The Fabulous Destiny of Alan Greenspan

December 6, 2002

This week marks an important anniversary.

"How do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions, as they have in Japan over the past decade?" asked the Fed chairman, when he was still mortal. The occasion was a black-tie dinner at the American Enterprise Institute in December - five years ago.

"We as central bankers," Greenspan continued, "need not be concerned if a collapsing financial asset bubble does not threaten to impair the real economy, its production, jobs, and price stability. But we should not underestimate or become complacent about the complexity of the interactions of the asset markets and the economy. Thus, evaluating shifts in balance sheets generally, and in asset prices particularly, must be an integral part of the development of monetary policy."

Mortals make mistakes. But Greenspan was right on target in '96. It was later, after he became a demi-god, the "Maestro," that the Fed chief erred.

In 1996, the bear market of '73-74 and the crash of '87 were still functioning as caution signs. Greenspan spoke on the evening of the 5th. On the morning of the 6th, markets reacted. Investors in Tokyo the Nikkei Dow a 3% loss for the day, its biggest drop of the year. Hong Kong fell almost 3%. Frankfurt 4%. London 2%. But by the time the sun rose in New York, where the Fed chairman was better known, investors had decided not to care. After a steep drop in the first half-hour, as overnight sell orders were executed, the market began a rebound and never looked back. By the spring of the year 2,000, the Dow had almost doubled from the level that had so concerned the Fed chairman.

But while the maestro was alarmed at Dow 6,437, he was serene at Dow 11,722. Fatal to Greenspan's judgment was a combination of bad information, bad theory and a human nature that - though unchanged for many millennia - seems to have avoided the notice of central bankers.

Greenspan's theory was that by carefully controlling the cost of credit and the money supply he could avoid serious economic downturns. You have suffered enough discussion of this issue here in the Daily Reckoning, dear reader. For today's purpose, we will just point out that Mr. Greenspan has everything he needs to get the economy back on track, except the essentials. He cannot make telecom debt worth what people paid for it. He can't restock consumers' savings accounts. He can't make Enron a good business. He can't erase excess capacity, nor make investment losses disappear.

In addition to the bad theory, Mr. Greenspan had bad information. The "information age" brought more information to more people - including to central bankers...but the more information people had, the more opportunity they had to choose the misinformation that suited their purposes.

Since the late '90s, however, many of the figures used to justify the New Economy have been revised, downward. "The government previously decided that neither corporate profits nor productivity improvements were nearly as good as they appeared to be in 1999 and 2000," reports Floyd Norris in the New York Times. "And now the industrial production numbers have been sharply revised downward."

"The new numbers show industrial production was dramatically overestimated, particularly in the high- technology area," Norris quotes John Vail, the chief strategist of Fuji Futures, a financial futures firm in Chicago.

What was true for the nation's financial performance was also true for that of individual companies. Companies engineered their financial reports to give investors the information they wanted to hear - that they earned one penny more per share than anticipated. But what they were often doing was exactly what Alan Greenspan worried about - impairing balance sheets in order to produce growth and earnings numbers that delighted Wall Street. Curiously, during what was supposed to be the greatest economic boom in history, the financial condition of many major companies - such as Enron and IBM - actually deteriorated.

But by 1998, Alan Greenspan no longer noticed; he had become irrationally exuberant himself. Markets make opinions, as they say on Wall Street. The Fed chairman's opinion soon caught up with the bull market in equities. As Benjamin Graham wrote of the '49-'66 bull market: "It created a natural satisfaction on Wall Street with such fine achievements and a quite illogical and dangerous conviction that equally marvelous results could be expected for common stocks in the future."

Stocks rise, as Buffett put it, first for the right reasons, and then for the wrong ones. Stocks were cheap in '82...the Dow rose 550% over the next 14 years. Then, by the time Greenspan warned of "irrational exuberance", stocks were no longer cheap. But by then, no one cared. Benjamin Graham's giant "voting machine" of Wall Street cast its ballots for slick stocks with go-go technology and can-do management. Stocks rose further; and people became more and more sure that they would continue to rise.

"Greenspan will never allow the economy to fall into recession," said analysts. "The Fed will always step in to avoid a really bad bear market," said investors. Over the long term, there was no longer any risk from owning shares, they said. And even Alan Greenspan seemed to believe it. If the Fed chairman believed it, who could doubt it was true? And the more true it seemed, the more exuberant people became.

"What happened in the 1990s," says Robert Shiller, author of the book "Irrational Exuberance," is that people really believed that we were going into a new era and were willing to take risks rational people would not take...people did not feel they had to save. They spent heavily because they thought the future was riskless."

But risk - like value - has a way of mounting up, even while it seems to disappear. The more infallible Alan Greenspan appeared...the more "unduly escalated" asset values became. Having warned of a modest "irrational exuberance," the maestro created a greater one.

Pure gold is non-toxic when ingested.