Big Al Greenspan needs no intro. He is the man in US financial markets. No, scratch that. In world financial markets. Go here if you've been living in a dirt bunker and need a bio.
Arnold: Al. Dude. Thanks for coming over. It's excellent to have you here.
Al: It's my pleasure. Before I begin with today's remarks, I would like to thank all the iTulip.com fans for attending. In the incredibly short span of just a few years, the Internet has made it possible for an amateur economist to hold a forum with so many professional economists. It is with this spirit that I look forward to your questions.
Arnold: Sure, what we here at iTulip.com know about economics you can fit into Cheerio hole. I've prepared some questions for you. Some of them are mine and others come from iTulip.com fans. So let's get to it.
Everyone knows you steer not only the US economy but the entire world economy as well. Investors from Boston to Bali hang on your every word. How do you feel about that?
Al: I think sometimes people read into my comments more than they should. One popular television investment show photographs my briefcase and tries to infer Fed policy from how thick it appears. Some viewers might be surprised to know that I keep much more than papers in there. They might be quite surprised to learn what I really keep in there. And if they knew, it might influence the equity prices of certain specific companies, including some large names in the leisure industry. Let's just leave it at that.
Arnold: Well, right or wrong, investors think you not only influence markets but you actually control them, and not just that but you're on their side. The press isn't doing much to counter this impression. The Spring 1999 issue of Fidelity Focus has a piece on you for their investors with the comically understated subhead, "Following the Federal Reserve's actions may give clues to the market's moves." The piece describes how the Fed stepped in last September with a few rate cuts that reversed a 19.5% drop in the Dow, a move followed by a Dow rise to new heights just five weeks after the cuts. The article offers many other illustrations of the Fed's positive influence on financial markets over the years, such as rate increases in 1994 that, "set the foundation for what became the best consecutive four year period in stock market history." The message that the entire article conveys to Fidelity investors is: "Your money is safe in the stock market. Al will make sure the market goes up over the long term." The impression is neatly summed up with the popular market maxim: "Don't fight the Fed." Do you feel it's fair to say that the majority of investors view the Fed as not only a defender of price stability and maximum sustained growth but also a protector of the stock prices?
Al: To be honest, it's not that simple. Certainly when the Fed lowers interest rates the money supply is increased. We try to ensure an adequate money supply to maintain a growing economy, and at the same time we limit money supply to prevent excessive economic activity which would cause excessive inflation. Some of that money supply indeed finds its way to the equity markets and those prices rise, but the system is more complex than that. Because the money supply is increased, businesses enjoy a lower cost of capital used for expansion. Certainly the recent large AT&T bond offering reflects this environment. That expansion, in the aggregate, increases the probability that companies will return higher profits to their shareholders, and consequently -- and quite appropriately -- equity prices rise.
There has been considerable debate as to why equity prices are currently high. To answer that, we must consider other important economic factors. Like what's in my briefcase.
Arnold: The public's impression that you're looking out for stock market investors contrasts with investor warnings that you have issued over the years, starting with your famous "irrational exuberance" speech back in 1996. Since then you have warned several times that the market is running at a high risk premium. But your warnings draw increasingly little reaction from investors who appear more interested in what you do than what you say. Investors can be forgiven for drawing the conclusion from recent events that if the market drops substantially, the Fed will step in with a rate cut.
Al: I certainly would not make that assumption. Fed interest rate policy does not consider the price of equities, other than certain popular Internet stocks. If small investors believe that they can foretell Fed policy, then they would be much better off speculating with instruments which directly reflect interest rate environments. Interest rate futures, interest rate swaps, forward rate agreements, and derivatives based on very long bonds should provide the action and leverage needed to satisfy many small investors. It should also be pointed out that the home equity and credit card loans can be a good source of the margin requirements for the small investor.
