What Greenspan Didn't Know
As a young man, Alan Greenspan considered himself to be a partial follower of Ludwig von Mises. Like Mises, he wrote in favor of capitalism, free markets, and sound money. He cofounded a successful economics consulting firm and earned a Ph.D. in economics at Columbia University. He served as chairman of President Ford's Council of Economic Advisers. In 1987, he became chairman of the Federal Reserve.
As Fed chairman, he orchestrated one of the greatest stock upswings ever. It featured a remarkable bull market within a bull market, the great Internet bubble that lasted from August 1995, when Netscape issued shares that soared in value, to March 2000, when the market peaked. Along the way, in his "irrational exuberance" speech of December 5, 1996, he famously warned about the overvaluation of stocks. On several occasions, Greenspan expressed skepticism of the bull market and recognized that a stock market bubble existed.
As Morgan Stanley economist Stephen Roach makes clear in a Feb. 27 report, Smoking Gun, behind the scenes the central monetary planners "appreciated the full gravity" of the market balloon. Roach quotes Greenspan at a September 1996 FOMC planning session as he declared that the Fed could eliminate the bubble by raising margin requirements for stock purchases. "I guarantee that if you want to get rid of the bubble, whatever it is, that will do it," he said. The Fed, which has sole control over margin requirements, refrained from changing them. The Fed chairman also said, somewhat darkly, that he was not sure what else raising margin levels might do. The Morgan economist himself argued for raising margin requirements in Barron's, March 27, 2000.
Stephen Roach quotes Fed Governor Lawrence Lindsay as saying at the same meeting that the Fed should have burst the bubble in its early stages before it did too much damage to the economy. The damage he referred to included "scarce financial human capital," i.e. speculators, devoting resources to acquiring wealth.
It apparently did not include the misallocation of resources that occurs when the central bank forces the rate of interest to fall below the natural rate established in the markets for investible resources--equity and debt capital. If his insights had included this Austrian point of view, both he and Chairman Greenspan would have been forced to admit that the great stock bubble was of their own making, and that the solution would have been to let the market work.
First, let it work by cleansing the economy of the malinvestments caused by the central bank-engineered credit expansion. Then, free the economy of the central bank--the Federal Reserve--itself. Let interest rates "tell the truth about time," in the illuminating phrase from Roger Garrison, by guiding entrepreneurs in making investment decisions in markets where the supply and demand for investible resources are not distorted by monetary central planners. Free markets, including free capital markets, are the key to maximizing employment, productivity, and income.
Both Alan Greenspan (somewhat uneasily) and Stephen Roach (more confidently) claimed that increasing margin requirements would have checked the bubble. Neither economist learned this in his economics training. Neither of them ever read it in a money and banking text. Changing margin requirements is not a tool of monetary policy because it has no effect on the monetary base. If they studied for the Series 7 exam (one of two licensing tests stockbrokers must pass), they would have been taught otherwise, because the theory that margin requirements affect the money supply is a staple of its section on monetary policy. Unfortunately for the nation's stockbrokers, and for Messrs. Greenspan and Roach, the idea that manipulating the stock loan market can break bubbles is dead wrong.
Altering margin requirements simply shifts the flow of central bank-juiced asset purchases from stocks to other assets, such as cars or homes (in the case of an increase), or from other assets to stocks (for a decrease). It simply moves the bubble from one asset class to another; it does not cause a net bubble reduction. Just as tellingly, because stocks cannot be purchased on margin for thirty days after an initial public offering, how would they explain the fact that scores of internet IPOs soared in value their first day and for many days before the margin restriction period ended? Enthusiastic bulls didn't wait to buy them until their twenty-first trading sessions, when they were first able to purchase them on margin.
More to the point, the theory of tinkering with brokers' loans (which should be determined on the free market anyway and not restricted by the Fed) ignores the fact that the bubble is caused by central bank manipulation of money and credit. By focusing on the market for brokers' loans, the monetary central planners and their Wall Street critics miss the fact that the market for these loans (even if margin requirements weren't frozen by the Fed), would be distorted anyway by the influence of credit manipulation on the loan market, just as it distorts every other capital market. The axis of influence is from the Fed's manipulation of, typically, the Fed funds rate to the brokers' call rate.
Using changes in the margin regulation as a stick to beat the stock bubble does not work, fails to solve the underlying problem, and further injures investors by restricting their choices. What Fed Chairman Greenspan didn't know is something that the young Greenspan and his mentor Ludwig von Mises did: that monetary freedom is the way to end market bubbles once and for all.