The Fed Chairman scared the daylights out of the financial markets this morning, with the Dow plunging more than 100 points and the long bond down 1½ points even before he read his prepared statement to the Senate Banking Committee -- as television reporters summarized his statement in the darkest possible terms. The actual text was only half as scary as the headlines, but that was bad enough, as the Dow’s loss was cut in half as he read the statement and the long bond retraced a third of its retreat -- only to unravel again later today as the news traveled into wider markets. For some reason, Greenspan chose to put the worst possible face on what he sees unfolding in the financial markets and the real economy. He not only amplified his remark of early last December about the irrational exuberance of the stock market, with an absolutely awful line about the drawbacks of free markets. He also sounded more sinister in warning that workers may soon start asking for bigger paychecks that he believes are inconsistent with low inflation, with the obvious inference that he would then have to throw the economy into reverse. The statement in its entirety reminds us that for all his qualities, Alan Greenspan still has embedded in him strands of thinking that are oddly elitist in their distrust of markets. My guess is that he now is perplexed at the market reaction to his testimony -- thinking his vigilance on inflation would bolster bonds even if stocks fell off somewhat.
His most distressing line, we think, was that “History demonstrates that participants in financial markets are susceptible to waves of optimism, which can in turn foster a general process of asset-price inflation that can feed through into markets for goods and services.” This “bubble” theory of market irrationality is really the basis for all interventionist agendas to be found in the history of political economy. That is, Greenspan is saying that he is better able to judge when the market rationally prices goods and when it does not, which gives him the right to intervene at those times when his better judgement takes over. This is still the conventional view of why the stock market crashed in 1929. It is also Greenspan’s view of why the market crashed on his watch in October 1987. This kind of thinking provides him with a rationale for actually causing a correction in the financial markets, as he did today, on the grounds that he is preventing a bigger crash in the future. He sees himself as guiding us through the business cycle with narrower amplitudes.
It’s not likely Greenspan will ever shoulder any responsibility for the ’87 Crash, human nature being what it is. It is a fact, though, that in the few days immediately preceding the crash, early copies of Fortune magazine were circulating on Wall Street with a rare Greenspan interview, in which he asserted the need to devalue the dollar by about 2% a year for several years to get it where it should be in relation to other currencies. At the time, the Louvre Accord negotiated by Treasury Secretary James Baker III early in 1987 -- prior to Greenspan’s appointment -- committed the United States to stable exchange rates. Baker has always gotten the brunt of the blame for the ’87 Crash, because of vague statements he and unidentified Treasury officials made about their willingness to see the dollar fall against the Deutschemark. The Greenspan interview in Fortune was another smoking gun, perhaps the bigger of the two.
Greenspan’s remarks about wage inflation are genuinely distressing, because they feed the Phillips Curve mentality that equates economic growth with monetary inflation. The Wall Street Journal’s excellent editorial this morning, “Phillips Think,” urged Greenspan to “do himself and the world a favor by finally burying the Phillips Curve, the notion that there must be a trade-off between inflation and unemployment.” Greenspan certainly doesn’t fear “irrational exuberance” in the bond market, for which he bears more direct responsibility. It baffles us how he gets away with fostering the view that he has to prevent wage inflation in order to protect corporate profit margins in order to prevent the stock market bubble from bursting. And the net effect is a dramatic sell-off in the bond market as well as in equities. The thrust of his remarks encouraged the markets to think he is now on a CPI standard and next month will be happy to lead the FOMC into a “pre-emptive” strike against inflation if he sees wages feeding into the CPI -- which, by the way, he believes overstates inflation by 1½% annually.
What we and the WSJournal editorial hoped Greenspan would say was that the decline in the gold price in the last three months, and the strength of the dollar on the forex markets, encourage him to believe inflation is under control -- and he will keep an eye on them. These are the primary indicators of incipient inflation he has cited in his career and of course are far better signals of monetary inflation. All he said in this area was to note “the appreciation of the dollar on balance over the last 18 months or so, together with low inflation in many of our trading partners, has resulted in a marked decline in non-oil import prices that has helped to damp domestic inflation pressures.” This is pure neo-Keynesian nonsense, compatible with the statement he gave Fortune in 1987 about having to devalue to get tradable prices where we want them to be. Worse, Greenspan goes on to say that “these influences, too, would be holding down inflation only temporarily, [as] they represent a transition to a lower price level than would otherwise prevail, not to a permanently lower rate of inflation.” Can he possibly mean he can’t be satisfied with a transition to a lower price level, which is what gold and commodity prices are signaling? Are we going to have to wrestle down a CPI that Greenspan already insists overstates inflation?
At the end of the day, all we can really say is that our favorite Fed chairman has been a big disappointment and should be ashamed of himself for scaring the daylights out of Wall Street, other global capital markets, and the widows and orphans who have been listening to the radio today. As for the fundamentals, nothing has changed. Greenspan even repeated his argument for elimination of the capital gains tax, in response to the very first question from Banking Chairman Al D’Amato. The price of gold is just where it began the day, which is $30 per ounce less than it was four months ago. The dollar today is stronger against the yen and Deutschemark than it was yesterday. The risk facing the market, in other words, is not an unexpected loss of dollar purchasing power but a higher probability that the Fed will engage in an ill-advised rate-raising episode. We still regard that as unlikely. Though the markets will be facing some rough waters in the weeks ahead, our forecast of a 6% long bond by year-end remains intact. It would have been nice if Greenspan had to come before the House Banking Committee tomorrow, to complete his Humphrey-Hawkins testimony. Alas, that session will be postponed until next Wednesday. The committee would have had an early opportunity to ask him if he was satisfied with the carnage he fostered, or would he like to try for a Crash? Now, we will have to wait a while for an answer.