Arnold: Take out a second mortgage and buy AOL. Good idea. But you're not really answering my question. Like it or not, the world thinks you determine the fate of the markets. As with the financial press, you and the various Fed governors don't do much to discourage this belief either. So that's the real risk you are creating. Most investors seem to think the Fed controls the market rather than that you influences it. There's a big difference. The latter implies that the Fed can make adjustments to optimize prevailing economic conditions, the former that Fed can keep the economy and financial markets operating smoothly no matter what. There's ample historical evidence to contradict the idea that the Fed can control things all the time. History also shows that the equities markets are driven not be the Fed but by secular changes in financial markets, especially market interest rates, which are at the moment drifting higher. If investors feel so safe in the stock market because of the Fed's apparent ability to control the economic environment, don't you think this represents a serious moral hazard for investors? Besides issuing warnings that no one pays any attention to, is there more that the Fed might do to alert risk averse investors to the danger of putting money they can't lose, such as retirement funds, into the stock market?
Al: At several universities in the Soviet Union, er, I mean Russia, there is some leading edge research exploring the parallels between electroshock therapy for mental depression and interest rate shocks for economic depression. One researcher hypothesizes that if the stock market were to crash, the best cure would be to force interest rates to oscillate at a very high frequency, say 50 times per day. Right now his ideas are being tested in computer models, and if those look good, we'll try it out during the next big market correction. That's the beauty of computer models: we can experiment with an exact replica of the economy without risking real damage.
Arnold: Interest rate shock therapy. Hey, that might just work. Rates at 6% in the morning, 8% in the afternoon, 5% in the evening. That'll keep 'em guessing. Ok, so the Fed basically spends it's time fighting inflation. But there doesn't seem to be any. The economy continues to expand yet inflation remains under 3%. You have dubbed this a "virtuous cycle." Until recently, the Fed in general and you in particular have resisted the notion that we're in a New Era of technology driven productivity gains that explains how the economy has been able to grow so many years into this expansion without producing price inflation. I'm guessing that the reluctance to come to this conclusion was to some degree due to your awareness of the 1920s period that was also called a New Era at the time but which turned out instead to be an Same Old Era in a deflationary boom that later collapsed horribly. Lately you're quoted everywhere saying that productivity gains from technology is the likely root of our good fortune. Before jumping on the New Era bandwagon, did you consider that global deflation and the expansion of credit may be a more significant contributors to the boom than increased productivity from new technology?
Al: There is little doubt that the global economic environment, particularly in Asia, has reduced commodity prices which, in turn, has helped our economy avoid inflation. It would be inappropriate however, to assume that commodity prices will remain favorable. At some point Asia, and Japan in particular, will increase its demand for commodities and finished goods, and this increased demand will result in higher prices. At the same time, it is true that the domestic economy is enjoying real productivity growth. Free trade and the demise of unions has also helped greatly, and I would like to thank our partners in the FBI for digging up all that dirt on the union top brass.
To address your question on the expansion of credit, yes, that is definitely a contributor to the current economic boom. To generate all those junk mail credit card applications requires new computer equipment purchases, new software development, additional paper and ink manufacture, and funds thousands of home-based Stuff Envelopes In Your Spare Time businesses. Additionally, the expansion of demand on the US Postal service results in additional spending for letter handling equipment, new automobiles and trucks, aviation systems, petroleum products, and shoes for letter carriers. And those discarded credit card applications can be ground up and recycled into new credit card applications, with an incredibly small marginal increase in economic input. This is a perfect example of the economic efficiency gains that I have spoken of recently.
Arnold: Let's look at the credit side of the equation more carefully. A recent Barron's article demonstrated that the rise in the stock market from 1992 to present coincides precisely with the net non financial private sector debt growth rate over the same period, growth that has pushing the debt level to an unprecedented $10.6 trillion. Total domestic debt now stands at $22.7 trillion, 260% of GDP. It now takes $5 of debt creation to produce $1 in GDP. First, might it be that the economy appears to be doing so well because consumers are out buying more houses and cars and other items on credit and corporations are borrowing like crazy for acquisitions and stock buy-backs and other non-productive purposes? Second, maybe the reason we're not seeing inflation from all this debt spending is that over capacity is providing a countervailing deflationary force?
