Greenspan's Bubble

John Mauldin poses the ever-insightful question: If the Fed, short of destructive policy, can do nothing to stop a bull market, then why do so many analysts assume that the Fed has some power to forestall a bear market?

More important and interesting economic analysis has come across my desk in the last few weeks than at any time I can remember. I have spent a lot of time pondering the meaning of several very different items, trying to see how the dots connect. I do so in the hope that my endeavor will reveal clues as to the right investment posture to take in the future.

Thus, I have masochistically thought long and hard about Greenspan’s recent speech in Idaho. Most of the analysis I have read seems to state that Greenspan was saying: “…

1. Yes, there was a bubble in the stock market, but how could we have known it at the time? and;

2. Even if we did know it, tightening the money supply to bring about a recession as a way to pop the bubble would have been unacceptable, and further;

3. The mission of the Fed is to control inflation and to provide stimulus to promote growth in times of weakness, therefore;

Lastly, “the Bubble wasn’t my fault because it was not in my job description. Anyway, there was nothing I could have done about it.”

Greenspan has been drug over the coals for that speech. Many have commented upon the fact that Greenspan clearly identified the presence of a stock market bubble in 1996, and in one very well documented remark stated that he could absolutely deflate the bubble by raising the margin requirements on stock brokerage accounts.

There were calls from many quarters, including this one, for him to do so. He did not, and he is now, quite correctly, catching grief for that failure.

I don’t have any quarrel with that analysis. But reading the speech left me feeling there was something else that Greenspan was saying. I couldn’t put my finger on it until I read Pimco’s Paul McCulley and his brilliant analysis:

“Greenspan was honest in acknowledging that the putative stabilizing properties of entrepreneurial capitalism, if believed by the masses and embedded in equity prices, lose their stabilizing properties. Heady, heady stuff, borrowing – without saying so – from Hy Minsky’s thesis that macroeconomic stability itself can be de- stabilizing, if and when the widespread belief in macroeconomic stability begets unstable financial arrangements.”

Let me translate: Greenspan said the Fed did its job and slowed down inflation and created an environment of economic stability and growth. When combined with an increase in productivity, a favorable international trade environment and new technological innovations, this priced an unusually favorable and growing economic environment.

Investors, businessmen and consumers began to assume that these conditions would continue into the future. We made investments in stocks, production capacity and spent money on a burst of consumption based upon our own oversized expectations, or what Greenspan called in 1996 “irrational exuberance.”

McCulley tells us that the sheer fact that things were so stable and so positive led to the conditions that created the instability. This is not a new concept. It is called boom and bust economics.

Greenspan seems to be saying that the Fed can do nothing that is politically feasible to combat the boom-bust stock market cycle, other than administer some aspirin (rate cuts and easy money) after the party! Let me quote directly from Greenspan’s speech:

“Moreover, it was far from obvious that bubbles, even if identified early, could be preempted short of the central bank inducing a substantial contraction in economic activity – the very outcome we would be seeking to avoid.

“Prolonged periods of expansion promote a greater rational willingness to take risks, a pattern very difficult to avert by a modest tightening of monetary policy.”

I may be missing something, but this seems to me to be a complete rejection of New Era economics! He seems to be saying that the longer the period of economic stability, the greater the bubble that will result.

In essence, Greenspan was saying that the stock market trends with a mind of its own, and there is nothing the Fed can do about it, short of causing a recession, which they have the power to do. In another section, he even stated that if the Fed had tightened the money supply, thereby choking the Bubble, that as soon as they began to ease again, the Bubble would resume, unless the Fed actually caused a recession!

“See,” he says, “I was helpless. You guys were determined to drive the stock market up.”

What is fascinating to me, and what is missing in his post-speech analysis, is what is implied but not said in this speech. Again, laying aside Paul Krugman’s argument that we will never know what would have happened if Greenspan had raised margin requirements, let’s look at the other side of Greenspan’s coin.

If the Fed, short of destructive policy, can do nothing to stop a bull market, then why do so many analysts assume that the Fed has some power to forestall a bear market?

The point of the speech was not simply to justify his actions (or lack thereof), but to clearly communicate that the Fed can only do so much, and that controlling investor sentiment is not one of the levers they have. The main goal of the Fed has been to control inflation, which they have done. In fact, I have argued that much of the increase in the money supply we have seen in recent years is now an effort to combat deflation.

