Alan Greenspan
is concerned about excessive optimism in the stock market. It is not
that he doesn't want prosperity -- he wants to take steps to "help
extend the period of sustained growth."
He knows, first,
that this expansion promises to be long lived because the Federal
Reserve did not acquiesce to an upcreep in inflation in 1994, and
he promises that the Fed will remain vigilant in 1997. Second, he
is warning that "participants in financial markets are susceptible
to waves of optimism," which can feed through asset-price inflation
to the market for goods and services. And he believes that stock market
excesses can act to amplify any downturn in economic activity.
His notification
to financial market participants that monetary policy continues to
seek price level stability is right on target. If price level stability
requires a temporary increase in interest rates, of course, that is
the judgment call of the Federal Open Market Committee. It would be
a mistake, though, to assume that the run-up in stock prices is an
indication that monetary policy is too easy. If Mr. Greenspan and
the Fed would like lower stock prices and lower bond prices, indeed,
the clear prescription is to make money easier -- that is, to lower
the value of money through inflation. The fact that the FOMC is not
going to tolerate an increase in inflation most likely will contribute
to the bull market continuing.
Mr. Greenspan
was warning us that the worst of all worlds would be to have an upturn
in inflation, which would require higher interest rates, at a time
that might coincide with or set off a reversal of stock market excesses.
He seems to be worry that declining stock prices would have a "wealth
effect" on consumer and business spending. If wealth drops in
a stock market crash, and the result is a fall in consumer spending,
which then leads to a fall in profits setting off another round of
wealth losses, then that kind of downward spiral could culminate in
a depression. In other words, a repeat of what is commonly believed
happened in 1929.
But is that what
happened in 1929? Was money easy? No. Wholesale prices fell 8% from
1925 to 1929. Gov. Benjamin Strong and the open market committee mistakenly
tightened the monetary purse strings in response to what they believed
was an asset "bubble" caused by too much money. Thank goodness,
there is no danger of today's FOMC tightening money to the point where
we have a deflation, as the Bank of Japan recently did.
The prevailing
view of the 1929 stock market crash and the ensuing economic depression
is decidedly Keynesian with its Marxist business cycle roots. Capitalism,
said Marx, generates ever worsening business cycles that eventually
culminate in a revolution. The Keynesian version is that fiscal and
monetary policy adjustments can provide offsetting stabilizing action
to smooth the cycle and thus save a socialized market system. The
notion that business cycles have not been repealed ignores monetary
policy mistakes as a business cycle generator.
It is time to
set the record straight.
The stock market
crash of 1929-34 was due to misguided monetary policy that led to
deflation and protectionism and then to the ruinous policies of the
New Deal. And the New Deal's heavy-handedness was justified because
only the New Deal saved us from a Marxian revolution. Many refused
to discover and to believe that the 1929 crash was the result of a
serious monetary policy mistake and the resulting rise of protectionism.
They ask, how
can monetary policy have initiated such a disaster when we were on
the gold standard? The answer is that we were not on a gold standard.
The Federal Reserve Act of 1913-14 repealed the gold standard and
replaced it with a system that ensured that the U.S. dollar would
be a better store of value than gold. The Federal Reserve Act guarded
against inflation, but permitted deflation.
The Federal Reserve
System was a "managed money standard" system. Being managed
meant that policy makers were not required to increase reserve bank
credit automatically when gold flowed to the U.S. as the rest of the
world failed to deflate as fast as the U.S. Rather, they could choose
to watch something else, for example the stock market, as a signal
that money was too easy.
The 1914 act
prohibited the Federal Reserve from inflating by specifying that Federal
Reserve bank credit, central bank funny money, could never be larger
than 2 1/2 times gold certificates held by reserve banks. As Great
Britain, France and other countries struggled to get back on the gold
standard, it became apparent to international investors that they
would not make it. In a way, they could never make it, since the Fed's
gold managed system refused to allow gold inflows to inflate the U.S.
price level. This meant other countries would bear all the price level
adjustment -- a significant deflation.
