by Maggie Mahar
Investor sentiment was not the only warning sign. In 1996, after reviewing historical data comparing earnings and stock prices, Shiller and Campbell projected that the reward for investing in the U.S. stock market over the next decade, after adjusting for inflation, would be roughly zero.
At the time, their forecasts sounded outlandish. But unlike many academicians, Shiller and Campbell put their theories to work in the real world. By the beginning of ’97, Campbell had bought futures to hedge his entire stock exposure (an alternative path to selling the stocks, which would have triggered capital-gains taxes). Shiller also confided that he had pulled most of his own money out of the stock market, though he added, “I’m not completely out. I don’t have complete confidence in this…. So many people may be willing to put money into the stock market that it will keep rising.”18 As it would, at least for a few years.
There was no question that Greenspan had assembled a skeptical group—another sign that he was concerned about the market’s meteoric rise.
As the five seers laid out their positions, “the chairman said very little,” Byron Wien later recalled. “But when he got to me, he implied that the market was overvalued. I told him that I disagreed. According to my valuation model stocks were 7 to 10 percent undervalued. I explained my model—I said this is just a tool, but it had stood me in good stead for many years.
“I left the meeting thinking that I had convinced him,” Wien added. “And that’s what I told people at Morgan Stanley when I got back to New York.”19
Two days later, Wien traveled to Houston to give a speech for the Juvenile Diabetes Foundation. Early Friday morning, he was sound asleep in his room at the Four Seasons Hotel when the phone rang.
“You idiot,” shouted the voice on the other end of the line. It was a Morgan Stanley trader.
To his chagrin, Wien discovered that he had been dead wrong. He had not convinced Greenspan. In fact, the night before, the Fed chairman uttered the words that would roil markets around the world: “irrational exuberance.”
In New York, the stock futures market opened down its limit and was not allowed to drop further for fifteen minutes. Because Morgan Stanley’s traders had listened to Wien, they were totally unprepared.
THE SPEECH
Thursday, December 5, 1996, and the chairman of the Federal Reserve stood up at a black-tie dinner and asked what could be construed as a perfectly reasonable question: “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?” The Fed chairman did not attempt to provide an answer. There was no need. Just by posing the question, he had done what he no doubt intended to do: he had, ever so carefully, raised a small but pointed red flag.
The phrase was buried on page 14 of an 18-page speech that the chairman was delivering that evening at a dinner sponsored by the American Enterprise Institute, a conservative think tank. But Greenspan had chosen his words carefully.
Bob Woodward would later report that after reading a draft of the speech, Alice Rivlin (the former budget director who had become a member of the Fed board), had come into Greenspan’s office and asked, “Do you really want to say that?”
“I think I do,” he replied.
According to Woodward, by December of 1996, not only the Fed chairman but Treasury Secretary Robert Rubin had been troubled by the market’s parabolic climb. “Rubin couldn’t believe how high the market had gone. Never in his lifetime had he seen anything like it, and he was deeply worried. People had lost their discipline in making financial decisions…. Did Treasury and the Fed have an obligation to do or at least say something?
“Both Rubin and Greenspan knew that the Treasury secretary could hardly speak out against the stock market and issue a warning,” Woodward wrote. “The White House would have to be involved, and the president’s political advisers considered the bull market a badge of honor. Several times, somebody at the White House had proposed that the President [Clinton] should ring the bell at the New York Stock Exchange, and Rubin had to go to the battle station to stop it.”20
That only Rubin understood just how unseemly it would be to have the president of the United States join CNBC’s Maria Bartiromo to ring in another day at the races on the trading floor says something about how little Washington understood about Wall Street. Few of the beltway’s policy makers seemed to recognize that the market was, after all, a casino. Rubin, by contrast, had been a trader; he knew the risks of the marketplace all too well. He also knew that if the market went down, the film clip of Clinton launching the Titanic would haunt him forever.