I will not address the argument that the increase in the money supply resulted in the stock market bubble. There may be some justification to that. The point to be understood here is Greenspan’s explicit admission of the lack of Fed power over the stock market. This is a clear challenge to those analysts and cheerleaders who think that somehow Fed policy will return the stock market to its former bullish ways. Investors would be wise to take note.

Warm regards,

John Mauldin,
For the Daily Reckoning
September 19, 2002

Editor’s Note : John Mauldin is the creative force behind the Millennium Wave investment theory and author of the weekly e-mail The Millennium Wave Investor. As well as being a frequent contributor to the Fleet Street Letter and Strategic Investment, Mr. Mauldin is authoring a book titled “Absolute Returns”, covering the hedge fund industry. You can learn more about Mauldin’s work by subscribing to his free e-letter…

The Accredited Investor Letter

How does the world end?

Not with a bang. But perhaps with Alan Greenspan’s whimpering excuses in Jackson Hole a few weeks ago. “Suddenly, everybody’s attacking the maestro,” writes Richard Russell. (See Jim Grant’s comments…and John Mauldin’s…below…)

And so, it has happened.

The world in which people mistook the Fed chief for a genius has come to an end. With each day that passes, his stock gets marked down a little more.

It will be many years before people again believe the inflated promises of central banking – that a banking cartel represented by the Fed and led by a mumbling bureaucrat can somehow smooth out the age-old boom/bust wrinkles and turn the fabric of the world’s economy into perma-pressed prosperity.

For if the greatest central banker of all time couldn’t spot a bubble forming – who can? And if he couldn’t do anything about it – who could?

Instead of pressing down the bubble…or pricking it…the benighted Fed chairman blew hot air into it and made it worse. Pretending that everything was under control and that systemic risks had been eliminated, he led investors and consumers to do what they otherwise would not. The former bought stocks that they shouldn’t have…the latter spent money that they didn’t have. Those who do not yet regret it will someday soon, we predict; they are losing their wrinkled shirts.

We urge readers to invest in gold – not because we know what will happen next, but because we don’t. Gold rose $3.60 yesterday. J.P. Morgan, the world’s largest holder of derivative contracts and one of many proxies for Greenspan’s reputation, fell. The stock – which was as high as $67 when “Maestro” was on the bookstore shelves – has lost 40% of its value this year and recently dropped below $19. Yesterday, the House of Morgan disclosed that it would lose $1.4 billion from bad loans.

Why are so many loans going bad?

Because Greenspan’s bubble corrupted not just the stock market, but the whole economy. Instead of borrowing money to invest in profitable new production, businesses borrowed to boost their own stock prices. That’s what ‘delivering shareholder value’ was all about.

Businesses debt soared $2.8 trillion in the 1995-2001 period. “But its proceeds went overwhelmingly for the corporate merger, acquisition and stock buyback mania,” explains Dr. Kurt Richebacher. “Obviously, the debt and credit creation that finances this kind of spending adds nothing to GDP growth.”

Without real growth in the economy, businesses have little profits and consumers have little extra money to spend. Instead, the bad investments get worse…and the interest on the bad debts compounds.

“A dismal retail season,” predicts the N.Y. TIMES. “Slowest sales in 5 years seen for holiday,” says the leading paper on the other coast. Spending in the Christmas season usually follows the pattern of the Labor Day sales – which weren’t great.

Eric, can you give us the latest from Wall Street?


Eric Fry in New York…

– The Dow tumbled about 150 points in the early going before reversing course in the afternoon. The blue chips managed to limp into the closing bell with a modest 35- point loss at 8,172. The Nasdaq dipped a mere 8 points to finish the session at 1,252. But some of the numbers behind the headline numbers told a more woeful tale. Only 22 Nasdaq stocks registered a new 52-week high yesterday, while a whopping 229 stocks fell to new yearly lows…The bear market lives.

– “Post-bubble shakeouts don’t end quickly,” writes Morgan Stanley strategist Stephen Roach. JP Morgan’s dire third-quarter earnings warning on Tuesday certainly makes Roach’s point. The nation’s largest lender blamed its profit shortfall on a litany of post-bubble era woes. Miniscule trading profits and soaring defaults among telecom companies were but two of the troubles plaguing Morgan.