In the 1920s,
prices and wages were extremely flexible to adjust to supply and demand
conditions. So the Fed was free to pursue a deflationary policy --
the only problem was that real estate prices -- farmland, houses or
factories -- eventually adjusted downward to be in equilibrium with
falling commodity prices.
Falling commodity
prices and the ensuing deflation forced real interest rates up and
nominal interest rates down. It was a paradise for lenders and a torment
for borrowers. Market interest rates were forced down. But the Federal
Reserve looked at the stock market and was reluctant to match the
lower interest rates determined in the market.
What was happening
to the price of gold? It remained at exactly $20.67 an ounce; the
secretary of the Treasury was required by law to support the price
of gold at the official rate. Gold was the first commodity held up
by a Federal price support. As a result of the disparity between falling
commodity prices and stable gold prices, Irving Fisher proposed a
commodity price standard. He invented a system of index numbers for
measuring changes in commodity prices, which could have guided the
Fed away from deflation. But the Fed's governors were not focused
on falling commodity prices; they were sure that rising prices in
the stock market meant money was too plentiful.
It is hard to
imagine circumstances in which U.S. stock prices would not have soared.
Falling oil prices, courtesy of the Standard Oil monopoly, created
a new market for automobiles. This led to innovations in assembly
line production, allowing Henry Ford to show the way with rising wages
and profits. World War I ended, leaving Europe in need of costly rebuilding
while the U.S. could build on the war-induced industrial stimulation.
And we had relatively free trade.
If you look at
the nearby chart depicting stock prices (see accompanying chart --
WSJ March 7, 1997), it is apparent that stock prices in 1929 were
not so far above the historic trend line. And this trend line encompasses
the adverse impact on the U.S. economy of all the stupid policies
that we instituted in the name of averting another 1929. If we had
simply avoided deflation, the Smoot-Hawley tariff, bank failures,
unemployment rates up to 25%, bankruptcies, New Deal regulation, big
government and the ruinous inflation of the 1970s, then real stock
prices today could have been twice as high as they are. And if the
Federal Reserve and European central banks had worked as hard on economic
policy convergence as the Europeans are today, there may have been
a way of enabling Germany to repay war reparations without bringing
Hitler to power, and of having such a prosperous world that Soviet
communism would have been brought to its knees much earlier.
Think how much
better off the world could have been if policy had been better. Wouldn't
it have been something if we had looked back on 1929, asking why stock
prices had not yet reflected the world's very bright future. Just
think about a world in the 1930s lowering tariffs, increasing trade,
shedding the elitism of Europe's class system, promoting independence
with market economies in Asia, South America and Africa. Colonialism
could not have survived free markets and increasing prosperity.
Our job is not
to rewrite history, but to free ourselves from the phobia created
by the Marxian-Keynesian interpretation of history. The point is that
our future can be much brighter. Stock prices can continue upward
if we continue this "new era" brought on by a favorable
economic environment which surely begets a yearning for freedom and
democracy.
Please, Mr. Greenspan,
stop worrying about the stock market. And read the minutes of the
Board of Governors from 1926-29. Note that they focused on the stock
market and not on commodity prices. By focusing on the stock market
they continued to maintain interest rates at levels above market equilibrium
and thus continued the deflation that would wreck the banking system.
We have a right
to expect that the Federal Reserve will continue to pursue a very
gradual disinflation, which will provide even more abundance of capital
as effective tax rates on real investment income fall to the statutory
level. More capital will mean increased labor productivity, rising
wages and an improved well being for the American people and for the
people of the world.
And stock prices
will go higher. If the Greenspan Fed is satisfied with keeping inflation
closer to the 2.5% achieved over the past three years then stock prices
will surely continue to reflect these new-era levels. Of course with
lower interest rates, lower stock yields and higher price-to-earnings
ratios, investors will need more wealth to buy their preferred retirement
lifestyle. But workers will never have had it so good.