Page 2 of
3 BOOK REVIEW The Fed's king of
bubbles Greenspan's Bubbles - The Age of
Ignorance at the Federal
Reserve by
William
Fleckenstein Reviewed by Julian
Delasantellis
if the health and prosperity
of his stock market flock was a concern of equal,
or more importance, to the health of the general
economy. As Fleckenstein put it, "he had herded
all the little fish into the stock market pool,
and he appeared to be leery of suffocating them if
he drained out liquidity too rapidly".
Here commenced the famed "Greenspan put",
the feeling that the US Federal Reserve would
always support the stock markets, would always cut
rates to backstop selloffs and re-ignite rallies.
Thus, according to Fleckenstein, the conditions
were set for the
largest speculative bubble in
American history.
It may seem like the
2003-07 period was pretty good for US stocks, but,
when you lengthen the perspective out a bit,
things don’t look so rosy. Even at last October’s
highs the S&P 500 index never got much past
its 2000 highs; not even close in real,
inflation-adjusted terms. The NASDAQ composite,
after topping out near 2900 last October, now is
once again more than 50% off its year 2000 highs
just over 5000.
Fleckenstein contends that
this is wholly Greenspan’s doing, in that the
speculative damage caused by the popping of the
1990s stock market bubble continues to weigh on
stocks.
For what a decade the 1990s was.
The S&P 500 index rose from 304 in 1990 to
over 1500 in 2000, a fivefold gain; the NASDAQ did
even better, with a 15-fold gain. Even by the
standards of what we’ve seen recently with
Southern California and Southern Florida
condominium prices, this was a very impressive
speculative bubble.
You should not have
had to tell an economic historian such as
Greenspan that bubbles are bad for an economy; the
17th century tulip craze in Holland and the French
Mississippi bubble of the 18th century damaged
both these countries’ economies for almost a
century afterward. But, according to Fleckenstein,
Greenspan not only refused to do anything to fight
the bubbles, he was, in fact, their cause.
Ron Insana of CNBC and Insana Capital
Partners wisely observes that the most dangerous
sound any investor can ever here is the phrase
"this time it’s different". Bubbles come and go;
they flourish when the human instinct of greed
decisively trumps its mirror image of fear. Still,
with every bubble, somebody comes along and says
this time it’s different, this time it’s not a
speculative blowoff, but some new technological or
societal feature has arisen that justifies the
madness. By 1995, Greenspan looked at the rise of
information technology and said this time it’s
different.
It was in the middle of 1995
that the US stock market, especially the NASDAQ,
really took off. From 1995 to the top in early
2000 the S&P 500 rose at a respectable average
rate of 24% a year, but that was nothing compared
with the NASDAQ, which rose at an annual average
of 40% a year, blowing off with over 50% rises in
both 1998 and 1999. By the end of the decade we
would witness the dot-com madness we all recall so
well.
Remember Pets.com, and its cute sock
puppet? TheGlobe.com, and its over 600% first day
of trading price rise? Webvan, the grocery
delivery company that went through $1 billion of
venture capital before going bankrupt? Boo.com,
the attempt to create a global internet fashion
conglomerate, which seemed to have chosen its
corporate name only because they knew they had to
have something to the left of the dot and the com?
My favorites were the newly born companies such as
FreeLotto.com, Alladvantage.com, and
ePipe.com.com, and their revolutionary business
plans; essentially, they were just going to give
away money, and for that, they raised billions of
dollars in investment capital for their daring
schemes.
By early 2000, the tech stock
madness had led to the stock of Cisco Systems
having a market capitalization of $550 billion,
which amounted to 6% of total US gross domestic
produt and just under 2% of total world GDP.
Bubble blindness We all knew it
was a bubble; it was obvious to all-except
chairman Greenspan. Looking at the madness of the
period through the rose-colored glasses that
presented the image of everything that markets did
being right, Greenspan delivered his blessing to
the insanity.
At a December 1995 meeting
of the Federal Reserve Board’s Open Market
Committee, Greenspan expounded on his new truth.
You may recall that earlier this
year I raised the issue of the extraordinary
impact of accelerating technologies … looking at
market values, we are not capitalizing various
types of activities properly. In the past, we
looked at capital expenditures only as spending
on a blast furnace or a steel rolling mill. Now,
improvement in the value of a firm is influenced
by such factors as how much in-house training
they have and what type. That creates economic
value in the stock market sense, and we are not
measuring it properly.
