| |
|
Wall Street History
https://www.gofundme.com/s3h2w8
|
09/06/2002
Alan Greenspan...In his own words
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.
-----
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
iskier 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 September 13.
Brian Trumbore
|
|
|
