Portfolio manager’s Letter March 2002
The conventional wisdom still reads that the policy of the Federal Reserve Board through out the 1990’s was a great success. While a year or two ago I would have been more than willing to agree with this assessment, recent events have raised many questions in my mind about the FED role in promoting the long bull market of the 1990’s and the jumbo bubble it gave birth to. What we all suspected before is now obvious, the longer the bull, the bigger the bubble, and the bigger the bubble the nastier the pop.
Greenspan has been basing monetary policy on an effort to control inflation in the prices of goods and services, and has been proclaimed a great Chairman because he was able to keep consumer prices in check while avoiding a recession for ten years. While this on the surface sounds like I great idea, it now looks naive. Too much money was flowing into the economy, because a high percentage to that money was being spent on capital spending, inflation never showed up in the consumer numbers.
The whole idea that we can hire some politicians to turn a knob here and change a little policy there, and presto, no more human grief, is not just naive it is dangerous, but that is what we are dealing with here. The notion that economic cycles are bad because they cause pain, and that we can fix this by adjusting a few monetary levers, has always been a foolish notion.
In light of the damage to the economy caused by the equity bubble. It is time to question Greenspan’s assumptions. Bubbles are the result of too much money, and it is the Federal Reserve Board’s job is to maintain monetary discipline not provide us with a party that goes on for ever.
Perhaps, Chairman Greenspan was looking at the wrong indicators. Maybe instead of concentrating on consumer information and basic commodity price he should have been targeting the bubble.
Last Month the minutes of the 1996 FED meetings were released and they contain some fascinating stuff. An Article in the Wall Street Journal describes an ongoing exchange between Greenspan and Lawrence Lindsey, who was then, a FED Governor, and is now part of the bush administration. The minutes reveal that even as far back as May 1996 Lindsey was concerned with the potential for a Stock Market Bubble and suggested that the FED would do better to pop the bubble while it was still mostly froth.
“Mr. Lindsey argued that rising stock price could destabilize the economy … the investment boom and rising prices in the equity market have been feeding on one another.” (Remember he was writing this back in 1996, a full three years before Wall Street started passing out hundreds of millions to pre-teens, because they knew how to turn on a computer.)
It was, in fact, Mr. Lindsey’s prodding that brought Greenspan to issue his famous “irrational exuberance” warning in December of 1996. At the September meeting Mr. Lindsey warned that profit expectations were too high and not realistic, and argued that the fed should broaden its mission beyond monitoring prices of goods and services to target asset prices. “as in the United States in The twenties and Japan in the late 1980’s the case for a central bank ultimately to burst the bubble becomes overwhelming”.
While Greenspan seemed sympathetic to Lindsey’s warning he never did admit to the belief that the FED’ duties extended to bubble popping. In 1997 Lindsey left the FED and Greenspan continued to base FED policy on traditional measures of inflation such as the prices of goods and services.
It was Greenspan’s choice to restrict the FED’s responsibility to the role of fighting inflation, and to define inflation narrowly. As long as basic price levels were stable. He was not going to mess with the Stock market. This led to the following three mistakes;
It is time for the FED to play what if. In particular:
Clearly the equity bubble was born in 1994. The soft landing that year established two ideas that at the time seemed fine at the time, but with a little historical perspective now begin to appear ridiculous, because they gave rise to all sorts of unintended consequences.
For investors this seemed to take a lot of the risk out investing. At the same time for the corporate CEO in this economy, where there is never a recession, there is no penalty for borrowing to increase capacity. The company that spends all the money they can get their hands on, and expands as fast as it can always wins.
In my opinion, 1994 was the worst of the above mistakes, because it was the first. A recession and a bear market in 1994 would have at least delayed, and perhaps prevented the formation of the mentality that later sustained the bubble. The cost to our economy of a recession in 1994 would have been a faction of the damage eventually caused by the great equity bubble.
If the FED had allowed a recession in 1994, would that have prevented the currency crisis in 1998? Probably not, but it might have kept this crisis at a level that would not have required the Fed to pump cash into the system in late 1998. This action in 1998 was followed by a NASDAQ rally of 3500 points in 18 months, and the greatest speculative binge in this country’s history.
1998 was the second mistake, but in my mind not as bad as the first mistake, because the rally was now four years older and the any damage caused by a serious market correction or a recession, would have been much greater.
Both of the above responses by the FED where wildly popular at the time, and they where followed by a strong stock market, but by the end of 1998 the die was cast and the bubble was probably inevitable. The problem with easy money is that it promotes the growth of hubris. Hubris is a disease that a flicks corporate CEO’s but does most of its damage to the owners of the companies stock.
In October 1998 Greenspan had again intervened and rescued the market. Wall Street had become the slot-machine that always paid. The money was pouring into Wall Street from all over the world. Within a year Wall Street was passing out hundreds of millions to any CEO in the tech sector that had enough IQ to stick out his hand.
It is clearly not fair to blame the Federal Reserve Board of all the investor stupidity, accounting fraud and despicable acts of CEO’s that were “diversifying their holdings” while telling the public and their employees to buy their stock. This bubble was a capital spending bubble, not a consumer bubble, and a lot of the money that fed the bubble came from overseas.
If there was too much money in the system it was because the FED had defined inflation too narrowly and because they were reading only those indicators that measured activity in the consumer section. But if it is not the FED’s job to pop bubbles whose job is it?
Loose money creates bad behavior. As Mr. Lindsey said in the Quote above, look at 1929 and 1973 in this country and 1990 in Japan. The fact is every major economic disaster of the Twentieth Century was preceded by a prolonged period of easy money. Giving CEO’s access to money that has no cost is the functional equivalent of passing out cocaine in our high schools.
The Good accomplished by government tinkering at any level is often dwarfed by the grief inspired by the unintended consequences of that meddling, and Central banks are surely at the top of the list when it comes to stupid government tricks.
There is a gorgeous irony here. The function of a central bank is to help stabilize the economy, and this is exactly what Greenspan was trying to do. Yet as he created and appearance of stability and steady growth in the 1990’s his success with the economy was establishing a mind set in the equity markets that presented the nation with a level of speculation never seen before.
The attendant consequences of the popping of this bubble have now manifested themselves, Enron, the dot coms, Irridium, Golbal Star, Global Crossing, empty fat pipe and dark fiber – hundreds of billions of dollars spent on capacity that will never be used. And all the petty human behavior they represent.
It seems that as the more the FED tries to stabilize and nurture the economy, the more likely it is to inflict pain.
Greenspan is no dummy. I think he will learn from his mistakes and acknowledge the FED’s responsibility for the past bubble and that the Federal Reserve will act in the future to prevent any repeat of the pattern of the nineties. I think that this will mean that while Larry Lindsey lost the battle in 1996, he will have won the war.
I also think that from now on the FED will have to broaden its mission from controlling prices of goods and services, to include the targeting of equity bubbles. It will also mean that bull markets in the near future will not last very long.