“Until some of these guys go to jail, we are not going to see a correction in the market.” When I read that phrase in a letter to the editor a few weeks ago, my mind boggled. The market was correcting downward every day. What more did the letter writer expect?
Duh! Then it hit me: This fellow was thinking of a “correction” as an upturn in the markets. I still viewed a correction as downward movement from what I saw as the unsustainable levels to which the Dow had so miraculously returned after Sept. 11.
But my misreading of an angry letter raises an important question. What is the “correct” level for equity markets right now and what role do present day “malefactors of great wealth” such as Ken Lay or Bernard Ebbers play in recent stock price drops? Is fraudulent corporate accounting responsible for driving share prices below where they would “correctly” be otherwise or are current scandals merely additional straws on straining camel backs?
Only time will tell. I was a history major before turning to the discipline of economics, and the part of me that is still a historian has been yelling, “Bubble! Bubble!” for some time. When Federal Reserve Chairman Alan Greenspan warned of irrational exuberance in December 1996, I felt reassured that I was not the only guy wondering how long markets could defy gravity. But the great high-tech bull market ran on for another four years.
The current downturn is the sort of natural correction that has occurred after major run-ups in financial markets in the United States and elsewhere over the past 400 years. Bad news about corporate accounting may be the precipitating factor, but historical precedent teaches us that there were few chances that the Dow could have hung on above 10,000 and the Nasdaq above 2,500.
Why not? Greenspan hit the nail on the head in his 1996 speech. When there is a long, multiyear period of rising stock prices, irrational exuberance sets in. Recent, widespread good news overpowers ancient history from 1974, 1964, 1929 or 1907. People assert that things are different now, that what goes up need never come down, that the old economic rules of thumb are obsolete.
But they never are. Every run-up in stock prices comparable to that from 1993-2000 has been followed by a substantial drop that took years, not months, to overcome.
Greenspan was certainly correct early last week when he said that fundamental aspects of the U.S. economy are solid. This is not to say that accounting scandals have not taken a toll on investor confidence. As in the past, busts expose flaws in economic and political systems that remained ignored as long as things went up and up.
But while the government should take action to fix some obvious problems, history also tells us that immediate interpretations of what went wrong often are not upheld in the longer view of history.
After the stock market crashed in 1929-1930, public attention focused on short sellers, buying stock on margin and the dual roles of banks as lenders and market players. Few looked at monetary policy and Fed actions both before and after the crash.
Historians across the political spectrum from left to right now give much greater weight to the Fed’s too-liberal monetary stance in the last half of the 1920s followed by a too abrupt tightening in 1929 and a criminally inept hands-off policy as the money supply shrank by nearly half in the two years or so following the crash.
Margin calls and short selling did play a role, but a secondary one. Bad Fed policy turned what might have been a garden-variety correction into a national disaster.
That is the perspective historians have after seven decades. What will their successors say about 2002 in 2072? They’ll probably raise the same issues Greenspan himself raised in his famous speech.
Conventional wisdom is that central bankers should worry about inflation in prices of goods and services and not pay attention to equity or real estate markets. Yet in Japan in the late 1980s, an overly expansionistic monetary policy clearly fed into bubbles in both stock and land prices.
After voicing his fears of “irrational exuberance,” the Greenspan-chaired Federal Open Market Committee continued to hold interest rates down for anther three years. There certainly were reasons, such as the Asian and Russian financial crises of 1997-1999, to err on the side of monetary looseness.
But I would not be surprised if 20 or 30 years from now analysts decide that the adjustment from the great bull market of the 1990s would have been a lot less severe if the Fed had not pumped so much liquidity into the world economy. And CEOs who cooked the books will be only a minor footnote in the history books.
© 2002 Edward Lotterman
Chanarambie Consulting, Inc.