Al: Buying houses is certainly a positive force on the economy. It encourages new home construction which provides many jobs in the private sector.
Stock buy-backs must be evaluated in the current tax environment where capital gains are taxed at much lower rates than dividends. Because of that bias, I am not particular concerned about this aspect.
Acquisitions and subsequent divestitures can also have a positive effect on the economy. That process provides a mechanism to terminate nonproductive businesses which might otherwise languish inside large conglomerates. If Microsoft is split up (you didn't hear it from me!), I think you will find dozens of business that serve no useful purpose whatsoever.
There is indeed over capacity in the economy at large, but again, this must be viewed in the light of Asia's current economic problems. At the same time, recent higher prices suggest insufficient capacity in certain critical sectors such as wearable rubber goods and video tape duplication.
Arnold: I'm not so much talking about the credit that usefully greases the wheels of capitalism, I'm talking about the proliferation of low quality stuff that usually shows up at the top of a debt cycle. Circumstantial evidence of an expansion fueled by easy credit abounds. Open any newspaper and you see cars advertised for sale on credit with low interest rates and no money down. More than 60% of all new homes purchased in the last two years were purchased without any down payment. At least once a week, I'm offered a home equity loan at Prime + 0%. The most outrageous attempts to get me to take on unnecessary debt are these sheets of "checks" I'm sent by credit card companies. I'm encouraged to write these checks, up to my credit limit, to "pay for holiday bills... go on a winter vacation... or write one to "cash" for some extra spending money." Although they charge standard credit card interest rates, I am told, incongruously, "the sooner you start using them, the sooner you can start saving." Is it any wonder that most Americans are net debtors? Depending on who you believe, between 60% and 80% of Americans are two paychecks away from insolvency. What do you make of this unbridled credit spree at a time when US savings, outside the stock market, are at an all-time low? Does this really suggest a "strong economy" or a feeble one sitting on a stock market and credit bubble?
Al: It is indeed difficult to know the optimal balance between consumer spending and consumer saving. Certainly individuals in Japan have a very high savings rate however their aggregate economy is in deep recession. And individuals in Russia currently have no savings and their economy is failing. That the US savings rate is approximately two paychecks from insolvency may indeed be an optimal value between these two endpoints. This is certainly an area for additional research, perhaps augmented by those computer models I mentioned earlier.
Arnold: Ok, this is a long set-up to a key question. First let's go back 20 years. The cover of Business Week in 1979 reads: "The Death of Equities." We had inflation around 14% and the prime rate near 25%. Most every U.S. financial institution, marked to market, had negative net worth. The equities markets appeared to be perma bear. If you wanted to invest, you were supposed to buy gold or real estate. But Fed Chairman Paul Volcker had a clever plan. He wanted to turn the US into a tax haven for the world's savers to finance the U.S. out of our high inflation, high interest rate mess. Sell first US Treasuries, then other government bonds, then junk bonds, tax free. Keep the dollar strong, inflation low, keep interest rates higher than any other countries' and the money will flow in. As the new investment boosted productivity, the economy would begin to improve, pulling in even more foreign investment. Then the process becomes self-perpetuating. No one believed the plan was going to work. Well, it did work. The Japanese and Europeans and everyone else bought $5.5 trillion dollars with of bonds, financed $1.5 trillion in current account deficit, and hold $1 trillion in cash dollars. The money financed our recovery and, in recent years, enormous growth in asset values.
