it’s real goods or services, or a variety of other things.

The size of the potential market is so huge that you have these pie-in-the-sky types of potentials for a lot of different vehicles. And undoubtedly, some of these small companies, whose stock prices are going through the roof, will succeed. And they very well may justify even higher prices. The vast majority are almost sure to fail. That’s the way the markets tend to work in this regard.

There is something else going on here though, which is a fascinating thing to watch. And it is for want of a better term, the ‘lottery’ principle. What lottery managers have known for centuries is that you could get somebody to pay for a one-in-a-million shot, more than the value of that chance. In other words, people pay more for a claim on a very big payoff, and that’s where the profits from lotteries have always come from.

And what that means is that, when you are dealing with stocks, the possibilities of which are either it’s going to be valued at zero or some huge number; you get a premium in stock prices, which is exactly the same sort of price evaluation process that goes on in a lottery. So the more volatile the potential outlook—and indeed in most of these types of issues, that’s precisely what’s happening—you will get a lottery premium in the stock.

But to answer the question—Is there some hype in this?—Of course, there is some hype. There is hype in lots of things.

But there is at root here something far more fundamental. And indeed it does reflect something good about the way our securities markets work; namely, that they do endeavor to ferret out the better opportunities and put capital into various different types of endeavor, prior to earnings actually materializing. That’s good for our system. And that in fact—with all of its hype and craziness—is something that, at the end of the day, probably is more plus than minus.”

While Mr. Greenspan’s defense of capitalism was elegant, even more exquisite was his introduction of the concept of a “lottery premium” to the discussion. He was precisely right then, and his analysis holds even more so today. By definition, if the lottery “principle” holds, then the New Economy equity market is overvalued—that is, the cumulative current market value of those stocks is greater than any realistic discounting of their cumulative long-term earnings potential.

Therefore, using Mr. Greenspan’s own analysis, we can fairly conclude that the New Economy portion of the stock market is a bubble. As Mr. Greenspan noted, the greater is jackpot of a lottery, the greater will be peoples’ willingness to overpay for a chance to win it!

Thus, it is just not credible for Mr. Greenspan to maintain that the wealth effect is not that closely linked to the stock market, when by his own analysis of a year ago, the New Economy stocks are running on a lottery principle. If his analysis of a year ago is still correct, and I certainly think it is, and if New Economy stocks have soared versus stagnant Old Economy stocks over the last year, which is a fact, then logic compels the conclusion that the excessive boost to aggregate demand that Mr. Greenspan abhors is related to the bubble in New Economy stocks.

Which brings us to the question of whether the interest rate tool is the right exclusive instrument for dealing with the problem. I know of no economic model that postulates a high interest elasticity of demand for lotteries! Virtually every economic model incorporates, however, a high interest elasticity of demand for the goods and services of the Old Economy.

Thus, using the interest rate tool exclusively to thwart wealth creation in New Economy stocks carries grave risks for the Old Economy. It makes no sense to try to get the attention of gluttons by starving anorexics. It’s bad macroeconomic policy, and it is also morally wrong.

This is particularly the case in the face of evidence that the bubble in New Economy stocks is being increasingly fueled by margin debt, as vividly displayed in the following chart (Figure 3). While it is a free country, and everybody has a right to foolishly overpay for lottery tickets, I do not believe that the Fed should passively endorse the purchase of lottery tickets on credit! 

Margin Debt Accelerates
vs. Market Capitalization
Figure 3 

Under Regulation T, the Fed has the authority to set initial margin requirements for the purchase of stocks on credit, which has been at 50% since 1974. The Fed should raise that minimum, and raise it now. Mr. Greenspan says “no,” of course, because (1) he cannot find evidence of a relationship between changes in margin requirements and changes in the level of the stock market, and (2) because an increase in margin requirements would discriminate against small investors, whose only source of stock market credit is their margin account. I have rejoinders to both of those objections.

When margin requirements were last changed in 1974, our financial system was dominated by banks and thrifts, living under Regulation Q ceilings on deposit rates. Thus, there are no data points on the effect of changes in margin requirements under the de-regulated, capital markets-driven financial system of today. But there are data points demonstrating that New Economy stocks are driving the wealth effect, and that margin debt as a percent of total stock market capitalization has accelerated sharply as New Economy stocks have taken on a lottery premium. Thus, I find Mr. Greenspan’s empirical evidence from over a quarter century ago that changes in margin requirements “don’t work” to be leaning on a very thin reed.

As to the issue of a hike in margin requirements being discriminatory to small investors, I have but one response: If a hike in margin requirements would be discriminatory, then the existence of margin requirements is discriminatory! Therefore, in this modern era of rooting out discrimination, Mr. Greenspan ironically makes a case for the elimination of margin requirements. But I don’t hear him arguing that!

Let me conclude with a few simple observations. What is going on in the New Economy is profoundly changing the world. Like Mr. Greenspan, I marvel at the ability of capitalism to fund the new and de-fund the old through a process of “creative destruction.” That said, it is clear to me—as it was to Mr. Greenspan a year ago—that stock market action in New Economy stocks is operating on a lottery principle, which by definition implies that it is a bubble. After all, the total market value of outstanding $2 lottery tickets is always greater than the size of the jackpots. Otherwise, there would be no profit motive for running lotteries.

It is also empirically the case that as New Economy stocks have risen dramatically relative to total stock market capitalization, margin debt has accelerated, both absolutely, and even more important, as a percent of total stock market capitalization. To me, this is prima facie evidence for a hike in margin requirements, rather than an interest-rate-hike only policy, which has its most nefarious effect not on speculation on Wall Street, but on the ability of average Americans to pursue their dreams on Main Street.

I thank you for the opportunity to present my views today, and look forward to your questions.

Paul McCulley
Executive Vice President


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