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Sir Alan's day of judgment

Vivek Moorthy
V.R. Pradeep

Should a central bank try to deflate an asset price bubble? While it is a difficult call, it was perhaps wrong of the Fed chief, Sir Alan Greenspan, to avoid confronting the bubble. One way to size up the bubble would be to compare the S&P 500 profits based on creative accounting with economy-wide figures of the National Income and Product Accounts based on Commerce Department data, say Vivek Moorthy and V. R. Pradeep.

ABOUT a year after the Federal Reserve Chairman, Sir Alan Greenspan's famous "irrational exuberance" speech in December 1996 describing the US stock market, Mr Eisuke Sakakibara, Japan's senior Finance Ministry official, known as Mr Yen, called the US the bubble.com economy. It was a prescient and insightful characterisation, well before the dot.com mania really took off. The most surprising aspect of the US monetary policy is how little the Fed has done to curb the prolonged bull market, despite the enormous impact it has had, not just upon the US, but upon the whole world economy.

Whether or not a central bank should try to deflate what may be an asset price bubble has been one of the most hotly debated topics in monetary policy in recent years. There has been an explosive amount of academic and policy analysis of this issue, to which The Economist of London has insightfully contributed since 1998. Indeed, there has been a bubble in the amount written on bubbles.

The basic policy dilemma is fairly straight-forward. When an economy is booming with unexpectedly low inflation, there are two possibilities. It is quite possible that a fundamental surge in productivity is underway, reflected in a rising stock market. Hence, the central bank should not kill the genuine expansion. On the other hand, it may an artificial boom, with reckless spending that has been fuelled by false perceptions of wealth based on unreasonably high valuations, facilitated by an easy money policy.

There is no way for a central bank to know which of these two scenarios prevails or, more accurately, the relative weights to be attached to these two scenarios, since both can and do occur at the same time. Policy decisions are fundamentally judgments under uncertainty, and similar to the trading off of Type I versus Type II errors.

Ex post, it is easy to criticise the Fed for being too lax during the late 1990s. By tightening, it could have triggered a recession and would have been accused of obstructing sustainable, non-inflationary growth. Indeed, Dr Greenspan's optimistic inflation prognosis turned out to be correct, providing some support for the rising productivity view, and thereby justifying his interest rate decisions. Even when unemployment fell and stayed well below the critical range of 5-6 per cent, inflation did not rise, contrary to econometric model based forecasts, including that by the Fed's own research staff.

Thus, at one level, the Fed's unwillingness to kill the boom can be justified on the grounds of a direct inflation targeting policy that is, a central bank should not raise rates unless it sees inflation in the "whites of the eyes" of the data. But as Milton Friedman perspicaciously argued in 1967, although as a target "the price level is clearly the most important in its own right", direct inflation targeting runs the grave risk of being too passive and reactive a strategy. If the central bank waits to react to actual inflation, it is often too late: The economy would have built up unsustainable financial or other imbalances by then. A pre-emptive approach based on intermediate targets and/or or information variables (equity and other asset prices, money, credit or nominal GNP growth, etc.) is far safer, even if it chokes off some part of a genuine expansion. A small recession now is preferable to what would inevitably be a large recession later.

On the grounds of being too reactive, the Fed's hands-off approach to stock prices can, therefore, be criticised. This is especially so since the Fed does not have an explicit direct inflation mandate, unlike some other central banks that do.

In August 2002, at the annual Fed Conference in Wyoming, Dr Greenspan said that a central bank should not try to curb high stock market valuations since it could not, in advance "definitively identify a bubble". Further, even if identified, according to him, the bubble cannot be pre-empted without "inducing a substantial contraction".

However, in our opinion it was wrong to avoid confronting the bubble.

When there is no direct inflation target or any other rule, a central bank must make judgments about data, not avoid doing so. More specifically, the monetary policy should analytically identify the sorts of data that would provide information about the respective prospects, or probabilities, of a genuine expansion versus those of an artificial boom, and then use these incoming data to make inferences leading to policy decisions.

In this regard, it can be argued that Dr Greenspan has failed. One way to ascertain the magnitude of the potential bubble would have been to compare the reported aggregate profits of companies (S&P 500 profits) with economy wide profits reported from National Income and Product Accounts (NIPA) data. S&P profits are based upon creative company accounting, while NIPA profits are based on official data of the Commerce Department.

From 1997 onwards the discrepancy between the two was growing (see chart). And, yet, the normally pragmatic, a-theoretical, data focussed Greenspan failed to react. Why could he not use this discrepancy to conclude that the so-called efficient market was being (our phrase) "a false prophet about true profit"?

Getting down to specific policy tools, why did Dr Greenspan not raise margin requirements on brokers' loans, which the Fed controls through Regulation T and which have not been changed since 1974? Unlike raising interest rates, which would adversely affect the robust mortgage rate based housing market and other sectors of the real economy, higher margin requirements are precisely focussed on tackling high stock prices.

As for violating free market principles and practices, changing margin requirements does not constitute any greater a degree of market interference than the changing of interest rates, routine and widely accepted Fed policy.

Higher margin requirements may or may not have worked. In a footnote to his speech Dr Greenspan stated that most likely raising margin requirements would be of no use, the conclusion of most academic research on this subject. But whether such pessimism was warranted or not, the Fed should have tried to use this obscure policy tool to full effect, and if necessary, later on considered following it up by hiking interest rates.

If nothing else, raising margin requirements would have sent a strong signal to the market that the Fed meant business. And at the very least, Dr Greenspan could have tried to dampen the market by highlighting the discrepancy between S&P and NIPA profits, instead of equivocating on the bubble and supporting the New economy view.

(The authors are affiliated with IIM Bangalore).

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