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Economic and Market Commentary

Look, Honey, I Caught A Liverwurst!​

Public policy figures, from the President of the United States to the clerk at your local Department of Motor Vehicles (DMV), like power. And on any given day, I’m not sure which end of that spectrum is more powerful, now that the United States no longer has a military draft. What I do know is that neither end of that power spectrum likes to have its ways and means questioned.

To be sure, all presidents wax eloquently about the wonders of democracy and the will of the people, particularly when they lose re-election. And behind most clerks at the DMV, there is a framed mission statement declaring that service is priority number one, which long lines provide plenty of time to read. At the end of the day, humans like power, and non-elected bureaucrats like it most, for the simple reason their power is not subject to the disinfecting powers of either democracy or the capitalistic market place. It is great to be king.

Which brings us to the matter of the Fed, whose economic power greatly exceeds that of both the White House and the DMV. Fed governors (but not regional Fed Bank presidents!) must be nominated by the President and confirmed by Congress, which is constitutionally charged with the power to create money. And since both the President and Congress are creatures of the democratic process, Fed governors are indeed birthed in democracy (and regional Fed Bank presidents indirectly, since the Board of Governors must approve their appointment). But once Fed governors are confirmed, the power relationship flips, and the President and Congress choose to become the supplicants of the Fed.

This is particularly the case with Fed Chairman Greenspan, who has been appointed and annointed by three different presidents. Not only has he been awarded independence over monetary policy, he has also been awarded de facto control of fiscal policy, because he can use his monetary powers to award or punish fiscal policymakers for fiscal policy action he does or does not like. Simply put, the President proposes, the Congress disposes, but the Fed rules! Except, I suppose, when Fed governors need to get their licenses renewed at the DMV, and in the case of Fed Chairman Greenspan, I suspect he is probably shown professional courtesies even there!

Do You Still Believe, Mr. Greenspan, That The
“Wealth Effect Is Not That Closely Tied To The Stock Market”?
 Figure 1 is a line graph showing the ratio of U.S. household net worth to disposable income versus the S&P 500, from 1980 to 2001. Both metrics roughly track each other over the period, especially from the mid-1990s onward. They are near the peaks in 2000. The ratio of net worth to income, scaled on the right-hand vertical axis, is around 6 by the third quarter of 2000, just off its peak of about 6.3 around the beginning of that year, and up from its last major low of around 4.7 in late 1994. The S&P 500 surpasses 1400 by 2000, and drops down to near 1200 by early 2001, but it’s up from just over 100 in 1980. Net worth to personal income is around 4.3 in 1980.
Figure 1
Source: Goldman Sachs

Too Much of a Good Thing
Conventional wisdom, particularly on Wall Street, argues that this is the way it should be, because politicians should not be trusted with monetary policy, which has the power to create money out of thin air, an inflationary powder keg. Let the Fed rule! Or in the politically-correct language of the economics profession, let the monetary authority dominate in the monetary-fiscal policy coordination game.

I certainly agree that a politically independent central bank is a powerful countervailing force to the inherent inflationary tendencies of the democratic process, which is founded on the proposition of one person, one vote . Indeed, central bank independence is probably the only effective arrangement for putting a loose inflationary genie back into its lamp. But it is also true that a belligerently independent central bank is a powerful force reinforcing the inherent deflationary tendencies of the capitalist process, which is founded on the proposition of one dollar, one vote .

If and when central bankers become so intoxicated with their independent power that they openly court deflation, then it is time for their independence to come under the disinfectant of the political process. “Disinfectant,” I hear some of you bellowing, “how can the political process disinfect anything? Only the market can do that!” If the exigent bacteria are of an inflationary strain, I agree. In fact, that is precisely why central bankers are one step removed from the political process. But with such inoculation, central bankers are susceptible to the human impulse of believing the Mae West dictum that if a little is good and more is better, then way too much is just about right.

When inflation is high, a deflationary central bank bias is desirable. And indeed, the Fed has exercised that bias consistently over the last two decades, pursuing something called “opportunistic disinflation,” which is just a fancy way of saying fighting inflation preemptively but fighting recession reactively . But when opportunistic disinflation is no longer a desirable goal, for the simple reason that a recession would bring deflation, not disinflation, it is appropriate for both the President and Congress to demand that the Fed aggressively pursue anti-recession policies, and to pursue them on a pre-emptive basis. With all due respect to Ms. West, there can be such a thing as too much of a good thing. And central bank independence is one of them.

