There is a principal about asset market bubbles: a policymaking authority like the Federal Reserve can never be sure enough that an asset market rise is a bubble in order for it to take steps to pop it. Why? Because if the Federal Reserve can be sure it is a bubble, the "smart money" in the stock market can be sure that it is a bubble too--and if the smart money is sure that it is a bubble, the smart money will already have gone short the market on a large scale, and so popped the bubble by itself. Therefore the only bubbles that can flourish and grow are those that people are not sure are asset market bubbles.
Here the Associated Press reports on Alan Greenspan's defense of Federal Reserve policy in the late 1990s. The only point on which I think Greenspan is weak is his claim that he knew that raising margin requirements would do no good, hence did not raise them. It's not clear to me that they wouldn't have had a beneficial effect--although probably a very small one.
Greenspan Defends Decisions of Policy Makers in Late 1990s: ...In addition to defending the Fed's decision not to raise interest rates in an effort to influence stock prices, Mr. Greenspan said that other possible Fed actions, such as raising margin requirements, wouldn't have worked either. Mr. Greenspan said the actual amount of stocks that are purchased on margin -- meaning the investor uses a percentage of the stock's value as collateral for a loan to buy the stock -- is very small relative to overall stock-market activity.
After he first raised the issue of whether the stock market was overvalued in his "irrational exuberance" speech in late 1996, Mr. Greenspan was criticized by some conservative Republicans for attempting to influence the value of stocks. Various GOP members of Congress questioned why Mr. Greenspan, a believer in free markets, was attempting to talk the market down. Mr. Greenspan said in discussions inside the Fed that central-bank policy makers realized it was very hard to determine when a bubble was actually developing. "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," Mr. Greenspan said.
WASHINGTON -- Federal Reserve Chairman Alan Greenspan said Friday that Fed policy makers couldn't have deflated the stock-market bubble that emerged in the late 1990s without raising interest rates to such high levels that it would have pushed the country into a severe recession.
Mr. Greenspan used an address to an annual Fed economic symposium to defend the central bank against critics who have contended that the failure to deflate the highflying stock market in the late 1990s was a major policy error.
Mr. Greenspan, who famously warned in December 1996 that investors could be in the grips of "irrational exuberance," said it was very difficult for policy makers to know when a stock-market bubble was developing. And he said that even if the Fed felt it should substitute its judgment for the actions of millions of investors, it would be very hard for the central bank to curb stock-market euphoria.
"The notion that a well-timed incremental tightening could have been calibrated to prevent the late 1990s bubble is almost surely an illusion," Mr. Greenspan said.
To support that view, Mr. Greenspan cited previous instances when the Fed raised interest rates by more than three percentage points in the late 1980s and mid-1990s, but stock prices, after initially retreating, resumed their upward advance.
He said that to have the impact of deflating an unjustified rise in stock prices, the Fed would have had to push rates up by such large amounts that it would almost inevitably would have triggered an economic recession, the very outcome the Fed was seeking to prevent.
"Such data suggest that nothing short of a sharp increase in short-term rates that engenders a significant economic retrenchment is sufficient to check a nascent bubble," Mr. Greenspan said in remarks prepared for an economic conference at Jackson Hole, Wyo. Copies of his remarks were released in Washington.
Two-Day Symposium
Mr. Greenspan spoke at the start of two days of discussions involving top academic economists and Fed officials, who this year are examining the topic of how Fed interest-rate decisions and budget and tax policies can be used to deal with recessions.
He used his remarks to defend the Fed's actions in the late 1990s when investor euphoria over the developing Internet economy and high-tech telecommunications companies sent Wall Street on a dizzying ride that peaked in the spring of 2000.
Since that time, investors have seen their portfolios shrink by more than $7 trillion. The technology-heavy Nasdaq composite index hit a peak of 5,132 on March 10, 2000, and since that time has shrunk to a Thursday close of 1,336, a loss of 74% of its value.
Wall Street's worst bear market since the mid 1970s was dealt another blow this summer as a number of formally highflying companies such as Enron Corp. and WorldCom Inc. suffered from accounting scandals.
President Bush, in an effort to keep the plunge in stock prices from bringing on a double-dip recession, recently signed into law tough new regulations governing corporate-reporting requirements, hoping to restore investor confidence.
The Fed, seeking to bolster an economy that fell into its first recession in a decade last year and then was jolted by the terrorist attacks, has pushed interest rates to their lowest levels in four decades.
At its most recent meeting two weeks ago, the Fed signaled that it was ready to push rates even lower if necessary to keep the fledgling recovery from faltering.
Mr. Greenspan made no mention of current economic conditions or the future course of interest rates in his prepared comments.
Margin Curbs Not Effective
In addition to defending the Fed's decision not to raise interest rates in an effort to influence stock prices, Mr. Greenspan said that other possible Fed actions, such as raising margin requirements, wouldn't have worked either. Mr. Greenspan said the actual amount of stocks that are purchased on margin -- meaning the investor uses a percentage of the stock's value as collateral for a loan to buy the stock -- is very small relative to overall stock-market activity.
After he first raised the issue of whether the stock market was overvalued in his "irrational exuberance" speech in late 1996, Mr. Greenspan was criticized by some conservative Republicans for attempting to influence the value of stocks. Various GOP members of Congress questioned why Mr. Greenspan, a believer in free markets, was attempting to talk the market down.
Mr. Greenspan said in discussions inside the Fed that central-bank policy makers realized it was very hard to determine when a bubble was actually developing.
"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," Mr. Greenspan said.
