The Second Most Powerful Man In The World

The Daily Reckoning Presents: A Guest Essay by James Grant, editor of Grant’s Interest Rate Observer (www.grantspub.com).

The second of a two-part essay, in which the author explores Fed Chairman Alan Greenspan’s culpability in accommodating, celebrating and defending the most excessive investment bubble in the history of mankind.

THE SECOND MOST POWERFUL MAN IN THE WORLD

The Fed chairman did not get to where he is in life by forgetting to hedge. Yesterday, you’ll recall, we posited that Greenspan contributed to the current bubble by heedlessly ignoring the risks of the technology bom.

“[L]arge voids of information still persist,” Greenspan told the Boston College Conference on the New Economy on March 6, 2000, “and forecasts of future events on which all business decisions ultimately depend will always be prone to error.”

Unfortunately, he neglected to point out that high-tech revolutions inflame the right portion of the brain even as they enable the left-hand side. They stir up the speculative juices, thereby introducing a new source of potential business error. It is an especially potent source as when, late in the 1990s, the chairman of the world’s leading central bank lends his imprimatur to a supposed new age.

Many are the blessings of information technology, Greenspan proceeded. He mentioned the mapping of the human genome, the refinement of financial derivatives and the explosion of big-company mergers: “Without highly sophisticated information technology, it would be nearly impossible to manage firms on the scale of some that have been proposed or actually created of late.”

Yet, he noted, “At the end of the day, the benefits of new technologies can be realized only if they are embodied in capital investment, defined to include any outlay that increases the value of the firm. For these investments to be made, the prospective rate of return must exceed the cost of capital.

“Technological synergies have enlarged the set of productive capital investments, while lofty equity values and declining prices of high-tech equipment have reduced the cost of capital. The result has been a veritable explosion of spending on high-tech equipment and software, which has raised the growth of the capital stock dramatically over the past five years.”

Having climbed so far into a logical trap, the chairman pulled the door shut behind him. “The fact that the capital spending boom is still going strong indicates that businesses continue to find a wide array of potential high-rate-of-return, productivity-enhancing investments. And I see nothing to suggest that these opportunities will peter out any time soon.” At least, not for the next 96 hours (the Nasdaq peaked on March 10).

Here was a remarkable set of ideas. What drives a capital spending boom, said the central banker, was not – even in part – an excess of bank credit or an artificially low money-market interest rate. It was the cold and detached analysis of cost and benefit. Here the chairman was being unwontedly modest.

Fearful of a Y2K calamity, the Fed stuffed tens of billions of dollars of credit into the banking system late in 1999. Not for the first time in monetary history, excess credit raised speculative spirits, inducing a sense of optimism bordering on invincibility.

Greenspan spoke only 18 months ago, but it was an eternity in speculative time. In March 2000, B2B promotions commanded preposterous valuations, which the chairman proceeded to validate. “Indeed,” he said, “many argue that the pace of innovation will continue to quicken in the next few years, as companies exploit the still largely untapped potential for e-commerce, especially in the business-to-business arena, where most observers expect the fastest growth…Already, major efforts have been announced in the auto industry to move purchasing operations to the Internet. Similar developments are planned or are in operation in many other industries as well. It appears to be only a matter of time before the Internet becomes the prime venue for the trillions of dollars of business-to-business commerce conducted every year.”

The Gartner Group had forecast that business-to-business commerce would generate $7 trillion of volume by 2004. Greenspan, a more experienced forecaster, gave no date and said only “trillions,” but even that was wide of the mark. B2B stock prices crashed, and hundreds of Web sites went dark. He was, however, prophetic on one important detail: The potential for e-commerce remains “largely untapped.”

The Fed was slow to raise the funds rate in 1999 and early 2000. It was slow to reduce the rate when, in the second half of 2000, boom turned to bust. The Austrian School economists who originated the theory of the investment cycle prescribed aggressive monetary ease in the bust phase, lest a depression feed on itself to become a “secondary depression.”

Greenspan, having failed to call a bubble a bubble, was slow to recognize a bust as a bust. In his New Economy talk, he did acknowledge a connection between interest rates and technology investment. However, because information technology was an absolute and unqualified good thing, it followed that it could not be held responsible for a bad thing – for instance, the bottom falling out of capital investment and, therefore, out of the GDP growth rate. Blame for the downturn must lie elsewhere – with inventories or even the weather, as he proposed to the Senate Banking Committee on February 13, 2001. “[A] round of inventory rebalancing appears to be in progress,” he told the senators.

“Accordingly, the slowdown in the economy that began in the middle of 2000 intensified, perhaps even to the point of stalling out around the turn of the year. As the economy slowed, equity prices fell, especially in the high-tech sector, where previous high valuations and optimistic forecasts were being reevaluated, resulting in significant losses for some investors…the exceptional weakness so evident in a number of economic indicators toward the end of last year (perhaps in part the consequence of adverse weather) apparently did not continue in January.” However, he added, the FOMC “retained its sense that the risks are weighted toward conditions that may generate economic weakness in the foreseeable future.” What portion of the future was “foreseeable” the chairman did not specify.