When asked later in the decade whether he thought it would be a good idea to invest some part of the Social Security fund in the stock market, the Treasury secretary blanched ever so slightly. “No,” he replied. Why not? “The market is too…” Always circumspect, Rubin searched carefully for a word other than “irrational.” “Psychological,” he said finally. “The market is too psychological.”21 In other words, the market is us.
From the beginning of the administration, according to Woodward, “Rubin had told Clinton, ‘If the economy does well, you ought to talk about it—but if the markets do well don’t use that as your credential because markets go up and markets go down.’”22
Nevertheless, the Treasury secretary could not be the one to issue a warning to the public. So it was left to Greenspan to raise that tiny red flag in the midst of the long, dry after-dinner speech that he gave on that December night.
Almost as quickly, he lowered it: “We as central bankers need not be concerned if a collapsing financial bubble does not threaten to impair the real economy, its production, jobs and price stability,” he added. “Indeed, the sharp stock market break of 1987 had few negative consequences for the economy.”
After delivering the speech, Woodward reported, “Greenspan returned to his table, where his girlfriend, Andrea Mitchell, was also seated.
“‘So what was the most important thing I said?’ he asked her.
“She looked perplexed, not at all sure.”
THE MORNING AFTER
Greenspan’s words rippled round the globe. Markets in Tokyo and London plunged. In New York, some observers predicted that when the market opened, the Dow would shed 300 points. In fact, the benchmark index did lose 145 points in early trading. But by midday, panic gave way to pragmatism: “Money managers showed themselves unexpectedly reluctant to sell, possibly for fear of pushing the prices of their remaining holdings lower as well as damaging their 1996 performance results only weeks before the end of the year,” observed The Wall Street Journal.23 Once again, careerism won out over caution.
By Monday, the market had shrugged off the chairman’s warnings: that day the Nasdaq posted its second-largest point gain in the history of the index.24
Nevertheless, Wall Street’s paper of record reacted sharply to what it considered the Fed chairman’s faux pas: “Financial markets figured out quickly enough that Alan Greenspan didn’t mean it,” The Wall Street Journal declared in Tuesday’s “Review & Outlook.” “But we hope the Federal Reserve chairman and those around him take a moment to ponder the world-wide turmoil following his Thursday night mumblings.”
Normally viewed as pearls of wisdom, the chairman’s words suddenly had been reduced to the “mumblings” of an old man.
As for the danger of a financial bubble, the Journal ’s editorial dismissed the very idea: “An irrational bubble, if indeed any such animal has ever been identified, will by definition go away of its own accord.” The paper’s editors did not dwell on the cost to investors when bubbles “go away.”25
Even Senate Majority Leader Trent Lott felt free to publicly rebuke the Fed chairman on nationwide television. “He probably shouldn’t have done that,” said Lott. “The next morning markets dropped all over the world…. I’ve always been a little nervous about the Fed,” Lott added. “They focus too much on one side of the eq
uation rather than the broader basket.” Lott also offered his counsel on monetary policy, suggesting that the Fed should lower rates.26
Meanwhile, the Journal ’s “Heard on the Street” column provided a window on how Wall Street’s analysts were coping with the crisis. It seemed that a bank analyst at Merrill Lynch had recently put out a report showing that, based on standard methods for calculating bank stocks, the banks he covered were fully valued. “But instead of cutting bank-stock ratings and sending a sell signal, Mr. Kraushaar chose to change his valuation methods,” E. S. Browning reported dryly.27 Everyone, it appeared, was doing his best to counter any loss of confidence brought on by the chairman’s unfortunate remarks.
THE CHAIRMAN RECANTS
Less than seven weeks later, Greenspan tried to assuage any fears that his words might have stirred. Testifying before the Senate Budget Committee, the Fed chairman gave a speech that Edward Yardeni, chief economist at Deutsche Morgan Grenfell, summed up neatly as “the case for rational exuberance.”