Copyright (c) 2002 Associated Press
Posted by DeLong at August 30, 2002 12:36 PM | Trackback>>Why? Because if the Federal Reserve can be sure it is a bubble, the "smart money" in the stock market can be sure that it is a bubble too--and if the smart money is sure that it is a bubble, the smart money will already have gone short the market on a large scale, and so popped the bubble by itself. <<
Didn't Larry Summers plus some coauthor or other write a paper a while ago explaining how this reasoning didn't work?
Posted by: Daniel Davies on August 30, 2002 12:48 PMIn everyday life we recognize a bubble before it blasts, its form, consistency ecc tells about its nature.
"Bubble" seems to be a bad metaphor, "thin ice" might be better.
>>Didn't Larry Summers plus some coauthor or other write a paper a while ago explaining how this reasoning didn't work?<<
Assuming that the "smart money" has a short horizon. But why is there no patient, smart money willing to go short over long periods of time? Institutional restrictions (i.e., finding somebody who will lend you the stock for a long time), career considerations (i.e., you have to show you're smart in six months or be fired--and making 20-year bets on fundamentals doesn't help), and risk--the possibility that the crazy yahoos are right. Kindleberger always stressed the third, and I guess I was channeling him more than I usually do...
Posted by: Brad DeLong on August 30, 2002 05:32 PMThe following quote is from a Morgan Stanley
website:
"[C]onsider the following statement by Chairman Greenspan, taken from the transcript of the September 24, 1996 FOMC meeting: 'I recognize that there is a stock market bubble problem at this point.' For the record, the Dow Jones Industrial average closed at 5,874 on that date, about half the level it was eventually to reach in early 2000. Nor was Greenspan reticent in expressing his opinion back in September 1996 on what should be done to pop the bubble. Again in his words, '…it is not obvious to me that there is a simple set of monetary policy solutions that deflate the bubble. We do have the possibility of raising major concerns by increasing margin requirements. I guarantee that if you want to get rid of the bubble, whatever it is, that will do it.'"
There is certainly room for doubt about whether
his faith was justified, but a claim that he knew raising margin rates would do no good sounds like an attempt to rewrite history to me.
Again - Why should the Fed try to regulate asset prices? Price controls have generally worked quite poorly, while efforts by the Fed to limit inflation through the economy have worked well. There may have been a market bubble in 1996, but 1999 may have marked the bubble. There may be a housing bubble now, or there may not. Price controls are too tricky. What did the Japanese get after their central bank burst the supposed bubbles? Should the Japanese bank have acted in 1986 rather than 1990?
Posted by: on August 31, 2002 01:21 PM>>Assuming that the "smart money" has a short horizon. But why is there no patient, smart money willing to go short over long periods of time? <<
Here's my theory (which I suppose I ought to be putting on my own weblog but what the hey).
If you model the decision of the smart money as a decision between two alternatives -- 1) short the market or 2) don't short the market -- then whenever the market is above fundamental value, smart, long-term money able to go short will converge on an equilibrium in which all the smart money is short.
But what happens when you bring into the model the following fact; that smart money always has the option to wait? If you model the decision as 1) go short today 2) go short never 3) wait until tomorrow, and (if and only if prices have risen further), go short, then I would assume (since time value of an option is always positive) that the model would always converge on the equilibrium in which people wait. More sophisticated models ... more sophisticated outcomes.
There's a big "real options" literature started by Avinash Dixit on the timing of big physical capital investments which I think is important in the understanding of why big smart money doesn't immediately puncture speculative bubbles. So it's not so much worrying a la kindleberger that the dumb ones "might be right", as the fact that smart money is not obliged to make the bet and therefore won't until the odds are massively in its favour.
Philip Caret in "The Art of Speculation" used to talk about "strong and weak hands" as the key to market analysis, rather than smart or dumb money ...
Posted by: Daniel Davies on September 1, 2002 11:24 PMaddendum; the key to the above is, of course, that the time-value of an option (the value to the holder of keeping the option open rather than striking, sometimes characterised by the parameter theta) is generally positive, particularly on a non-dividend-paying stock, which a short position obviously is.
Posted by: Daniel Davies on September 2, 2002 02:38 AMThere are considerable costs to going massively short for extended periods. There is the cost of missing out on further market gains, which can cause investors in a large hedge fund to grumble and withdraw. There is the cost of borrowing the shares.
Also, trying to talk up a bursting of a bubble in the American stock market seems quite a bit more difficult than talking up a decline in a foreign currency.
Wall Street was doing all it could in early 2000 to convince the public and perhaps itself that there was a new form of market about. "Wall Street Week" on PBS had dropped every bearish analyst from the program between 1996 and 1999.
Warren Buffett and John Bogle were warning investors to be most careful in the winder of 1999. Were "you" listening? Was "I"?
Posted by: on September 2, 2002 09:08 AMBut why is there no patient, smart money...?
Larry Tisch was short equities via futures and options for much of the bubble, and took epic losses before being "right". As a trustee of NYU, he kept their portfolio mostly in cash and debt, causing major financial dislocations for his alma mater.
He is the only such public example I know of.
Posted by: George Zachar on September 3, 2002 05:44 AMIt's not so much "patient smart money" that's absent, as a particular, and IMO bizarre kind of money; patient, smart money with no particular opinion on market timing, that is prepared to go massively short the moment prices drift above fundamental value, without being remotely tempted to see whether they won't drift a little bit further ...
Posted by: Daniel Davies on September 3, 2002 09:48 AM