Summa Contra Curmudgeons

["Ian Murray" <seamus2001@xxxxxxxxx>]

 < http://www.independent.co.uk >
Andrew Smithers: American anxiety is bubbling under
07 April 2002

In 1996 the chairman of the US Federal Reserve, Alan Greenspan, said
investors seemed to be suffering from "irrational exuberance". The phrase
became famous, but the concern did not linger in his mind. During the
market's subsequent rise, he appeared to move from critic to cheerleader.

A minority view holds that the Fed committed a big mistake in allowing
the bubble to grow. Over the next few years, this minority will either
dwindle to nothing or become the majority. As usual in such matters, it
is unlikely either result will depend on the arguments currently being
aired. Events will be the arbiter.

The case against allowing asset bubbles is that there can be no
satisfactory resolution to their demise. Once assets get out of line with
incomes, the return to normality needs either a large fall in nominal
asset prices or a large rise in nominal incomes. The former gives rise to
bankruptcies and risks setting off a liquidity trap. The latter can only
occur if inflation reaches heights that central bankers are dedicated to
avoiding.

The recession that followed the bursting of the recent US bubble has so
far been mild. America is recovering and it is widely expected that
growth can be sustained without a sharp rise in inflation.

The curmudgeons, though, see the dramatic fall in interest rates, and
rapid expansion of money supply that has gone with it, as postponing the
problem rather than curing it. Since the asset bubble was built on debt,
cutting rates had the effect of making the burden more bearable. But it
did not reduce debt, which has continued to grow much faster than GDP.

Central bankers respond to markets. This was seen after the crash in 1987
and when LTCM went bankrupt in 1998. They tend, however, only to respond
in one direction. They support markets but don't deflate them. This
asymmetry adds to the likelihood of stock market bubbles and has become
known as "the Greenspan Put".

A central bank that strives to ensure investor losses are small and
short-lived will be hugely popular, at least until the economic price
comes to be paid. But the intellectual case for this policy is not based
on popularity. The traditional view is that central bankers are there "to
take away the punch bowl, just as the party is getting started".

The case against central banks intervening to dampen asset bubbles is
based on two ideas. The first is the Efficient Market Hypothesis (EMH),
which asserts that markets provide the best estimate of the value of
shares. The second, dubbed the Efficient Central Banker Hypothesis
(ECBH), is that monetary pol- icy should be about controlling inflation
and nothing else.

If the EMH is correct, bubbles cannot occur and there can be no
justification in central banks seeking to prevent them. The orthodox view
now is that this philosophy must be rejected.

The ECBH, meanwhile, has been gaining rather than losing adherents. If Mr
Greenspan had tightened policy when he expressed concern about irrational
exuberance, the proponents of the ECBH would have seen it as unnecessary
since there was then little sign of rising inflation. Subsequent events
have, so far, supported this view.

But if, as the curmudgeons fear, the US economy fails to find a way of
avoiding a severe recession without a sharp rise in inflation, the ECBH
will come under attack and a more symmetrical approach to stock market
crashes and bubbles should become the new orthodoxy.

Andrew Smithers is chairman of Smithers & Co. This article is based on a
longer piece in the current issue of 'World Economics' jointly authored
with Stephen Wright, lecturer in economics at Birkbeck College, London.
www.smithers.co.uk

"Of all the great motors handed down from the manufacturing period,
horsepower is the worst, partly because a horse has a head of its own"
Karl Marx