Time To Let The Fiscal Dogs Out
I submit we are at precisely such a juncture. No, I’m not suggesting any changes to the formal legal independence of the Fed. What I’m suggesting is that both the President and Congress should no longer genuflect when Alan Greenspan walks into the room. They should also quit assuming that the kool-aid he offers to wet the lips is necessarily a refreshing beverage. More specifically, it is time to “take back” their prerogatives with respect to fiscal policy. Don’t ask, just do it!

The ritual of deciding who disciplines whom in the monetary/fiscal policy coordination game needs to be reversed. Reflation of aggregate demand growth is now the dominant policy imperative, not reduction of inflation. And fiscal policy is quite apt at reflating aggregate demand, if monetary policy is demoted to accommodating fiscal policy. Mr. Greenspan would, no doubt, object, as he doesn’t like taking orders from anybody.

He did, to be sure, do an about face in January on fiscal policy, telling his putative bosses in Congress that a little tax cutting would be in order, as the dividends of stronger structural productivity growth, over which he preceded and forecast would continue, were sufficiently large to create a need for a measured “glide path” to eliminating the federal debt. But he also rejected the notion that fiscal policy should re-adopt any role in fine tuning aggregate demand, the quintessential job of monetary policy. More specifically, Greenspan refused to endorse proposals for a retroactive tax cut, arguing that it would likely be a damp squib if the economy went into a recession, a low probability outcome itself, he averred.

And true to form, legislators genuflected. Old habits are hard to break, I suppose. What legis-lators didn’t/don’t seem to grasp is that there is no sound macroeconomic argument against an aggressive, old fashioned Keynesian fiscal stimulus at this moment. Yes, there are arguments against it, but there are no sound arguments. When the dominant risk on the business cycle horizon is debt deflation, which even Mr. Greenspan would have to admit if he was honest with himself, timidity in the pursuit of aggregate demand growth is not a virtue, but a vice. In such a circumstance, to eschew aggressive and pre-emptive use of fiscal policy to reflate aggregate demand is an act of ignorance, hubris or both.

What A Long Strange Trip
In Mr. Greenspan’s case, the evident affliction would appear primarily not to be ignorance but hubris, borne of his unwillingness to admit that he both accommodated and burst a bubble in the stock market. In December 1996, of course, he pondered out loud about the possibility of a stock market bubble, when he declared:

“Clearly, sustained low inflation implies less uncertainty about the future, and lower risk premiums imply higher prices of stocks and other earning assets. We can see that in the inverse relationship exhibited by price/earnings ratios and the rate of inflation in the past. But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade? And how do we factor that assessment into monetary policy?

We as central bankers need not be concerned if a collapsing financial asset bubble does not threaten to impair the real economy, its production, jobs, and price stability. Indeed, the sharp stock market break of 1987 had few negative consequences for the economy. But we should not underestimate or become complacent about the complexity of the interactions of asset markets and the economy. Thus, evaluating shifts in balance sheets generally, and in asset prices particularly, must be an integral part of the development of monetary policy.”

And in February 1999, Mr. Greenspan presented a very elegant way of looking at NASDAQ (technology) stocks, which pointed ineluctably to the existence of a irrational exuberance:

“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 that goes on in a lottery. So the more volatile the potential outlook – and indeed in most of these types of issues, that precisely what’s happening – you will get a lottery premium in the stock.”

I thought that was a beautiful piece of analysis and said so at the time. If indeed the “lottery principle” explained NASDAQ, then it was incontrovertibly a bubble, which would pop, when the winning numbers of the “lottery” were, in the fullness of time, revealed.

But then only six months later, in August 1999, with the NASDAQ on the asymptotic launch pad, Mr. Greenspan lost his appetite for making asset prices an “integral part of the development of monetary policy.” In effect, he renounced his insightful “lottery principle” analysis, and declared himself to be evangelically agnostic about trying to preemptively identify a bubble in stocks:

“To anticipate a bubble about to burst requires the forecast of a plunge in the prices of assets previously set by the judgments of millions of investors, many of whom are highly knowledgeable about the prospects for the specific companies that make up our broad stock price indexes.”

