The Second Most Powerful Man in the World

Leading up to another meeting of the Fed, we thought it might be worth taking a look at what we were saying this time last year with regards to the same topic.

Forthwith, a DR CLASSIQUE originally broadcast on August 16, 2001, by James Grant, editor of Grant’s Interest Rate Observer (www.grantspub.com). Mr. Grant explores Fed Chairman Alan Greenspan’s culpability in accommodating, celebrating and defending the most excessive investment bubble in the history of mankind.

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 boom.

"[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,
for The Daily Reckoning
August 12, 2002

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.

"Try as it might," writes Strategic Investment’s Dan Denning, "Japan cannot get savings-minded consumer to spend. Nor can it get its banks to pump money into the economy to stimulate economic activity. There is simply no demand for new services or new capacity."

Economic malaise, consumer ennui… are these the kind of things the average American ought to get used to? "In America," Denning suggests "the psychological worm has not yet turned, although it may soon. In America, the government can’t get consumers to STOP spending money they don’t even have. And so now, as usual, the burden falls on the American consumer to rescue the world from deflation."

But what if the consumer doesn’t cooperate?

On a like-minded note, Ray Devoe suggested this week in a Reuters interview that we might expect the same slow-motion boredom in the stock market. Devoe: "The final stage [of the bear market] may not necessarily be a sharp sell-off that clears the air," like the press and Wall Street are pining for. "Rather it will be complete exhaustion, followed by (investor) contempt for stocks as an investment vehicle."

Bear-market routs have been known to end with widespread investor panic but, "there is just too much stock in the hands of the public for this to occur," says DeVoe.

"There is over $4 trillion in stock mutual funds and the question about a V-shaped climax and recovery, if the public does decide to dump stocks, would run into the classic, ‘sell to whom?’"

Eric, what’s the word on the Street?

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Eric Fry in New York…

– The market stumbled early on Friday, but the dip-buyers appeared on cue to rescue the Dow from a triple-digit loss, and carry it to a 33-point gain. For the week, the blue-chip average soared 432 points, or 5.2%, to finish at 8,745. The NASDAQ meanwhile, dropped 10 points Friday, but still put in a solid performance for the week by gaining 4.7% to close at 1,306. The Standard & Poor’s 500 advanced 5.1% to 908.

– Gold rebounded from its Thursday selloff to gain $3.80 Friday to $316 per ounce. Over the full week, gold rose 2.3%, despite the strong stock market.

– "Is the stock market rally for real? The answer is yes. Is it for long? The answer is no," writes Alan Abelson in this week’s Barron’s. "On the first score, the market, we don’t have to tell you, has taken a fierce pounding and is entitled to a decent bounce.[But] our doubt that the respite is anything more than your typical run-of-mill bear-market rally is grounded in the fact that the economy is punkish and due to get worse. And there’s this: Too many folks are still bullish. Richard Bernstein, Merrill Lynch’s top strategist, for instance, reports that an astounding two-thirds of his fellow seers are bulls. When we finally hit bottom, they’ll all be bearish — or unemployed."

– Abelson’s colleague at Barron’s, Micahel Santoli, offers another interesting (and bearish) perspective on the stock market’s current prospects. "Exactly 20 years ago," he writes, "on Aug. 12, 1982, the Dow and the S&P 500 hit low points they’ve never revisited and, barring unthinkable chaos loosed on the world, never will. That was the beginning of the biggest and longest bull market in history, begun quietly in ripest summer and in the depths of a recession, with the Dow at 776 and the S&P at 102. Even after the wealth destruction of the past two years, the value of U.S. stocks is enormously higher than it was in those bleak days two decades past, of course."

– In short, Santoli observes that August 12, 2002 bears almost no resemblance to August 12, 1982. Comparing the two eras "raises questions about some current bullish arguments."

– "The U.S. economy in 1982 was suffering its worst postwar recession; Treasury yields sat at 13%; oil was fetching $34 a barrel; and the Dow was below its level of 14 years earlier, having just lost 25% in the 14 months prior to what would prove to be The Bottom. Most blue-chip stocks in the Dow were wallowing at about 4-8 times earnings, the Dow collectively had a 7% dividend yield."

– By contrast, Santolli notes, "Most bullish arguments today begin with an overture that recites what stocks have in their favor in terms of the broad economic backdrop, namely low interest rates and mild inflation. But these factors fail to form a persuasive case for outsized gains from current levels.

– "This doesn’t speak to shorter-term opportunities or the ability of the Dow to ascend back toward its years-long trading range between 9000 and 10,500 or so," Santoli winds up. "But it puts the talk of bottoms in some perspective. Happy anniversary."

– Jim Grant also throws cold water on the notion that The Bottom has arrived by citing the superb work of Andrew Smithers. "As a quant, Smithers believes that certain things are exactly true and others are exactly not. Among the true things are these: Stock prices are mean-reverting; when they diverge too far from the average return, they go back to it. The long-term real return on equities averages around 7%. The long-term P/E ratio averages around 14.And the long-term real return to investors on their shares must be the same as the real return to corporations on their equity. It’s a mathematical truism."

– In other words, the stock market still has some mean-reverting to do before this old bear market will have finished its work.

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Back in Paris…

*** "The developing world can’t jump from an agrarian society," "to a laptop society without building infrastructure: roads, schools and the like." our own John Myers said in a Forbes.com interview last week.

"It’s going to take gravel, cement, lumber, petroleum. These countries that are trying to build themselves up have to go through an industrial revolution, which is fueled by oil, coal, minerals and other resources. So the way I see it, you have surging demands and declining supplies. Think of it: If the Chinese reach their goal by 2010 of having as many cars per capita as the European nations, the world would run out of oil in five years."

Because of the weakening U.S. dollar and federal debt and because commodity prices worldwide are measured in U.S. dollars, Myers predicts that "as the greenback slides, as it did in the 1970s, the prices of commodities [will] rise."

"In recent months, the dollar has been fading," Myers continues. "Why? For one reason, the government has been printing money like crazy, making it worth less. Last June the adjusted monetary base was $66 billion. Three months later, it was $87 billion. And a weak dollar is just one of the fundamental factors I see setting the stage for a runup in commodities. There are trillions of dollars jumping out of the stock market, looking for new opportunities, feeding a growing demand for real, hard assets."

*** It’s the opening to a hectic week, here at the Daily Reckoning. Bill is making his way back to Paris after a whirlwind Baltimore-Aspen-Nicaragua tour… he’ll be back on the job tomorrow. Addison and crew are making their way [in slow-motion] to San Francisco for the annual Agora Wealth Symposium… which begins on Wednesday.

For any delays in the arrival of your Daily Reckoning, we apologize in advance. We promise we’ll do our best to keep the program on schedule. Thanks for your understanding…

Addison Wiggin,
The Daily Reckoning