Sun, Sep 01, 2002 page11

• Alan Greenspan says the Fed couldn't have prevented a bubble on Wall Street

  • NY TIMES NEWS SERVICE
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  Alan Greenspan, the Federal Reserve chairman, defended the central bank on Friday against criticism that it had mishandled the rise and fall of the stock market, saying the Fed could not have prevented the bubble on Wall Street without damaging the economy.

  Greenspan said the only way to have reined in the stock market would have been to raise interest rates sharply, a step that he said would have put the entire economy in peril. Smaller but more frequent rate increases, he said, would not have done the trick either.

  "The notion that a well-timed incremental tightening could have been calibrated to prevent the late 1990s bubble is almost surely an illusion," he said.

  The other tactic that his critics have suggested he could have used, limiting the ability of investors to pay for stock purchases by borrowing against their holdings, would also have had little effect, Greenspan said.

  His speech, delivered here to an audience of government officials and economists at a symposium sponsored by the Federal Reserve Bank of Kansas City, was his most extensive and detailed explanation so far of how he viewed the Wall Street boom of the late 1990s and what the Fed did -- and did not do -- about it.

  It addressed head-on the assessment of some investors and economists in the last few years that the Fed had failed to protect the economy and millions of 401(k) accounts from a wild and destabilizing swing in stock prices.

  "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," Greenspan said. "Moreover, it was far from obvious that bubbles, even if identified early, could be pre-empted short of the central bank inducing a substantial contraction in economic activity, the very outcome we would be seeking to avoid."

  Greenspan made no mention of how the Fed is dealing with the bursting of the bubble and the economy's difficulties in recovering from last year's recession. Neither Greenspan nor any other Fed official here said anything to counter the growing impression among investors that signs of halting economic improvement and increasing optimism on Wall Street that stock prices have bottomed out will keep official interest rates on hold in September and perhaps for the rest of the year.

  His speech on Friday had an air about it of defending his legacy; at 76, he starts his 16th year as Fed chairman. His main message was that even in retrospect, he could find no way that thecentral bank could have averted the boom and bust on Wall Street without giving up much of the economic gains of the 1990s, including low unemployment and improved international competitiveness.

  "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," Greenspan said. "But is there some policy that can at least limit the size of a bubble and, hence, its destructive fallout? From the evidence to date, the answer appears to be no."

  Many of economists agreed that rate increases were too crude a tool to contain an unsustainable rise in stock prices. But some economists said Greenspan had glossed over the Fed's role at critical times during the stock market's rise, especially in 1999, when the Fed was seen by some analysts as too slow to raise rates in the face of a red-hot economy and a steep rise in equity prices. And they said the Fed chairman had not fully acknowledged his own role in promoting a bullishness about the economy's prospects and therefore about stock market valuations.

  Greenspan has always maintained that the Fed should not use monetary policy to try to push the stock market up and down. But he has also made clear that Wall Street is increasingly one of the major influences on the economy and that the Fed must therefore be concerned with what goes on there.

  In late 1996, Greenspan sent shudders throughout markets around the world when he raised the question of whether rising asset prices reflected "irrational exuberance" among investors.

  But he subsequently focused his public remarks on the long-term economic gains likely to result from a resurgence in the growth rate of productivity, the most basic measure of business efficiency and the primary determinant of an economy's ability to grow faster without igniting inflation.

  But during the boom most investors seemed to ignore Greenspan's warnings.

  Greenspan pointed Friday to testimony he gave to Congress in July 1999 that laid out the benefits the US was reaping from the rebound in productivity. In that testimony, he said explicitly that productivity improvements did not justify ever-rising stock prices and that the Fed's role in a market bubble was to be ready to clean up the mess when it burst.

  Greenspan described the Fed's attempts to determine during the last decade whether stock prices were getting out of hand. He said the main focus was on corporate profits, and whether the productivity improvements would permit them to rise at a rate that would justify the values put on stocks by investors.

  The Fed also tried to judge how much risk investors were willing to accept to buy stocks rather than securities, like government bonds, which carry almost no risk, he said.

  In the end, though, it was psychology as much as a rational assessment of the numbers that led investors to push equity prices so high, Greenspan suggested.

  "Bubbles are often precipitated by perceptions of real improvements in the productivity and underlying profitability of the corporate economy," Greenspan said. "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 later stages are often supported by implausible projections of potential demand."

  As a strong believer in market forces, Greenspan has always been uncomfortable in the role of second-guessing the decisions of millions of investors. But he said Friday that he had few tools at his disposal even if he was able to conclude that the market had gotten dangerously out of whack.

  Jawboning the market, he said, "will be ineffective unless backed by action."

  One course of action is moderate interest rate increases, but history suggests that they are ineffective in dampening stock prices over the long run, he said.

  "In fact, our experience over the past 15 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," he said.

  The alternative is big rate increases. But raising rates enough to squeeze the speculation out of the financial markets would also probably kill off an economic expansion, he said, making the cure at least as bad as the disease.

  The other weapon open to the Fed, which in addition to controlling official interest rates helps regulate the financial system, would be to tighten requirements for margin lending.

  But Greenspan said there was little evidence that raising margin requirements would have tamed the market.
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