– “It’s like peeling away the layers of an onion,” Roach continues. “Nasdaq was the first layer to go, followed by IT and then telecom. But there are still more layers to come off this onion. They include the dollar bubble, the property bubble, and the biggest bubble of them all – the American consumer.

– “The consumer bubble will undoubtedly be the last to go,” says Roach. “Saving-short and overly-indebted, the aging America population is coming to that point in the life-cycle when it must begin to come to grips with the looming reality of retirement…So what might cause this last bubble to pop? It’s hard to say…[Maybe] a spike in oil prices, a surge of white-collar layoffs, or a deflation of the property bubble…Whatever the trigger, I have little doubt of the end game for the consumer bubble.

“And so the world economy is likely to remain in the doldrums for some time to come…I see only two ways out from this vicious circle – a purging of America’s post- bubble excesses or the emergence of a new engine of global growth. Until I am convinced that either one of these two saviors is on the scene, I see little reason to alter this dour prognosis.”

– Most CFOs agree – more of less – with Roach’s “dour prognosis.” According to a recent survey conducted by, “CFOs are the most pessimistic about the short- term prospects of the U.S. economy since December of last year.”

– According to’s Global Confidence Survey of U.S. finance executives, “58 percent of those who responded say their attitude toward the domestic economy in the next year is either ‘concerned’ or ‘very pessimistic,’ up from 19 percent in the last quarter.”

– In other words, CFO pessimism has tripled in just three months!

– “So just when do they expect things to brighten up?” wonders. No time soon is the answer. “Only 16 percent expect a broad recovery to begin this year. Another 35 percent expect the recovery to begin in the first half of next year, while 29 percent say it won’t start until the second half of next year. And 20 percent aren’t looking for things to get a whole lot better until – yikes – 2004.”

– Lastly, from the “sign of the times” category, observes: “For the first time since the survey was begun in September 2000, ‘increased regulation’ and ‘accounting concerns’ weighed heavily on the minds of respondents, with 43 percent ranking one or the other among their top three concerns.” It’s just no fun playing by the rules.

– Last week, the Daily Reckoning expressed its amazement over Alan Greenspan’s infamous “It’s not my fault” speech in Jackson Hole. The inimitable Jim Grant offers a few more choice words about the Chairman:

“On August 30, at the annual monetary jamboree of the Kansas City Federal Reserve Bank in Jackson Hole, Wyo., Alan Greenspan washed his hands of responsibility for the bubble he said he could not have pricked even if he had noticed it floating above his desk on a string…The Chairman’s Jackson Hole speech has been, will be and should be deplored as the worst kind of self-exculpating revisionism…Until he presided over the great bull market, Greenspan did not give many outward signs of genius. But the higher stock prices went, the smarter he seemed to become. By late in the 1990s, he was heralded as a miracle worker…At the peak of their renown, Alan Greenspan and Robert Rubin seemed to work with tomorrow’s edition of The Wall Street Journal always open before them…[Greenspan] has been hailed as a saint and a clairvoyant. Now it develops that he is neither, but only a fellow in a business suit trying to hold his job and not look bad.”


Back in Paris…

*** “For the first time in 50 years,” begins an article in USA Today, “entrepreneurs are failing to lead the U.S. out of recession.” Self-employment hit a record low of 6.2% in February.

What’s wrong with America’s entrepreneurs? They seem to have lost some of their vim and vigor. USA Today guesses that they can no longer afford health care and start-up costs.

What happens to the world’s consumer economy when the consumers of last resort stop consuming, we’ve wondered? And now this…what happens to American entrepreneurial capitalism when the entrepreneurs stop entrepreneuring?

*** Even being a CEO, with health care insurance, is losing its appeal. A Harris Poll shows that just 16% of parents wish it on their children.

*** Greenspan’s dollar is probably toast too. The BBC reports that the euro is catching on in Russia, so much so that the government felt it necessary to warn citizens not to dump their dollars. Will people worldwide soon want to get rid of their dollars in favor of other paper…or gold? We don’t know, but it might be the sort of thing to protect against.

*** “Did you see that Vivendi publishing is for sale?” asked my friend, Michel, over lunch yesterday. Michel runs a small book publishing house specializing in Greek and Latin classics.

“You know how the capital markets work,” Michel continued. “Why don’t we raise a couple of billion dollars from investors so we can buy it?”

“But we don’t know anything about running a big publishing conglomerate,” I protested.

“We know more than the current owners,” he replied.

The Daily Reckoning