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The Fed Was Also at Fault

The Federal Reserve System had much to do with the Internet bubble, and should not be as permissive the next time.

At the end of this chapter appear excerpts from the speeches and Congressional testimony of Federal Reserve Chairman Alan Greenspan given during the years of the bubble. In 1996 Greenspan saw the danger of a bubble and gave it a name, "irrational exuberance," but the Federal Reserve (the "Fed") did nothing. As the bubble grew, Greenspan pointed to it as a danger, and simultaneously justified it—as if he were debating the matter in his own mind and giving the debate public utterance. It seemed he couldn't make up his mind.

On the negative side, he recognized the threat to the economy from an unrestrained bubble that must someday burst. But on the positive side, he argued that the bubble was justified by the improving performance of the U.S. economy; that the bubble was itself a constructive force that was causing consumers to spend more and thereby increasing economic growth; and finally that the bubble was of limited scope and if it burst, was not likely to damage the economy as a whole. In fact, as we revisit Greenspan's testimony, we realize that no one else gave stronger support to the notion of the new economy—of a new high level of productivity improvement based on the dissemination of information technology in the economy—than Alan Greenspan. As we've seen previously, it was the assumption of a new high level of productivity, and of more rapid economic growth, that was used on Wall Street to justify the very high valuations of Internet companies. Greenspan gave the assumptions of the analysts credibility, and he continues to do so today, even after almost everyone else has given up the mirage of the economic miracle.

In fact, it was a miracle that didn't occur—or at least if it did occur, it was a very small miracle, not the big one the Fed's chairman repeatedly endorsed. Recent revisions in economic data for the United States and Europe show that the growth of labor productivity in the domestic American economy from 1996 to 2000 was only 1.75 percent per year, near our long-term average rate, and was only .25 percentage point ahead of the rate of productivity growth in Europe.

Further, economic growth itself had been overestimated by the government. In 2000, for example, industrial production had grown not at three percent as originally reported, but at less than two percent.

Overestimation of productivity and economic growth rates meant that the economic miracle of the 1990s on which the stock market inflation was based never really happened. The Fed had based its policies and its glowing endorsement of the new economy on illusions.

Further, some say the real Internet bubble was started in late 1999 by the actions of the Fed with respect to the nation's money supply. The bubble emerged from the crisis in Long Term Capital Management when the Fed flooded the markets with liquidity.86 Already the story about an economic miracle had primed the pump with investors—the Fed's immense credit creation combined with margin borrowing by investors to inflate the market.

Fed Chairman Alan Greenspan's few attempts to deflate the bubble with words—criticizing the market for "irrational exuberance" being one—were not matched by actions. Instead, the Fed ran a largely expansive money policy for years, while excess liquidity was permitted to be poured into stock market speculation.

The Fed's incapacity was noted before it was too late. "My concern about the bubbling of American financial markets," wrote Henry Kaufmann, "was heightened in August, 1999, as I sat in the audience listening to Alan Greenspan... and... [realized] that the Fed did not know how to deal with a bubble."87

The bubble was the Fed's business because the Fed was partly responsible for it. It was also the Fed's business because a bubble in financial markets can get transferred by wealth effect into real economy. When the bubble was inflating and the wealth effect was increasing economic growth, the Fed looked on it as benign. When the bubble burst and the wealth effect worked the other way, threatening a recession, the Fed looked the other way. The Fed both contributed to the growth of the bubble and then let it crash.

In fact, the sequence and timing of Fed policy in late 1999 and early 2000 couldn't have been worse. When the bubble was expanding in 1999, the Fed poured liquidity into the economy as a result of both the Long Term Capital Management debacle and the Y2K fright. Then, when people in early 2000 were beginning to perceive the lack of foundation for the Internet bubble, the Fed cut liquidity and drove asset values down so fast that the economy fell into a recession.