In essence,
what Greenspan was saying here, and in many other
forums at other times, was that investment in high
technology spending and training should not be
treated as an expense, but as an asset.
Stock market professionals judge whether a
stock is over, under or fairly priced not by its
nominal share value but by dividing the stock
price by the company’s earnings, to produce a
number called the price/earnings ratio, or, the
p/e. (For a discussion of the mechanics and
importance of p/e ratios, see The decline in US equity
markets, Asia Times Online, May 10,
2007.) In early 2000, Cisco Systems p/e stood at
150, compared with its current ratio of under 20.
If a stock rises without a commensurate
rise in earnings, its p/e ratio rises; it is said
that the stock is getting expensive. That is what
seemed to be happening to US stocks from 1995 to
the top in early 2000.
But the Greenspan
analysis, believing that high technology
investment should be accounted as an asset rather
than expense, meant that the rising price/earnings
numbers did not exist; they were much lower in
reality than what the companies were reporting.
Low p/e numbers automatically implied no bubble,
no matter what the nominal stock prices were
doing.
As smooth defense lawyers in the
American South say to witnesses who claim they saw
the lawyer’s client committing a crime, "Who are
you going to believe, me, or your own lying eyes?"
In essence, Greenspan argued that a productivity
miracle occurred just by putting a computer on a
worker’s desk, even if the machines were not even
networked, as they are now.
The official
US productivity statistics never were able to find
Greenspan’s miracle. According to a 2000 study by
Northwestern University Professor Robert J Gordon,
prepared for the US Congressional Budget Office:
There has been no productivity
growth acceleration in the 99% of the economy
located outside the sector that manufactures
computer hardware. Indeed, far from exhibiting a
productivity acceleration, the productivity
slowdown in manufacturing has gotten worse. When
computers are stripped out of the durable
manufacturing sector, there has been a further
productivity slowdown in durable manufacturing
in 1995-99 as compared to 1972-95, and no
acceleration at all in nondurable
manufacturing.
If you want to argue
against Professor Gordon, and say that the
computer on your office desk has made you more
productive, your argument might have more credence
if you first closed the Windows Solitaire game you
have open on your desktop. But still, as the stock
market madness continued and intensified,
Greenspan was continually bedeviled by charges
that he was facilitating a dangerous stock market
bubble.
Nothing can be
done Greenspan's replies to this charge
evolved through the '90s, and have continued to
evolve over time. Besides the high technology
argument, occasionally he would contend that the
presence of bubbles could not be ascertained while
they existed; that you only knew you had been in
one after they had broken. Then, he would
sometimes argue that, even if you could determine
that a bubble was currently existent, you couldn’t
really do anything to stop it. Fleckenstein notes
that Greenspan vehemently resisted the application
of the standard implement to curb excessive stock
market speculation, the raising of stock margin
rates.
The Securities and Exchange Act of
1934 explicitly assigned to the Federal Reserve
the power to regulate margin rates. This is the
ability of speculators (not investors - buying
stocks on margin is just about the textbook
definition of speculation) to buy stocks with
borrowed money to boost their cash returns if the
stock rallies; in the same way their losses are
accelerated if the stock sells off.
Just
as the home mortgage debt has exploded in the past
few years, stock margin debt ballooned in the
1990s. At their core, speculative bubbles are
always caused by excessive utilization of credit.
Fleckenstein expounds on just how pervasive stock
margin speculation had become.
As of February 2000, total margin
debt stood at $265 billion. It had grown 45
percent since the previous October, and had been
more than tripled since the end of 1995.
Relative to GDP, margin debt was the highest it
had been since 1929, and over three times as
high as it was in October,
1987.
Academics scratched their heads
at Greenspan’s contention that raising margin
rates does nothing to tamp down speculation. Doing
just that is the standard method by which
financial exchanges cool overheated markets; the
New York Mercantile Exchange did so with gold
futures in late January of this year. A few weeks
later, gold broke 15% lower, and has still come
back to nowhere near its highs of $1,000 an ounce.
As the stock bubble raced towards its
final denouement, Fleckenstein noted that
Greenspan found a new way to rationalize
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