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Alan
Greenspan?In His Own Words
Brian
Trumbore
President/Editor, StocksandNews.com
On
Friday, August 30, Federal Reserve Chairman Alan Greenspan
delivered a speech at a symposium in Jackson Hole,
Wyoming, one which I commented rather negatively on
in my "Week
in Review" column of August 31. The following
is that address, dry like every other Greenspan epistle,
but this one will be much discussed for months to
come and since the chairman does discuss the Bubble,
it's now part of Wall Street history. Next week I'll
have more on the Fed and its actions of the past few
years, but from my perspective and others, not his.
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Alan
Greenspan:
Over
the past two decades we have witnessed a remarkable
turnaround in the U.S. economy. The aftermath of the
Vietnam War and a series of oil shocks had left the
United States with high inflation, lackluster productivity
growth, and a declining competitive position in international
markets.
But
rather than accept the role of a once-great, but diminishing
economic force, for reasons that will doubtless be
debated for years to come, 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 seemingly-heightened
instability for individual businesses, somewhat surprisingly,
was an apparent reduction in the volatility of output
and in the frequency and amplitude of business cycles
for the macroeconomy. While the empirical evidence
on the importance of changes in the magnitude of the
shocks impacting on our economy remains ambiguous,
it does appear that shocks are more readily absorbed
than in decades past. The massive drop in equity wealth
over the past two years, the sharp decline in capital
investment, and the tragic events of September 11
might reasonably have been expected to produce an
immediate severe contraction in the U.S. economy.
But this did not occur. Economic imbalances in recent
years apparently have been addressed more expeditiously
and effectively than in the past, aided importantly
by the more widespread availability and more intensive
use of real-time information.
But
faster adjustments imply a greater volatility in expected
corporate earnings. Although direct estimates of investors'
expectations for earnings are not readily available,
indirect evidence does seem to support an increased
volatility in those expectations. Securities analysts'
expectations for long-term earnings growth, an assumed
proxy for investors' expectations, were revised up
significantly over the second half of the 1990s and
into 2000. Over that same period, risk spreads on
corporate bonds rose markedly on net, implying a rising
probability of default. Default, of course, is generally
associated with negative earnings. Hence, higher average
expected earnings growth coupled with a rising probability
of default implies a greater variance of earnings
expectations, a consequence of a lengthened negative
tail. Consistent with a greater variability of earnings
expectations, volatility of stock prices has been
elevated in recent years.
The
increased volatility of stock prices and the associated
quickening of the adjustment process would also have
been expected to be accompanied by less volatility
in real economic variables. And that does appear to
have been the case. That is, after all, the purpose
of a prompter response by businesses: to prevent severe
imbalances from developing at their firms, which in
the aggregate can turn into deep contractions if unchecked.
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.
But,
as we indicated in congressional testimony in July
1999, "... productivity acceleration does not ensure
that equity prices are not overextended. There can
be little doubt that if the nation's productivity
growth has stepped up, the level of profits and their
future potential would be elevated. That prospect
has supported higher stock prices. The danger is that
in these circumstances, an unwarranted, perhaps euphoric,
extension of recent developments can drive equity
prices to levels that are unsupportable even if risks
in the future become relatively small. Such straying
above fundamentals could create problems for our economy
when the inevitable adjustment occurs."
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.
The
consequent reversal in stock prices that has occurred
over the past couple of years has been particularly
pronounced in the high-tech sectors of the economy.
The investment boom in the late 1990s, initially spurred
by significant advances in information technology,
ultimately produced an overhang of installed capacity.
Even though demand for a number of high- tech products
was doubling or tripling annually, in many cases new
supply was coming on even faster. Overall, capacity
in high- tech manufacturing industries rose more than
40 percent in 2000, well in excess of its rapid rate
of increase over the previous two years. In light
of the burgeoning supply, the pace of increased demand
for the newer technologies, though rapid, fell short
of that needed to sustain the elevated real rate of
return for the whole of the high-tech capital stock.
Returns on the securities of high-tech firms ultimately
collapsed, as did capital investment. Similar, though
less severe, adjustments were occurring in many industries
across our economy.
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.
*
* *
The
struggle to understand developments in the economy
and financial markets since the mid-1990s has been
particularly challenging for monetary policymakers.
We were confronted with forces that none of us had
personally experienced. Aside from the then recent
experience of Japan, only history books and musty
archives gave us clues to the appropriate stance for
policy. 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 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.
For
example, stock prices rose following the completion
of the more than 300-basis-point rise in the federal
funds rate in the twelve months ending in February
1989. And during the year beginning in February 1994,
the Federal Reserve raised the federal funds target
300 basis points. Stock prices initially flattened,
but as soon as that round of tightening was completed,
they resumed their marked upward advance. From mid-1999
through May 2000, the federal funds rate was raised
150 basis points. However, equity price increases
were largely undeterred during that period despite
what now, in retrospect, was the exhausted tail of
a bull market.
Such
data suggest that nothing short of a sharp increase
in short- term rates that engenders a significant
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.