But then only six months later again, in February 2000, Mr. Greenspan announced war on asset price appreciation (if faster than household income growth), even as he denied aiming rate hikes at stock market appreciation. I will never forget the moment I heard him declare, in response to a direct question from Senator Schumer:

“Let me emphasize that we are not focusing monetary policy on the stock market. We are focused on the economy. To the extent that the stock market affects the economy, we respond to that. But it doesn’t necessarily follow that if stock prices go up or go down they will have an effect on the economy which requires us to respond. We don’t look at stock prices and say, if they’re rising, we have to raise interest rates. We look at the wealth effect and the wealth effect is not that closely tied to the stock market. I mean, it’s a broad sort of thing, but we cannot argue there is a direct relationship between what’s happening in the stock market and what’s happening to monetary policy. That is not our interest.”

It physically pained me to watch Mr. Greenspan that day. It is hard to watch a hero openly utter words that you know he knows are false. But that’s what he did. And once he duplicitously declared that he wasn’t targeting lower stocks, Mr. Greenspan had little choice but to also declare that he was not making a judgment as to whether stocks were overvalued, even though his “lottery premium” analysis of a year earlier pointed ineluctably to that conclusion. Specifically, he said:

“I’m not making a judgment as to whether in fact the wealth effect is overdone, the values overdone or not. It’s not relevant to the argument that I’m making very specifically. As I’ve argued previously, it is very difficult to make a judgment on whether we have a bubble, which is really what that would be, except after the fact. So, I’m not raising the issue in this context of there being an irrational surge in stock prices or speculative imbalances which are threatening the economy. That’s a different type of argument. It’s not the one I’m making.”

What a long strange trip, starting with musings about irrational exuberance in stocks and ending with rates hikes non-targeted at a non-bubble in NASDAQ. 1 If the only matter at hand was Mr. Greenspan’s legacy, his duplicity would be of no great importance. But if Mr. Greenspan is unwilling to accept that we are living in a post-bubble world, it is a matter of grave importance. Macroeconomic life after bubbles is not a self-correcting process of renewal, but a self-feeding process of debt deflation — to wit, it’s a Minsky Moment. 2

Tis Sad, Very Sad
Mr. Greenspan remains in denial. Just yesterday, he offered up yet again the putative wisdom of sell-side equity analysts’ earnings forecasts, to justify a rosy outlook for business investment spending, in support of the Fed’s forecast V-shaped recovery. Specifically, he said:

“Corporate managers more generally, rightly or wrongly, appear to remain remarkably sanguine about the potential for innovations to continue to enhance productivity and profits. At least this is what is gleaned from the projections of equity analysts, who, one must presume, obtain most of their insights from corporate managers. According to one prominent survey, the three- to five-year average earnings projections of more than a thousand analysts, though exhibiting some signs of diminishing in recent months, have generally held at a very high level. Such expectations, should they persist, bode well for continued strength in capital accumulation and sustained elevated growth of structural productivity over the longer term.”

It is beyond me why Mr. Greenspan cites the Wall Street shills that helped create the bubble as a basis for forecasting prospective strength in business investment. Returning to his wonderful analogy of a lottery, how can Greenspan take seriously the foresight of those selling the lottery tickets?

I don’t know. And I wish I didn’t have to ponder that question. While Mr. Greenspan and I may differ as to whether policy makers should identify bubbles in the making, he and I ostensibly agree that policy makers should identify them after the fact, and respond accordingly. Indeed, in his own criticism of Japanese policy makers of a decade ago, Mr. Greenspan faults them not so much for creating a bubble economy, but for their tardiness and timidity in responding to the bursting of the bubble. It is time for Mr. Greenspan to take his own advice.

It is sad to watch the embarrassing spectacle of a man fly fishing in a deli, and sadder still to watch him explain bringing home a roll of liverwurst.

Paul A. McCulley
Managing Director
March 1, 2001

1"Fly Fishing In A Deli," Fed Focus March 1, 2000
2 "Capitalism's Beast of Burden," Fed Focus, January 4, 2001


No part of this publication may be reproduced in any form, or referred to in any other publication, without express written permission.

This article contains the current opinions of the author but not necessarily Pacific Investment Management Company, and does not represent a recommendation of any particular security, strategy or investment product. 
The author's opinions are subject to change without notice. Information contained herein has been obtained from sources believed to be reliable, but is not guaranteed.

This article is distributed for educational purposes and should not be considered as investment advice or an offer of any security for sale. Past performance is not indicative of future results and no representation is made that the stated results will be replicated. Copyright ©1999-2003 Pacific Investment Management Company LLC. All rights reserved.

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