The Fed should have intervened to dampen the bubble far sooner than the year 2000, and it would have been perfectly proper for the Fed to do so. The Fed plays an important role in regulating financial markets. For example, in order to stop a bubble in the price of silver in 1979–80, "Paul Volcker, chairman of the Fed, ... warned American banks... not to supply loans for speculation...." wrote a historian of the period. "[Yet] the Hunts' [Texas billionaires who tried to corner the silver market] borrowing for speculative losses during February and March [1980] accounted for 12.9 percent of all business loans in the United States..." In this period, the historian continued, "federal officials... [took] a series of increasingly strong actions... to ensure that the price decline was orderly and a spiral of bankruptcies was avoided. This direct government intervention insured the survival of banks, brokerage houses and exchanges."88

But during the Internet bubble, the financial institutions remained strong. It was only investors who were being mauled. So the Fed remained largely inactive.

Perhaps the Fed should have taken a wider view of its responsibility to the American people, and acted on their behalf—but it did not. "I believe the primary objective of a central bank," wrote Henry Kaufmann, "should be to maintain the financial well-being of society in the broadest sense. That means establishing stable financial conditions by exercising careful oversight over financial markets, institutions, and trading practices; anticipating potential problems; and taking remedial action before those problems can do widespread damage." In retrospect, as the bubble was inflating, the Fed should have increased borrowing margins for investors and reduced liquidity.

The Fed chose not to intervene to protect small investors, or even the economy, from the bubble and its consequences, until a recession loomed on the economic horizon and the Fed belatedly began to cut interest rates.

The Fed bears a dual responsibility for the bubble and its consequences—one via its actions to encourage the financial excesses and provide liquidity for them; and one via its inaction as a regulator to stop the excesses. "[The NY Fed] . . . wants to hear about anything that might upset markets or. . . the financial system," wrote a historian of the Long Term Capital Management crisis, quoting an officer of the New York Fed.89 What more "upset" could the Fed have desired in order to take action against the bubble? The financial markets were generating instability in world economy, and interfering with economic growth.

There was too much speculation, noticed and remarked upon, but nonetheless tolerated too generously by regulators, especially the Fed. Following are excerpts from Chairman Greenspan's speeches and testimony before Congressional committees during the period before, during, and after the bubble. The total volume of the Chairman's speeches and testimony is quite large, so that it cannot be provided here in its entirety. But these are representative comments, and their full context would not, we think, change their interpretation by the reader. The Chairman's views were important for three reasons: First, his favorable views of the new economy helped influence investor opinion favorably toward investing in new economy businesses; second, Greenspan's views were continually cited by Wall Street professionals as evidence of the value of Internet companies; third, his views help explain why the Fed chose not to act for the explicit purpose of avoiding or deflating the bubble.

Alan Greenspan and the Great Bubble

Excerpts from Federal Reserve Chairman Greenspan's Speeches and Congressional Testimony 1996–2001


Chairman Greenspan recognized early on the danger a financial asset bubble posed to the economy.

...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.

Remarks by Chairman Alan Greenspan

"The Challenge of Central Banking in a Democratic Society" At the Annual Dinner and Francis Boyer Lecture of The American Enterprise Institute for Public Policy Research, Washington, D.C. December 5, 1996


But he became a proponent of the new economy.

...it has been the ability of our flexible and innovative businesses and work force that has enabled the United States to take full advantage of emerging technologies to produce greater growth and higher asset values...

As I have testified before the Congress many times, I believe, at root, the remarkable generation of capital gains of recent years has resulted from the dramatic fall in inflation expectations and associated risk premiums, and broad advances in a wide variety of technologies that produced critical synergies in the 1990s.

...the rate of return on capital facilities put in place during recent years has, in fact, moved up markedly. While discussions of consumer spending often continue to emphasize current income from labor and capital as the prime sources of funds, during the 1990s, capital gains, which reflect the valuation of expected future incomes, have taken on a more prominent role in driving our economy.

He asserted that the bubble was helping people save for retirement.

...the net worth of the average household has increased by nearly 50 percent since the end of 1992, well in excess of the gains of the previous six years. Households have been accumulating resources for retirement or for a rainy day, despite very low measured saving rates.

Yet he recognized that the bubble might not be sustainable.

The recent behavior of profits also underlines the unusual nature of the rebound in equity prices and the possibility that the recent performance of the equity markets will have difficulty in being sustained. The level of equity prices would appear to envision substantially greater growth of profits than has been experienced of late.

Testimony of Chairman Alan Greenspan
State of the Economy
Before the Committee on Ways and Means, U.S. House of Representatives
January 20, 1999

Again he endorsed the notion of the new economy.

