The wonderfully confusing language of the former Fed Chairman in the equally confusing academic field of economic forecasting
05-Jun-2015 •Vivek Kaul
Alan Greenspan, the former chairman of the Federal Reserve of the United States, was a master at speaking in a roundabout way. One of his famous quips was: "I know you think you understand what you thought I said but I'm not sure you realise that what you heard is not what I meant."
In a speech Greenspan gave on December 5, 1996, he said: "Clearly, sustained low inflation implies less uncertainty about the future, and lower risk premiums imply higher prices of stocks and other earning assets. We can see that in the inverse relationship exhibited by price/earnings ratios and the rate of inflation in the past. But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade?"
At the end of the speech he wondered if financial markets would understand what he was really trying to say. The phrase to mark in this 4,344-word long speech was "irrational exuberance." In simple English, what Greenspan was effectively saying was that there was a bubble in the stock market.
Financial markets were by then used to Greenspan's way of speaking and they sure did get the message. The Japanese stock market, which had opened by the time Greenspan finished his speech, reacted instantly. The Nikkei index dropped 3.2 per cent. The Hang Seng in Hong Kong dropped 2.9 per cent. The DAX in Germany went down 4 per cent and so did the FTSE 100 in London. The next day, when the stock markets in the United States opened for trading, the Dow Jones Industrial Average was down 2.3 per cent.
When the stock market opened for trading again on December 9, 1996, after the weekend, it was back trading at the levels it had been at before Greenspan had made the "irrational exuberance" speech. Dot-com stocks drove the American stock market from strength to strength in the years to come.
As the economist Ravi Batra writes in Greenspan's Fraud: "The lure of free lunch is so powerful that it clouds our vision. For once Greenspan had offered words of wisdom, but in doing so he lost his audience. The master bartender wanted his customers to sober up. They wanted more: whiskey, champagne, rum, just bring it on."
Greenspan never used the phrase "irrational exuberance" again. In fact, he came around to the view (at least publicly) that bubbles can be recognised only once they have burst. As he told the US Congress in June 1999: "Bubbles are generally perceptible only after the fact. To spot a bubble in advance requires a judgement that hundreds of thousands of informed investors have it all wrong. Betting against markets is usually precarious at best." Instead the central bank could only "mitigate the fallout" once the bubble burst, Greenspan believed.
So the Federal Reserve could not spot a bubble. But once it had burst, steps could be taken to ease its fallout, Greenspan felt. As he said in a speech titled "Economic Volatility" on August 30, 2002: "The notion that a well-timed incremental tightening could have been calibrated to prevent the late 1990s bubble is almost surely an illusion. Instead, we noted in the previously cited mid-1999 congressional testimony the need to focus on policies "to mitigate the fallout when it occurs and, hopefully, ease the transition to the next expansion."
There is a fundamental problem with this argument. Greenspan was basically saying that the Federal Reserve could not recognise a bubble, but it could figure out when the same bubble had burst. If ever there was a convoluted argument, this was it.
As Raghuram Rajan writes, in Fault Lines, about Greenspan's speech: "This speech seemed to be a post facto rationalization of why Greenspan had not acted more forcefully on his prescient 1996 intuition: he was now saying the Fed should not intervene when it thought asset prices were too high but that it could recognize a bust when it happened and would pick up the pieces."
There is an important lesson that emerges here. As Humphrey B. Neill writes in The Art of Contrary Thinking: "The whole field of economics remains a 'guessy' one. Little, if any, progress has been made over the years in attaining profitable accuracy in economic forecasting. And, mind you, this condition still exists, notwithstanding the extraordinary volume of statistics that is now available...which was not known to former forecasters."
Neill wrote the book in 1954 and not much has changed more than six decades later. While Greenspan was right in calling the bubble, he came in when the bubble was 'possibly' still in its early stage. The bubble continued for the next few years.
So Greenspan was right and wrong at the same time. He did predict the bubble correctly. But he got the timing horribly wrong. Why? What makes economics a very 'guessy' subject as Greenspan found out is that it is very difficult to predict how people will react. As Neill writes: "You may have all the statistics [Greenspan surely did] in the world at your finger tips, but still you do not know how or why people are going to act."
Further, people expect a trend that has started to continue for a while. As Neill writes: "It has been my observation that it takes us average humans a considerable interval to shift our viewpoints, once we have established a given mental outlook. That is, if we have (mentally) accepted a trend as moving in one direction, we are not inclined to change our outlook until well after the trend turns." This is precisely what did Greenspan in. And therein lies a lesson for all of us.
Vivek Kaul is the author of the Easy Money trilogy. He can be reached at [email protected]
This column appeared in the May 2015 Issue of Wealth Insight.