“His comments indicate that he is very pleased with the performance of the economy and sees no reason to either raise or lower interest rates at this time,” noted Yardeni. “I believe that his analysis of the economy’s recent performance is especially bullish for stocks. In his formal presentation, there was no mention of ‘irrational exuberance.’ He simply observed that the stock market continued to climb at a ‘breathtaking’ rate.”28
From “irrational” to “breathtaking.” It was not just an about-face; it was a pirouette.
In March, the Fed lifted interest rates by a quarter point—a small but important move. Reportedly, Fed Governor Laurence Meyer considered this a “brilliant” stroke on the chairman’s part. “Here is Greenspan, the poster boy for the New Economy, playing the Old Economy inflation hawk card. The chairman was keeping a foot in both camps, both the New Economy/higher productivity school and the Old Economy/inflation-fighting school. It was a masterly management of the process,” Meyer concluded.29
But neither Wall Street nor Washington welcomed the tightening, and Greenspan would not lift rates again until June of 1999. In the interval, he cut interest rates three times.
In the spring of ’96, Greenspan also publicly repudiated the idea of raising margin requirements. Once again testifying before Congress, he rejected the notion as an “anachronism,” recalled Morgan Stanley’s Steve Roach—“and this was just six months after declaring that if the Fed wanted to pop the bubble ‘I guarantee, that would do it.’”
In retrospect some would claim that even if the Fed had made it more difficult to borrow in order to buy stocks, studies show that raising margin requirements would have little effect. Roach disagreed: “No one knew what effect it would have—they hadn’t touched margin requirements since ’75,” he said. Moreover, any action by the Fed would have had a psychological impact. “As a signaling mechanism, lifting margin requirements could have been very powerful,” Roach observed in 2003.30
For by now, the bull market had become a confidence game, and Greenspan had the nation’s confidence. As noted, the Fed chairman’s power was, to a large degree, psychological. In the past, “the Fed exerted control by regulating the dollars called bank reserves. Figuratively speaking, Citibank (to name one of the central bank’s charges) was a dog at the end of a leash. The Fed was the master and the leash was the monetary transmission mechanism,” noted James Grant. “Nowadays, in a freer environment, Citi may be thought of as a cat. No longer inclined to walk at heel, it can lend and borrow without undue reliance on these Fed-supplied balances.”31
Moreover, by the nineties, four-fifths of the working capital used to finance industry and commerce came, not from the banks the Fed supervised, but from the market itself. As a result, the chairman’s power was greatly circumscribed, observed Martin Mayer, the author of a seminal study of the relationship between the Federal Reserve and the New Economy, The Fed: The Inside Story of How the World’s Most Powerful Financial Institution Drives the Markets.
True, the Fed could pump liquidity into the economy—as it did in the early nineties when the Fed bought up so much Treasury paper that the nation’s immediate cash supply (cash plus balances in checking accounts) rose by more than 12 percent in one year. And the Fed could create abundant credit by lowering short-term interest rates—as it would, most fatefully, in 1999. But the Fed chairman’s ability to direct the economy was greatly exaggerated both in the media and in the mind of the public: “The Fed is always in the news, as if it alone holds the key to prosperity,” as if “minor changes in interest rates and liquidity…will decide economic growth rates, employment levels, inflation, deflation or stability,” Mayer noted. But, he added, “this certainly is not the case.”
Yet, there was no doubt, Greenspan’s words could move markets—sending “a frisson through the markets and then the media” simply because so many people believed that Greenspan’s was “the most authoritative and thus predictive voice.” No matter that the Fed chairman’s power was largely a matter of what Mayer called “custom, belief, and the power of theatre.” Economics could not explain it: “We just don’t know how it happens—or why it sometimes doesn’t happen.”32 In other words, like many psychological phenomena, the chairman’s power remained both inexplicable—and unpredictable.