Can this favorable performance be sustained? In many respects the fundamental underpinnings of the recent U.S. economic performance are strong. Flexible markets and the shift to surplus on the books of the federal government are facilitating the build-up in cutting-edge capital stock. That build-up in turn is spawning rapid advances in productivity that are helping to keep inflation well behaved. The new technologies and the optimism of consumers and investors are supporting asset prices and sustaining spending.

But he expressed concern about overvalued equities.

Equity prices are high enough to raise questions about whether shares are overvalued.

Testimony of Chairman Alan Greenspan
The Federal Reserve's semiannual report on monetary policy
Before the Committee on Banking, Housing, and Urban Affairs,
U.S. Senate
February 23, 1999

Greenspan remained one of the strongest proponents of the new economy.

Something special has happened to the American economy in recent years. An economy that twenty years ago seemed to have seen its better days, is displaying a remarkable run of economic growth that appears to have its roots in ongoing advances in technology.

I have hypothesized on a number of occasions that the synergies that have developed, especially among the microprocessor, the laser, fiber-optics, and satellite technologies, have dramatically raised the potential rates of return on all types of equipment that embody or utilize these newer technologies. But beyond that, innovations in information technology—so-called IT—have begun to alter the manner in which we do business and create value, often in ways that were not readily foreseeable even five years ago.

...the recent years' remarkable surge in the availability of real-time information has enabled business management to remove large swaths of inventory safety stocks and worker redundancies, and has armed firms with detailed data to fine-tune product specifications to most individual customer needs. Intermediate production and distribution processes, so essential when information and quality control were poor, are being bypassed and eventually eliminated. The increasing ubiquitousness of Internet Web sites is promising to significantly alter the way large parts of our distribution system are managed.

Still he expressed some reservations.

The rate of growth of productivity cannot increase indefinitely. While there appears to be considerable expectation in the business community, and possibly Wall Street, that the productivity acceleration has not yet peaked, experience advises caution.

Testimony of Chairman Alan Greenspan
High-Tech Industry in the U.S. Economy
Before the Joint Economic Committee, U.S. Congress
June 14, 1999

He advised caution about the bubble.

As recent experience attests, a prolonged period of price stability does help to foster economic prosperity. But, as we have also observed over recent years, as have others in times past, such a benign economic environment can induce investors to take on more risk and drive asset prices to unsustainable levels. This can occur when investors implicitly project rising prosperity further into the future than can reasonably be supported.

But he insisted that asset inflation is good for the economy.

The rise in equity and home prices, which our analysis suggests can account for at least one percentage point of GDP growth over the past three years.

Then he returned to the danger of a bubble and its bursting—he saw it coming.

One of the important issues for the Federal Open Market Committee as it has made such judgments in recent years has been the weight to place on asset prices. As I have already noted, history suggests that owing to the growing optimism that may develop with extended periods of economic expansion, asset price values can climb to unsustainable levels even if product prices are relatively stable.

The 1990s have witnessed one of the great bull stock markets in American history. Whether that means an unstable bubble has developed in its wake is difficult to assess. A large number of analysts have judged the level of equity prices to be excessive, even taking into account the rise in "fair value" resulting from the acceleration of productivity and the associated long-term corporate earnings outlook.

But he refused to place confidence in his own judgment.

...bubbles generally are perceptible only after the fact. To spot a bubble in advance requires a judgment that hundreds of thousands of informed investors have it all wrong. Betting against markets is usually precarious at best.

And he insisted there was not much danger.

While bubbles that burst are scarcely benign, the consequences need not be catastrophic for the economy.

Testimony of Chairman Alan Greenspan
Monetary Policy and the Economic Outlook
Before the Joint Economic Committee, U.S. Congress
June 17, 1999

Greenspan continued to praise the new economy.

At the root of this impressive expansion of economic activity has been a marked acceleration in the productivity of our nation's workforce. This productivity growth has allowed further healthy advances in real wages and has permitted activity to expand at a robust clip while helping to foster price stability.

Testimony of Chairman Alan Greenspan
The Federal Reserve's Semiannual Report on Monetary Policy
Before the Committee on Banking and Financial Services,
U.S. House of Representatives
July 22, 1999


Near the height of the bubble, Chairman Greenspan saw the danger it posed to the economy but called it only a "remote possibility."