Now let's fast forward to the year 2000. Imagine a scenario where the process runs backwards. The stock market has dropped significantly for some reason. Maybe another so-called hedge fund collapses. Who knows. Investors freak out. The "wealth effect" of the stock market reverses and becomes a "poverty effect." As consumer confidence drops and consumers increase savings rates, the US economy goes into recession. Due to the high level of private debt and minimal savings, rising unemployment causes a rapid contraction of the economy as fewer Americans are in a position to borrow to make new purchases and fewer creditors want to lend to the shrinking pool of credit-worthy borrowers. The weakening of US economy lessens returns on dollar denominated assets - stocks and bonds issued in the U.S. The weaker economy causes a net redemption of these assets by foreign holders. The currency markets sell dollars and buy other currencies on the sellers' behalf. Inflation rises as trillions of dollars flood the system. The Fed must raise interest rates to stem the tide of redemptions and fight rising inflation. The higher rates send stocks into a protracted bear market and slows the economy more. The economy contracts further as Americans' "savings" in the stock market disappears and consumer confidence continues to fall. And so on. I call this the "unvirtuous cycle." My guess is it lasts for five to ten years until the unserviceable debt is retired, rescheduled, or inflated away. At it's conclusion, the dollar has lost 30% - 40% of its buying power, inflation stands at between 10% and 15% and the prime rate at 18% to 25%. The USA is then in an inflationary depression. As in "Buddy can you spare twenty bucks." Ok, so here's the "when did you stop beating your wife" question. Is this scenario possible and, if so, what if anything can the Fed do to prevent it from occurring?
Al: The prospect of money fleeing to other currencies depends largely on the strength of those currencies. There is no short term likelihood that Japan's currency will quickly become more valuable, and the Euro while off to a very promising start, has many challenges ahead. A quick glance at the European political situation and pending Balkan wars certainly reinforces that a united Europe remains unlikely. Finally, emerging markets may attract some new funds, but it us unlikely that they would attract the amounts mentioned in your question.
That said, it is indeed possible that confidence in the dollar could be reduced. Fortunately I'll be long retired when that poop hits the fan!
Arnold: Many visitors to iTulip.com sent us questions to ask you. A common theme was to wonder how aware you are of the parallels between the 1920s and 1990s. So let's look at the 1920s more closely. I'm going to quote someone. This is a trick question. The following was written back in 1966:Ok, Guess who wrote that."When business in the United States underwent a mild contraction in 1927, the Federal Reserve created more paper reserves in the hope of forestalling any possible bank reserve shortage. More disastrous, however, was the Federal Reserve's attempt to assist Great Britain who had been losing gold to us because the Bank of England refused to allow interest rates to rise when market forces dictated -- it was politically unpalatable. The reasoning of the authorities was as follows: if the Federal Reserve pumped excessive paper reserves into American banks, interest rates in the United States would fall to a level comparable with those in Great Britain: this would act to stop Britain's gold loss and avoid the political embarrassment of having to raise interest rates.
The "Fed" succeeded: it stopped the gold loss, but it nearly destroyed the economies of the world in the process. The excess credit which the Fed pumped into the economy spilled over into the stock market -- triggering a fantastic speculative boom. Belatedly, the Federal Reserve officials attempted to sop up the excess reserves and finally succeeded in braking the boom. But it was too late: by 1929 the speculative imbalances had become so overwhelming that the attempt precipitated a sharp retrenching and a consequent demoralizing of business confidence. As a result, the American economy collapsed. Great Britain fared even worse, and rather than absorb the full consequences of her previous folly, she abandoned the gold standard completely in 1931, tearing asunder what remained of the fabric of confidence and inducing a world-wide series of bank failures. The world economies plunged into the Great Depression of the 1930's."
Al: I did.
Arnold: Yes, in The Objectivist Newsletter 1966. Just as today, in the 1920s the Fed was also focussed on price inflation while stock market speculation and credit excesses drove the economy and produced enormous asset inflation. Also, just as today, in the 1920s the inflation created by credit expansion was covered up by the deflationary trend in the economy that resulted from over-capacity and an oversupply of goods. The net effect of the two forces resulted in low inflation. So the Fed maintained an expansionary policy. This extended the boom even more and set the stage for the Great Depression. When the inflationary force of credit expansion collapsed after the stock market crashed, the deflationary forces took over. The rest is history. Tell me why you think the Fed is not repeating this scenario again.