He refused to waver from his previously established line, the transforming significance of new technologies. Productivity growth and the availability of real-time information would cut short this inventory and profits slump, he said.

Besides, Wall Street wasn’t worried: “[A]lthough recent short-term business profits have softened considerably, most corporate managers appear not to have altered to any appreciable extent their longstanding optimism about the future returns from using new technology… Corporate managers more generally, rightly or wrongly, appear to remain remarkably sanguine about the potential for innovations to continue to enhance productivity and profits. At least this is what is gleaned from the projections of equity analysts, who, one must presume, obtain most of their insights from corporate managers. According to one prominent survey, the three- to five- year average earnings projections of more than a thousand analysts, though exhibiting some signs of diminishing in recent months, have generally held firm at a very high level. Such expectations, should they persist, bode well for continued strength in capital accumulation and sustained elevated growth of structural productivity over the long term.”

Such expectations, needless to say, have not persisted, and the Wall Street analysts who held them have been scorned and mocked. Not only have earnings plunged, but sales have weakened, undercut by the unforeseen disappearance of demand. “Business sales,” observes Moody’s Lonski, “are down minus 0.7% in the second quarter of 2001 from the second quarter of 2000. This is the sum of retail sales, manufacturing and wholesale sales. Manufacturing got clobbered – it is down 4.5%. The last time business sales were down year-over-year was the three quarters from the first quarter of 1991 to the third quarter of 1991.

“Before that was the five quarters from the first quarter of 1982 to the first quarter of 1983. And before that, it was in the 1970s, when inflation made the numbers do funny things, but it was in the first quarter of 1970. All the previous declines occurred in and around recessions.”

Alan Greenspan never understood the problem. This defect does not mean he will never hit on the solution. What it does suggest, however, is that he will come to it belatedly, and likely for the wrong reasons.

James Grant,
August 16, 2001

for The Daily Reckoning

James Grant is the founder of Grant’s Interest Rate Observer (www.grantspub.com) and author of several books including Money of the Mind: Borrowing and Lending in America from the Civil War to Michael Milken, and The Trouble with Prosperity. Mr. Grant recently hosted “Time Machine: The Crash” on The History Channel and is a regular commentator on CNN and a panelist on “Wall
Street Week with Louis Rukeyser,” as well as a frequent columnist with the Financial Times and Forbes.

*** “ohayougozaimasu” – the saga continues…yesterday we noticed Japan’s economic minister announced a “surprise” drop of interest rates in the hopes that they can stave off recession until the U.S. economy gets back in gear this fall. Economic minister Heizo Tekenaka has labeled the new quantitative ease “super-zero rates”…

*** Meanwhile, on the front lines of the global economic “resurrection” effort…things are looking bleak. “Forget the Fed,” urges a Financial Post headline, “save yourself.”

*** “Investor confidence in Mr. Greenspan rests on a string of Federal Reserve successes,” the article suggests. “Rate cuts brought us safe landings after the 1987 crash, and again during the Asian crisis in 1998. But it’s Mr. Greenspan’s very success that is to blame for today’s difficulties. Believing in the omnipotence of the Fed, consumers and businesses have imprudently racked up unsustainable levels of debt.”

*** But why, we ask with tedious regularity, won’t the Fed’s elixir nurse the U.S. economy back to health this time?

*** Here’s a clue: Since January 3rd of this year the Fed has chopped rates 6 times… a feat they’re likely to repeat on Tuesday. The Fed funds rate has fallen from 6.5% to 3.75%… But interest rates on credit card debt – at over 15% – have barely budged. Consumers – with U.S. $650-billion of debt – are not getting any relief from Fed inducements to pile on more debt.

Furthermore, banks have taken the Fed’s cue and slashed the interest they pay on cash accounts. Those who rely on short-term interest income are likely to be hit with a 30% decline in “interest income”. Mortgage rates are heading down, but the refinancing binge is simply paying down personal debt.

*** “Students of economic history will know we’ve been here before,” the FP reminds us. “In Japan, stock prices are down 65% from their 1989 peak – even though interest rates have been cut to nearly [super]-zero. In the Dirty Thirties, interest rates fell from 6% to 1.5% [oh, so similar to our current pace], but it was not enough to prevent stocks from delivering their worst performance in history.

“Both crises had this in common: They happened in the aftermath of heavy speculative bingeing, massive buildup of public and private debt and steep declines in personal savings.”

*** Modest prediction: when the glow of summer evenings fade, so will “investor confidence” in the Fed and its chairman. Then what? Look out below.

