Fed's Greenspan should just ignore stock market

Human Events, Feb 11, 2000 by Bartlett, Bruce

Federal Reserve Board Chairman Alan Greenspan recently gave another speech in which he warned of a stock market bubble. Although he acknowledged that technology is fundamentally transforming the American economy for the better, the rise in the stock market is creating imbalances that are unsustainable.

Says Greenspan, "Through the.so-called wealth effect, these gains have tended to fos-, ter increases in aggregate demand beyond the increases in supply. It is this imbalance between growth of supply and growth of demand that contains the potential seeds of rising inflationary and financial pressures that could undermine the current expansion."

Supporting the Greenspan view, economist John Makin of the American Enterprise Institute thinks that the Fed will eventually prick the stock market bubble, leaving investors with higher debts and fewer assets. At that point, there will be a liquidation and the inevitable recession.

History certainly supports Makin's seenario. In 1928, the Fed was in almost exactly the same position it is in today, worrying about a stock market bubble that it believed was undermining economic and financial stability. And, like today's Fed, it sought to engineer a soft landing by gradually raising interest rates. The problem was that the Fed could not restrict only that credit which was flowing into the stock market, because money is fungible. If credit were restricted, it would also affect those sectors, like manufacturing and farming, that had legitimate needs for credit.

Ironically, as the Fed restricted credit, it actually pushed the stock market higher. That is because the available credit flowed into the one place where returns were great enough to cover the higher borrowing costs. Consequently, the real sector of the economyupon which the financial sector rests--was even more starved for credit. When it finally began to falter, leading to lower profits and dividends, the financial sector collapsed.

Increased Profitability For Traditional Business

In his book, Benjamin Strong: Central Banker, economist Lester V Chandler condemns the Fed's obsession with stock speculation. "Even with the benefit of hindsight," he says, "one cannot state dogmatically that the level of stock prices attained by mid- 1928 could not have been sustained if prosperity had been maintained and the economy had continued to grow as in preceding years."

It may well have been the case that the stock market was in an unsustainable bubble that was bound to burst with a major correction. But there was no reason why the Fed should have concerned itself with the prospect. Such a naturally occurring revaluation of stock prices would have had, at most, a temporary impact on the overall economy. But by actively intervening to bring the bubble under control, the Fed took actions that impacted on the economy as a whole, with disastrous consequences.

My own belief is that there is indeed a bubble for Internet stocks, but that the market as a whole is not grossly overvalued. A key reason is that traditional businesses are only beginning to reap the benefits, in terms of efficiency and productivity, that computers and the Internet have to offer. Thus while Internet stocks may well take a big fall when expected profits fail to emerge, traditional businesses should see increased profitability.

Greenspan should stop worrying about the stock market. If the Fed should continue to tighten monetary policy out of misguided fears of a stock market bubble, it could very easily repeat the mistakes of 1928 and 1929. If there is a bubble, the Fed should just let it play out. As long as economic fundamentals remain solid, any downturn in the stock market will mainly impact those foolish enough to buy stocks that they know are overpriced.

Mr. Bartlett, a senior fellow at the National Center for Policy Analysis, is a nationally syndicated columnist.