Instead,
we noted in the previously cited mid-1999 congressional
testimony the need to focus on policies "to mitigate
the fallout when it occurs and, hopefully, ease the
transition to the next expansion."
*
* *
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??
The
equity premium, computed as the total expected return
on common stocks less that on riskless debt, prices
the risk taken by investors in purchasing equities
rather than risk-free debt. It is a measure largely
of the risk aversion of investors, not that of corporate
managers. An increased appetite for risk by investors,
for example, is manifested by a shift in their willingness
to hold equity in place of psychologically less-stressful,
but lower- yielding, debt.
In
this case, the cost of equity confronting corporate
managers falls relative to the cost of debt. With
greater access to lower-cost equity, managers are
able to finance a higher proportion of riskier real
assets with a lessened call on cash flow and fear
of default.
Thus,
it is generally the changing risk preferences of investors,
not of corporate managers, that govern the mix of
risk investment in an economy. Managers presumably
employ market prices of debt and equity coupled with
the calculated rate of return on particular real investment
projects to determine the level of corporate investment.
To be sure, managers' personal sense of risk aversion
can sometimes influence the capital investment process,
but it is probably a secondary effect relative to
the vagaries of investor psychology.
Bubbles
thus appear to primarily reflect exuberance on the
part of investors in pricing financial assets. If
managers and investors perceived the same degree of
risk, and both correctly judged a sustainable rise
in profits stemming from new technology, for example,
none of a rise in stock prices would reflect a bubble.
Bubbles appear to emerge when investors either overestimate
the sustainable rise in profits or unrealistically
lower the rate of discount they apply to expected
profits and dividends. The distinction cannot readily
be ascertained from market prices. But the equity
premium less the expected growth of dividends, and
presumed earnings, can be estimated as the dividend
yield less the real long-term interest rate on U.S.
Treasuries.
If
equity premiums were redefined to include both the
unrealistic part of profit projections and the unsustainably
low segment of discount factors, and if we had associated
measures of these concepts, we could employ this measure
to infer emerging bubbles. That is, if we could substitute
realistic projections of earnings and dividend growth,
perhaps based on structural productivity growth and
the behavior of the payout ratio, the residual equity
premium might afford some evidence of a developing
bubble. Of course, if the central bank had access
to this information, so would private agents, rendering
the development of bubbles highly unlikely.
Bubbles
are often precipitated by perceptions of real improvements
in the productivity and underlying profitability of
the corporate economy. But as history attests, investors
then too often exaggerate the extent of the improvement
in economic fundamentals. Human psychology being what
it is, bubbles tend to feed on themselves, and booms
in their later stages are often supported by implausible
projections of potential demand. Stock prices and
equity premiums are then driven to unsustainable levels.
Certainly,
a bubble cannot persist indefinitely. Eventually,
unrealistic expectations of future earnings will be
proven wrong. As this happens, asset prices will gravitate
back to levels that are in line with a sustainable
path for earnings. The continual pressing of reality
on perception inevitably disciplines the views of
both investors and managers.
As
I noted earlier, the key policy question is: If low-cost,
incremental policy tightening appears incapable of
deflating bubbles, do other options exist that can
at least effectively limit the size of bubbles without
doing substantial damage in the process? To date,
we have not been able to identify such policies, though
perhaps we or others may do so in the future.
It
is by no means evident to us that we currently have--or
will be able to find--a measure of equity premiums
or related indicators that convincingly presage an
emerging bubble. Short of such a measure, I find it
difficult to conceive of an adequate degree of central
bank certainty to justify the scale of preemptive
tightening that would likely be necessary to neutralize
a bubble.
As
we delve deeper into the questions raised by the developments
of recent years, the interplay between structural
productivity growth and equity premiums, so evident
during the past business cycle, is bound to play a
prominent role. We need particularly to determine
whether the periodic emergence of market bubbles,
which have occurred so often in the past, is inevitable
going forward. As financial wealth becomes an ever-
more-important determinant of activity, we need also
to understand far better how changing equity premiums
affect and reflect real and financial investment decisions.
If the equity premium has so demonstrable an influence
on our economies as it appears to have, the value
of further investigation of this topic is evident.
*
* *
In
conclusion, the endeavors of policymakers to stabilize
our economies require a functioning model of the way
our economies work. Increasingly, it appears that
this model needs to embody movements in equity premiums
and the development of bubbles if it is to explain
history.
Any
useful model needs to credibly simulate counterfactual
alternatives. We must remember that structural models
that do a poor job of explaining history presumably
also will provide an incomplete basis for policymaking.
Often the internal structure of such models has been
employed to evaluate the effect of various stabilization
policies. But the results from models whose internal
structure cannot successfully replicate key features
of cyclical behavior must be interpreted carefully.
The recent importance of movements in equity premiums
and asset bubbles suggests the need to better understand
and integrate these concepts into the models used
for policy analysis.
-----
We'll
return on next week.
Brian
Trumbore
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