*** So it goes…what’s up on Wall Street, Mr. Fry?

*****

Eric Fry reporting from New York:

– During the nuttiest phase of the bubble, Charles Schwab Inc. just had to have a Wall Street address. And so…last year, the discount brokerage firm opened a gleaming new office just down the block from me on Wall Street. Across the front of the office, a very large sign continuously flashed price updates for the Dow, the Nasdaq and, of course, the Schwab Index.

– During the bubble, it became a pleasant daily diversion for the local office workers passing by to gaze up at the sign, watch the stock market go up for a while and mentally recalculate their soaring wealth. Now the sign is dark. In fact, it has been dark for weeks. It is not missed.

– Yesterday was a good day for new lows. The Nasdaq slumped to a four-month low; the dollar dropped to a three-month low; and capacity utilization, at 77%, hit an 18-year low.

– The Nasdaq tumbled 45 points to 1,919, its lowest close since April 16. The big stocks in the Nasdaq seemed to suffer the brunt of selling, as the Nasdaq-100 dropped 3.6%. The Dow fell 66 to 10345.

– Lately, the commodities markets are playing host to the hottest trading action. Yesterday, natural gas grabbed the excitement with its largest one-day gain in eight months. Kicking off the rally was a report from the American Gas Association indicating that natural gas supplies are well below expectations. Gas for September delivery rose 37.4 cents, or 12.1%, to $3.47 per million British thermal unit.

– Natural gas stocks soared as well. The rally was probably overdue, as these stocks have suffered mightily during the past couple of months. You’d think the natural gas companies were struggling to make money. They aren’t. At current gas prices, most companies in the sector are minting money.

– Moody’s points out, “In contrast to the 6% revenue growth rate and the 20% decline in profits of all U.S. companies, oil and gas concerns posted aggregate revenue growth rates of around 86% year-to-year and aggregate profits growth of nearly 57% year-to-year.” Keep a close eye on this group, folks.

– Elsewhere in the commodity sector, U.S. gasoline inventories fell for a fifth consecutive week. Come what may, we Americans still drive our cars. Amazingly, even in a slowing economy, gasoline demand since June 1st is 3.8% higher than during the same period last year.

– Finally, as noted in the Daily Reckoning earlier this week, coal prices remain very strong. “Although natural gas prices have dropped about 70% this year,” reports Bloomberg News, “market prices for coal had remained strong. In July, prices for low-sulfur coal…reached their highest levels since 1989.”

– And while commodities climb, so do most foreign currencies against the greenback. The euro shot up to more than 91 cents yesterday. The dollar is looking a little worn (pun intended).

– Are you sitting down? Last year, a Senate study found that 77% of all day traders lose money (It’s hard to believe, I know). Ironically, one Harvey Houtkin testified before Congress to refute these claims.

– As (bad) luck would have it, Mr. Houtkin, the self- proclaimed father of day trading and also chief executive of All-Tech Direct Inc., a Montvale, N.J.- based brokerage for active investors, has had more than a few bad trading days. He lost $392,000 in 1998 trading a company account.

– The news of the loss became public in an arbitration that four former clients of All-Tech brought against the firm, claiming they were misled by the company’s aggressive advertising. Do you think they have a case?

– The high-end home construction industry is living off of last year’s harvest. Friends of mine who build $2 million to $5 million homes tell me that business is slowing… future business that is. Says one, “everyone’s living off projects commissioned one or two years ago. I’m not seeing anybody getting new jobs for next year and beyond.”

– Says the other, “The spec market for $2 million homes is dead, but my bread-and-butter custom home construction business is booked for the next twelve months. After that, who knows. I just hope things pick up by then.”

– So do I, my friend. So do I.

*****

Back to Addison Wiggin, in Paris…

*** What else? How about this e-mail I recently received from friends “in the business” in New York. The CEO of a firm that hosts conferences for venture capital professionals and tech start-up entrepreneurs seeking funds wrote to his troops recently:

“Although our customers are startups and those who provide them with capital, we have been relatively unaffected by their troubles – until recently. Now, however, we are suffering, too, and we must adapt.

“The process of creating new companies, of which we are a small part, seems to be returning to its historic patterns. This year, I look for fewer than two dozen technology IPOs; that’s down from 300 last year. Going forward, I expect four or five years to pass before the typical start-up is ready to sell shares to the public…as opposed to the 18-month pace of last year and the year before.”

*** The e-mail goes on to announce the closure of the San Francisco office, layoff of the staff there, and the early retirement of its biggest cheese.

*** Apart from the usual “negative drivel” we normally publish at the Daily Reckoning…it might be worth noting that the author of this e-mail is a CNN correspondent, a columnist for Fortune Magazine and the Wall Street Journal and a personal adviser to Bill Gates, Michael Dell and Steve Jobs.