WallStreet Journal, October 29, 1999
By Lincoln Anderson, formerly director of economic research at Fidelity Investments. He is chief investment officer at LPL Financial Services in Boston.
Seventy years ago today the stock market crashed. While 1999 isn't 1929, then as now the Federal Reserve had been stepping up its public expressions of concern over U.S. stock market values. In 1928 and 1929, a desire to slow the stock market was a major factor in Fed actions that increased deflationary pressure on the economy.
The current Fed campaign aims at two objectives: controlling bank risk and braking the economy. Controlling bank risk is a good idea and is certainly a proper objective of the Federal Reserve. But attempting to manipulate stock and bond markets to slow growth is as bad an idea today as it was 70 years ago.
Fed Chairman Alan Greenspan's public remarks about equity valuations are now much more blunt than they were three years ago, when he famously worried about "irrational exuberance." In a speech two weeks ago, he repeatedly referred to the history of losses of market confidence and price crashes. "At a minimum, managers need to stress-test the assumptions underlying their models and set aside somewhat higher contingency resources--reserves or capital," he said.
Taken at face value, that is a direct order to banks to tighten lending standards on security loans. Mr. Greenspan is likely responding to the fiasco last year at Long-Tenn Capital Management. There, deposit-insured banks made imprudent loans to a highly levered hedge fund. The potential loan losses and possible taxpayer liability forced the Fed to take an active role in the restructuring process. This was poor public policy, and I am sure Mr. Greenspan does not want a repeat occurrence.
Unlike banks, the securities industry has never needed a taxpayer bailout. It is quite proper for the Fed to worry about, and rein in, overly risky securities lending by deposit-insured banks. If this were the sole purpose of the Fed's public expressions of concern over equity valuations, I think the markets would be much less concerned about Fed policy and hence less volatile.
But another Fed agenda has financial markets worried. On Oct. 12 Fed Governor Laurence Meyer stated there is an "inescapable trade-off' between growth and inflation. "Monetary policy affects inflation primarily through its initial effect on the amount of slack in the economy. Tightening monetary policy slows spending growth, opens up some slack temporarily in labor and product markets, and allows the slack to reduce inflation."
He cited "an emerging consensus" that the Fed should "retain the flexibility to damp cyclical fluctuations in the economy around full employment." In other words, the Fed can, and should, fine-tune U.S. economic growth. While Mr. Meyer and other Fed officials never clearly state that they are seeking to knock down stock and bond prices to slow the real economy, the market has received the message loud and clear.
In truth there is no consensus and little empirical evidence that growth causes inflation or that fine-tuning is an appropriate objective for the Fed. His premise is that economic growth is driven by rising demand, which pulls prices higher. Yet it is equally plausible that competition, technical innovation, high world-wide capacity, increasingly skilled and equipped labor, and especially the information-technology revolution are raising production at lower cost. The chart nearby tells the story: With business investment in information-processing equipment now twice as high as all other equipment investment combined and growing at 50% a year, growth in supply continues to outstrip demand.
Traditional economic thinkers worry about consumer spending. After all, retail sales constitute half of the gross domestic product, so this might be a source of "demand pull" price pressure. The argument that rising demand would push up prices seems sensible. Yet there is one glaring problem: The data do not support the notion that faster growth in consumer spending drives up prices. Rather they point to the opposite conclusion: that lower retail prices generate higher consumer spending. That is, consumers tend to buy more cars, furniture, computers and the like when prices are slowing or falling. These days, it takes a sale to move the merchandise.
What might happen if the Fed is successful in crimping real growth? First, because firms are reluctant to lay workers off, productivity growth would slow and unit costs would rise. Then business would be confronted with the choice of firing workers or raising prices to maintain profit margins. This is not a theoretical concern; every U.S. recession since the 1950s has been characterized by a productivity slump and zooming unit labor costs leading to both higher unemployment and inflation.
Fed attempts at short-run countercyclical stabilization usually have destabilized the economy and markets. Such policies compress investment horizons and inject additional market volatility. Worried about a stock-market bubble, Mr. Greenspan wants investors to focus on long-term fundamental valuation. Instead investors are forced to focus on Fed saber rattling. Thirty-year bond yields are moving 10 basis points on the release of monthly employment reports, and the Dow Jones Industrial Average is swinging up and down by several percentage points on Fed speeches. Injecting risk into U.S. financial markets raises the cost of capital and slows productive investment. That could end up delivering slower growth and higher inflation.
It is the Feds job to ensure that deposit-insured banks do not take undue risks and avoid taxpayer-financed bailouts. It is also the Fed's job to take the economy to price stability and keep it there. It is not the Feds job to set and enforce speed limits on economic growth. In the 1960's William McChesney Martin described the Fed's role as taking away the punch bowl before the party really gets started. The problem with that line is that the economy isn't a party and consumers, businesses and investors are not a bunch of drunks who cannot be trusted to drive home (even if banks sometimes are).
Fortunately, the global economy and U. S. financial markets today are far stronger than they were 70 years ago. By attempting to limit growth through sneaky attacks on stocks and bonds, the Fed may do some damage. But the ability to cause irreversible harm has moved--thank goodness--well beyond its reach.