Al: In this discussion it is important to remember that the Objectivist and its Ayn Rand disciples are the purest free market believers. My writing certainly reflected my thoughts at that time, but because I was writing for that publication I chose to emphasize a criticism of the Fed's failed attempts at market manipulation.
It is indeed a sad lesson of history that manipulation against market forces frequently fails dramatically. And clearly the Fed made another very serious error in judgment: considering the interests of another nation before those of the US. It is folly to manipulate domestic money supply to satisfy a foreign need.
Your more insightful readers are probably wondering why it would then be acceptable for the Fed to raise money supply after the recent problems in Asia, Russia, and Latin America. We believed that lowered demand from these regions would negatively impact domestic export businesses, and by raising money supply, we would offset some or all of that demand loss. I would point out that this is structurally very different from manipulating market prices as the Fed did in the late 20's. As a secondary positive effect, the additional liquidity was beneficial to these other countries, but this was not our goal.
Arnold: You're an old gold bug from way back. Kind of ironic that you're running the very institution that regulates the fiat money system that replaced the gold based money system. Even as recently as last year, you mentioned gold in testimony before Congress. Is this nostalgia or do you see a time in the future when the old relic might have some utility?
Al: It is certainly true that my work would be simpler with a gold standard. But unless we also eliminate fractional banking, then the Fed or some other policy making body must still manage the money supply. I cannot point to a single congressman hungry for pork projects who would revert to a non-manipulable gold standard, and therefore I conclude that it is a very unlikely future scenario.
There are some people on the Internet, however, who believe that gold's benefits are compelling and that the US will inevitably go back to a gold standard. They're not exactly the crowd that Andrea and I party with, and so I don't think I'll be particularly swayed. She won't even let me talk to them with that AOL Instant Massager thing.
Arnold: Well, it's been a kick talking to you, Al. As a gift from us to you, please accept this iTulip.com Stock Certificate. Maybe next time we get together, you'll pose for us so we can take some pictures and apply the iTulip.com Spinning Head Technology and get you on our advisory board.
Al: It has indeed been my pleasure to speak with your audience and answer so many insightful questions. Thank you also for the stock certificate; it will hang proudly in my office. I would like to leave you with a little poem I wrote just for the iTulip.com fans:
How much money supply?
So many eTrade accounts,
so many SUVs,
so many dream kitchens,
don't ask me why.
Naturally, it's not easy getting Alan Greenspan to visit iTulip.com. In fact, it's impossible. That's why we created this mock interview. The role of Alan Greenspan was played by the reclusive iTulip.com contributor D.W. and Arnold Greenspatz was, as always, played by Eric Janszen.
July 22, 1999 Update
Four months, almost to the day, after the faux iTulip.com interview of Alan Greenspan at iTulip.com, Representative Ron Paul of Texas asks Alan Greenspan at the semiannual Humphrey-Hawkins testimony before the House Banking Committee a series of questions not unlike those posed in the iTulip.com interview.
NEW YORK, July 22 (Reuters) - Following are excerpts from the question-and-answer session after the first leg of Federal Reserve Chairman Alan Greenspan's semiannual Humphrey-Hawkins testimony before the House Banking Committee on Thursday:
REP. RON PAUL R-TX: "There are some economists who in the past...have emphasized that inflation is a monetary phenomenon, and not a CPI phenomenon, its not a labor costs phenomenon, and that we incessantly talk about this, whether it be the Federal Reserve, Treasury, the Congress or the financial markets, we really distract from the source of the problem and the nature of our business cycle.
"I certainly agree that technology has given us a free ride and has allowed us this leverage but we've also been permitted the...of inflation, that is the increase in the supply of money and credit.
"Since 1987, we've had a tremendous increase in money. The monetary basis doubled, M3 has gone up two-and-a-half trillion dollars, and this money has gone into the economy but we have reassured ourselves that the CPI has been stable so therefore everything is ok, yet CPI has gone up 44 pct since 1987, real growth for the GDP has not been tremendous, it's about 2.3 (percent) per year but we've had a tremendous increase in capitalization in our stock market, going from $3.5 trillion to $14 trillion, so that's where the money's going.