The Federal Reserve... must... foster the fundamental soundness of our financial system and put in place safeguards to protect against the remote possibility that unsound behavior in the financial sector is transmitted beyond the firms involved to the economy more generally.

Testimony of Chairman Alan Greenspan
On nomination to fourth term as Chairman
Before the Committee on Banking, Housing, and Urban Affairs,
U.S. Senate
January 26, 2000

Just as the bubble was about to break, Greenspan expressed no concern.

There is little evidence that the American economy, which grew more than 4 percent in 1999 and surged forward at an even faster pace in the second half of the year, is slowing appreciably.

He remained an advocate of the new economy.

Underlying this performance [of strong economic growth], unprecedented in my half-century of observing the American economy, is a continuing acceleration in productivity.

He declared the bubble to be good for the economy.

Outlays prompted by capital gains in excess of increases in income, as best we can judge, have added about 1 percentage point to annual growth of gross domestic purchases, on average, over the past five years.

Yet he saw the problem coming in the economy and connected it to the wealth effect of asset inflation.

With foreign economies strengthening and labor markets already tight, how the current wealth effect is finally contained will determine whether the extraordinary expansion that it has helped foster can slow to a sustainable pace, without destabilizing the economy in the process.

But decided there was no significant danger.

Although the outlook is clouded by a number of uncertainties, the central tendencies of the projections of the Board members and Reserve Bank presidents imply continued good economic performance in the United States.

The Federal Reserve's Semiannual Report on the Economy
and Monetary Policy
Before the Committee on Banking and Financial Services,
U.S. House of Representatives
February 17, 2000


Even as the economy prepared to enter a recession and the federal budget surpluses were about to disappear, Chairman Greenspan continued to applaud the new economy.

The key factor driving the cumulative upward revisions in the budget picture in recent years has been the extraordinary pickup in the growth of labor productivity experienced in this country since the mid-1990s... The most recent indications have added to the accumulating evidence that the apparent increases in the growth of output per hour are more than transitory... It is these observations that appear to be causing economists, including those who contributed to the OMB and the CBO budget projections, to raise their forecasts of the economy's long-term growth rates and budget surpluses...

And insisted that the bubble was good for the economy and appropriate.

Had the innovations of recent decades, especially in information technologies, not come to fruition, productivity growth during the past five to seven years, arguably, would have continued to languish at the rate of the preceding twenty years. The sharp increase in prospective long-term rates of return on high-tech investments would not have emerged as it did in the early 1990s, and the associated surge in stock prices would surely have been largely absent. The accompanying wealth effect, so evidently critical to the growth of economic activity since the mid 1990s, would never have materialized.

Testimony of Chairman Alan Greenspan
Outlook for the Federal Budget and Implications for Fiscal Policy
Before the Committee on the Budget, U.S. Senate
January 25, 2001

The U.S. economy entered a recession in March 2001, and the great productivity advances of previous years were revised out of the nation's economic statistics, but Chairman Greenspan remained a proponent for the new economy.

The prospects for sustaining strong advances in productivity in the years ahead remain favorable... Even consumer spending decisions have become increasingly responsive to changes in the perceived profitability of firms through their effects on the value of households' holdings of equities. Stock market wealth has risen substantially relative to income in recent years—itself a reflection of the extraordinary surge of innovation. As a consequence, changes in stock market wealth have become a more important determinant of shifts in consumer spending relative to changes in current household income than was the case just five to seven years ago.

Testimony of Chairman Alan Greenspan
Federal Reserve Board's semiannual monetary policy report to the
Before the Committee on Banking, Housing, and Urban Affairs, U.S. Senate
February 13, 2001

Taken as a whole, including his frequent qualifications, Chairman Greenspan's public comments endorsed the notion of a favorable new era in the American economy driven by new technology and the Internet. Further, his views helped investors believe that there was no great danger of an economic downturn or of a market collapse, even at times encouraging them to believe that the investments they were making with their pension money in new economy stocks would in fact increase their retirement nest eggs. Greenspan's comments were widely reported in the press and were heeded by many Americans, including small investors.

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