The wizard behind the curtain, Greenspan was left in a nearly impossible position. On the one hand, he was expected to manage the bubble—but he was never, ever, to suggest that there was a bubble. This would upset the people who believed that he could manage it.
Moreover, even if he wanted to let the air out, the truth is that there is no way to prick a bubble without running the risk that the thing will splatter all over the room. Better to leave it alone. Better yet, announce that what looked like irrational exuberance is in fact justifiable euphoria.
Before long, the Fed chairman would be singing with the choir. And the excesses that the bubble had created would have a new name: “The New Economy.”
—15—
THE MIRACLE OF PRODUCTIVITY
In July of 1997, Business Week announced the Fed chairman’s conversion: “The staunch conservative who once personified industrial-era economic thinking has turned into the avant-garde advocate of the New Economy.”
What the magazine called “Alan Greenspan’s Brave New World” was built on the premise that the United States was undergoing “a productivity revolution not seen since early in the 20th century.” When output was compared to hours worked, American workers were producing more goods and services per hour. Admittedly, the Bureau of Labor Statistics reports on productivity showed gains stuck at around 1 percent, but, Business Week explained, Greenspan believed that “statistical distortions are understating efficiency gains.”
“The suspected productivity payoff is also making Greenspan more sanguine about the rising stock market,” the magazine reported. “When he raised his famous concern last December about whether stocks were in the grip of ‘irrational exuberance,’ the Fed chief was worried that corporate profits couldn’t keep pace and that a steep correction might ensue. But margins have been rising smartly—faster than Greenspan can ever recall. His only explanation: ‘productivity.’
“So confident is Greenspan of his argument, that he has required researchers to make a second productivity measure by ‘zeroing out’ any industry sector—such as health care—where statistics show falling productivity. Reason? In this cost-cutting era, he can’t fathom any sector becoming less efficient. Still, these exercises drive researchers nuts. ‘A lot of the staff are skeptical of overmining the data,’ said Fed Governor Susan M. Phillips. ‘They’ll complain about it, but in hindsight, it has made a lot of sense.’”1
As anyone who has ever started with a high concept and then worked backward to find numbers to fit the theory knows, it is not unusual for the theory to make a lot of sense “in hindsight.”
Somewhat belatedly, the chairman of the Federal Reserve was falling in line with Business W
eek’s own assessment of the economy. No wonder the magazine was impressed. Seven months earlier, Business Week had heralded “The Triumph of the New Economy,” explaining how the new technology was driving American workers to new heights of productivity: “Business investment in computers and communications hardware has soared by 24% over the past year alone, accounting for almost one-third of economic growth. From the Internet to direct-broadcast television, new companies are springing up almost overnight to take advantage of cutting-edge technologies.
“GREEN LIGHTS,” Business Week proclaimed. “The stock market’s rise is an accurate reflection of the growing strength of the New Economy. Productivity growth, although understated by official statistics, is rising as companies learn to use information technology to cut costs, a necessity for competing in global markets.”2
Like most supernatural events, the “productivity miracle” depended, to a fair degree, on blind faith.
A CLOSER LOOK AT THE NUMBERS
When economists talk about “productivity,” they are referring to the amount of goods and services the nation produces per hour of work. In theory, when businesses produce more per worker, they increase profits and raise wages. The growth of gross domestic product (GDP) is the sum of increases in productivity and the labor force. In other words, when more people work more hours, GDP grows. But everything turns on how you measure the value of those goods and services.
Not surprisingly, as long as the market rose, the optimists carried the day. The government reported that productivity had grown nearly 2.9 percent a year from 1995 to 2000—double the 1.4 percent rate of growth from 1973 to 1995. In the cold light of 2001, however, the government would be forced to revise its numbers. “Overestimates of computer software sales and consumer spending” had inflated productivity gains, explained New York Times columnist Jeff Madrick. Now, it became clear “how thin the new-economy thinking has been all along. Those gains turn out mostly to have been the product of a counting error.”