"This generates revenues to the government, this has helped with our budgetary problems, at the same time we ignore the fact that not everyone benefits and there's been a lot of concerns that people are left behind. Farmers get left behind, the marginal worker's left behind some people suffer from a higher CPI than others.
"These are all monetary phenomenon that we tend to ignore but you have admitted here today, and in the past, that the business cycle is alive and well and that we shouldn't ignore it. In your opening statement, that we should be especially alert to inflation risks, I think we certainly should be and you've expressed concerns today and at other times about the current account deficit, and this is getting worse, not better. Our trade balances are off.
"But, I would suggest maybe we have seen some early signs of serious problems because foreign central bank holdings now, of our dollars, have dwindled to a slight degree. In 1997, they were holding over $650 billion and they are slightly below $600 billion, and at the same time, we've seen an income from our investments dwindle to a negative since 1997. So I think the problems are certainly there.
"I would like to ask you a question about this balance of trade and the value of the dollar, because history shows that these dollars eventually will come back and you have assumed that, that they will, but that's essentially the problem we got into in 1979, 1980 and there's no guarantee that that won't happen again.
"That means that the markets will drive interest rates up, we will have domestic inflation, the value of the dollar will go down, now my question is what will your monetary policy be under the circumstances. In 1979, 1980, the Fed was forced to take interest rates as high as 21 percent to save the dollar.
``So my suggestion is, it's not so much that we should anticipate a problem, its the problem's already created by all the inflation of the past 12 years. And, that we have generated this financial bubble worldwide and that we have to anticipate that and when this comes back we're going to have a big problem and you're going to have to deal with this. And, my big question is why would you want to stay around for this, it seems I'd get out while the getting's good.''
GREENSPAN: "Dr. Paul you're raising an issue, which a significant number of people have been raising through the years, and for which frankly we're not quite sure what the answers are.
``It's by no means clear, for example, that one can place the increase in money supply, which presumably is not reflected itself in CPI, into stock values. A lot of people say it's happening, a lot of people assume that's what happens, but it's definitely clear by any means.''
PAUL: ``Did you not write that that was the case with the 1920s and this was a problem that led to our depression?''
GREENSPAN: "No, I didn't raise the issue, that in effect, that the money supply per se, what I was arguing many, many years ago and I still think is doubtless the case, that in 1927 involving ourselves with an endeavor to balance the flow of gold in favor of Britain at that time, that we did create a degree of monetary ease which was one of the possible creations of speculation in the market in 1928 and 1929.
"What is not evident in today's environment, that anything like that is going on, we cannot trace money supply into a speculative bubble. If the bubble turns out to be the case, after the fact, we will have a considerable amount of evaluation of where it came from.
"But as I've said before this committee and indeed before the Congress on numerous occasions, I think we are uncertain as to the extent to which there is a bubble, because as I said in the prepared remarks, to presume there is a bubble at this particular stage of significant proportions, and a bubble that isn't significant doesn't have any meaning, we have to be saying that we know far more than the millions of very sophisticated investors in the markets, and I've always been very reluctant to conclude that.
"We do know that a significant part of the rise in prices reflects rising expected earnings, and a goodly part of that is a very major change in the view where productivity is going.
"What we do not know is whether it's being overdone, or to what extent it is being overdone. I've always said I suspect it is but firm hard evidence in this area is very difficult to come by.
``It's easy to get concerned about it on the basis of all sorts of historical analogies but when you get to the hard evidence we do know that inflation is a monetary phenomenon but (what) we have very great difficulty in knowing is how to measure what that money is. Remember M2, M1, all of that, are proxies for the money that people are talking about when they are referring to money being the creator of...we have had great difficulty in filtering out of our database a set of relationships which we can call true money. It's not M2, M3, its not M1, because none of those work in a way which would essentially describe what basically...and others have been arguing on this issue.''