Fed Chief Now Blamed for Inflating Stock Bubble


Americans desperately seeking to understand what happened to their once-ballooning investments and retirement nest eggs were offered a striking answer last week by the nation’s premier economic policymaker.

“Infectious greed” is behind the stock crash and corporate scandals that are erasing trillions of dollars of paper wealth, declared Federal Reserve Chairman Alan Greenspan. Otherwise, the economy is sound, he asserted.

But a growing group of economists and financial players have come to believe that the economy’s troubles go beyond the avarice of a few executives. Among the principal problems, they say, is Greenspan himself and the pivotal role he played in feeding a classic stock-market bubble that began to pop in early 2000.


“Greenspan clearly was the lead character in the drama of the market’s upside, and he’s the lead now it’s on the downside,” said Stephen S. Roach, chief economist at Morgan Stanley & Co. in New York and one of a small group of analysts who long decried the dangers of an overheated market.

As scandal has broken over one company after another, sending stocks tumbling, Americans have been offered the comforting thought that corporate America’s problems--and therefore the economy’s--could at least partly be solved with a few accounting reforms and some jail time for executive bad actors. Greenspan’s prescription was only the latest version.

What is really underway, analysts say, is the collapse of a classic stock bubble, in which share prices were driven to stratospheric heights by the hope of further gain rather than remaining tethered to something fundamental like a company’s profits.

If that is true, the future may require reduced expectations for millions of Americans who staked their hope for their comfortable retirement on stocks. The average recovery time--the length of time it takes the market to return to its boom-time peak--during the big busts of the 20th century was 20 years. Those declines were 1906, 1929 and the late 1960s.

And, as even President Bush acknowledged in his Saturday radio address, the effects are likely to reach well beyond retirees. “This is a crucial moment for the American economy,” he said. “Investors have lost money ... workers have lost jobs and the trust of the American people has been betrayed.”

So who or what was behind the stock bubble?

There was no single cause, but as much as any factor, say analysts, was Greenspan’s increasingly optimistic assessment of the economy during the late 1990s and especially its high-tech productivity gains.

“His comments about productivity definitely were fuel for the bubble,” said Gail Dudack, chief investment strategist for SunGard Institutional Brokerage Inc. in New York. She was among the group of analysts who warned of the bubble.

A comparison of the Fed chairman’s current assessment of the economy and the markets and his sunny pronouncements at the height of the 1990s boom suggest that, at a minimum, Greenspan mistook some of the bubble’s effects for evidence of a new economy.

Given his knowledge of economic history and his own repeated mention of bubbles during the final years of the decade, there is another possibility as well. That is that Greenspan may have been aware that a bubble was forming but decided he did not have the political power to stand in its way. Perhaps he was willing to stand aside because he was confident that he could guide the economy to a gentle landing when the bubble popped.

Whichever is closer to the truth, both the country and the central banker’s reputation as an economic manager face a serious challenge now.

“Central banking was really invented to stand in the way of excesses, whether it’s in the real economy or financial markets,” said Morgan Stanley’s Roach. “In this case, that didn’t happen,” he said.

Some observers argue that Greenspan can be forgiven for not wanting to stand in the path of the expanding bubble when even his mildest, early warnings set off a political hue and cry.

Consider, for instance, his December 1996 “irrational exuberance” speech, which is remembered as the central bank equivalent of Horatio at the bridge. In fact, the phrase came on the eighth page of a 10-page speech on the history of central banking in America, and then only in a question: “How do we know when irrational exuberance has unduly escalated asset values ... ?” But the words made front-page news, and the criticism directed at Greenspan was swift and savage.

Or consider the Fed’s decision four months later to nudge up interest rates a modest quarter of a point. “People went wild,” remembered veteran Fed watcher and economist David M. Jones. “I’ve never seen the right and the left of the political spectrum so up in arms over such a tiny move.”

Even if Greenspan knew a bubble was forming, he can also be forgiven for being confident he could protect the economy from it.

After all, he had already guided the country through the 1987 stock crash and the late 1980s-early 1990s commercial real estate bust seemingly without a scratch.

What is harder to understand is the lengths to which the Fed chairman went after the early warnings of 1996 and 1997 to highlight positive economic developments, especially involving productivity.

What’s also hard to understand--or square with his current assessment--is a slow shift in Greenspan’s focus: from embracing the new economy notion that technology was transforming America, to a seemingly uncritical defense of sky-high and rising stock prices.

A review of Greenspan’s speeches and testimony show that he knew as early as 1995 that the stock market was changing the economic landscape.

He warned participants at the annual economic conference in Jackson Hole, Wyo., that year that old ways of measuring prices and production no longer worked.

“There are important but extremely difficult questions surrounding the behavior of [stock] prices” that must be answered before policymakers can be confident again of their ability to steer the economy, he said.

There are records showing that, in the fall of 1996 and again in the spring of 1998, members of the policymaking Federal Open Market Committee argued for raising interest rates to pop the bubble.

And in a May 1998 interview with Lawrence B. Lindsey, a former Fed governor who has since become President Bush’s chief economic advisor, Greenspan acknowledged striking parallels between the years leading up to the 1929 crash and the late 1990s. But he noted confidently that if actions after the 1929 crash “were taken differently ... we would not have had the deep fall that we know as the Great Depression.”

Despite all these indications that Greenspan understood the danger, the Fed chairman seemed to move ever closer to embracing the wild run-up in stock prices.

When asked, for example, at a January 1999 congressional hearing how much of the dot-com boom was “based on sound fundamentals and how much is based on hype,” Greenspan snapped, “You wouldn’t get hype working if there weren’t something fundamentally, potentially sound under it.”

In a speech a few months later, he suggested that Wall Street analysts must have known what they were talking about when they predicted a historically unprecedented 15% annual growth in profits for the following five years because they were so close to the companies they covered.

By June 1999, he appeared to have given up any effort to put a brake on the upward arc of stock prices, arguing, in effect, that markets know best. To conclude otherwise, he warned a congressional committee, “requires a judgment that hundreds of thousands of informed investors have it all wrong.”

The Fed chairman’s defenders argue he was deterred from acting against the bubble by the triple whammy of the Asian currency crisis, Russian debt default and the collapse of hedge-fund giant Long-Term Capital Management. They point out that within weeks of the June testimony, the central bank approved the first in a string of interest rate hikes that brought an end to the great bull market of the 1990s.

But the fact that stocks have continued to tumble and that one company after another has admitted using shady accounting to prop up share prices suggests that the Fed’s action came too late certainly to protect investors and, perhaps, to protect the economy as well.

Indeed, some analysts worry the central bank’s decision to reverse course last year, driving interest rates to a 40-year low and hold them there to limit the market damage and cope with fallout from Sept. 11, could be setting the stage for the next bubble, this one in housing.

Greenspan said recently he does not see a housing bubble in the works.

In the late 1990s, “an irrationally exuberant equity bubble was

“Today’s script seems hauntingly familiar.”

An overly long rise in housing prices “is being legitimized as a sustainable source of economic expansion,” he said.

“From bubble to bubble, there seems to be no stopping the follies and perils of [stock-] and debt-driven economic growth.”