BARRON'S: Economic Beat

When To Burst The Bubble And Other Recent Lessons

By Mark Zandi

The economy's volatile performance since the mid-1990s is best explained by

the inflating and subsequent bursting of the stock market bubble. Surging values

fueled the booming economy up and through Y2K; plunging values since then are

the proximate cause for last year's recession and this year's increasingly

disappointing recovery. Although revelations of increasingly widespread

corporate, accounting and Wall Street malfeasance are likely the last of the

fallout from the bursting bubble, they threaten to upend the already-listing

economy.

Policymakers have responded meekly to the mounting threat. The Bush

administration's proposals to combat corporate corruption were viewed by the

markets as too little, too late, largely confined to broadening and toughening

penalties on corporate wrongdoers and expanding enforcement efforts.

The Federal Reserve Board has had no response, although it is unclear what it

could, or even should, do. Shell-shocked investors are unlikely to find much

solace in the very modest monetary easing that is now possible with the

federal-funds rate target already so low at 1 3/4%.

While policymakers have been ineffectual in responding to the current crisis,

they have been instrumental in its making. Much has already been made of the

seeming lack of SEC oversight of U.S. corporations and financial markets in the

boom times. The Federal Reserve's contribution to the recent crisis, in

contrast, has been wrongly ignored.

Monetary policymakers have admirably navigated the global economy through

numerous crises in recent years, ranging from the late 1990s Asian financial

crisis, to legitimate fears of widespread Y2K computer glitches, to Sept. 11.

The severity of the threat posed by this most recent crisis, however, is due in

no small part to the shifting and flawed thinking regarding the appropriate

conduct of monetary policy with respect to the developing stock market bubble.

The first expression of a bubble policy was Fed Chairman Greenspan's

"irrational exuberance" speech in December 1996. Surging stock prices over the

preceding two years had policymakers worrying about the potential for a

Japanese-style break in prices and the subsequent "negative consequences for the

economy." Greenspan argued that shifts in asset prices "must be an integral part

of the development of monetary policy."

This policy view soon changed, however. By the summer of 1999, Greenspan was

forcefully arguing that policymakers should not directly respond to a potential

bubble. It is too difficult to know, he explained, whether surging asset prices

are the result of a fundamental change in the economic value of the asset or

simply raw speculation. As the Fed chairman noted at the time, "to spot a bubble

in advance requires a judgment that hundreds of thousands of informed investors

have it wrong." Monetary policy may indirectly respond to a bubble, but only if

it poses a clear threat to the Fed's dual goals of stable prices and sustainable

economic growth.

If a bubble did exist and it burst, he continued in that same 1999 speech, it

would be much easier for policymakers to recognize this and respond aggressively

by easing policy, heading off much of the economic fallout. Greenspan observed

that Japan's economic malaise during the 1990s, and even this nation's Great

Depression were not the result of bursting stock-market bubbles, but the

"ensuing failures of policy." He also recalled his own success in warding off

any significant economic impact from the 1987 stock-market crash.

Moreover, if policymakers tighten monetary policy in response to what was

mistakenly thought to be a bubble, then they threaten to short-circuit what

could be a "once-in-a-generation acceleration of innovation." This would violate

an important operating principle of monetary policy; namely that the appropriate

policy is that which, if wrong in hindsight, will do the least economic damage.

Better to risk the building of "speculative excess" than undercut the seemingly

"remarkable wave of new technologies."

Greenspan's uncharacteristically clear views provided the intellectual cover

investors needed for their frenzied stock buying. Told by the Fed Chairman that

it was unclear whether or not there was a bubble, investors bought; told that if

a bubble existed and it burst, they could be sure that the worst of their

financial pain would be mitigated by aggressive monetary easing, investors

bought at even higher prices.

This policy is deeply flawed. Bubbles are potentially so encompassing, they

undermine the value of the economic data that policymakers so faithfully rely on

in setting policy. The stock-market bubble clearly lifted measured corporate

profits, contributed significantly to the record budget surpluses of the period,

juiced-up job growth, and lowered unemployment and inflation.

As has become clear in recent data revisions, the economy's much vaunted

productivity gains were overstated. Policymakers cannot and should not wait to

change policy until bubbles have measurable negative economic consequences. By

the time the bubble's effects appear in the economic data, it is too late.

Recent experience also undermines the notion that aggressive monetary easing

is an adequate antidote for an economy reeling from a bursting bubble.

Policymakers have slashed the federal-funds rate target nearly five percentage

points since the market began sliding. Despite this and unprecedented fiscal

stimulus, the economy continues to struggle. Monetary policy does work with long

and variable lags, but with the funds-rate target at a 40-year low, policymakers

must be increasingly concerned they are running out of room to maneuver.

Moreover, even if policymakers are able to head off the worst of the direct

economic fallout from the bursting bubble, there are other tertiary impacts to

consider.

What, for example, are the long-term implications of fiscal policymakers not

having used the budget surpluses of recent years to address the looming problems

posed by Social Security and Medicare?

Would policymakers have been more willing to tackle these problems if they

hadn't been disabused of the idea that they could provide large tax cuts,

increase spending, and still have hundreds of billion of dollars in future

surpluses to work with?

What is the longer-term implication of recent events on the willingness of

developing economies to adopt U.S.-style capitalism and political freedoms?

Will the average American household ever be as willing to direct their 401(k)

or other pension savings toward stocks?

Would the misleading and even fraudulent accounting practices in corporate

America have been as endemic if it had not been rewarded by soaring stock, and

thus option, prices?

The stock market's current pummeling is likely the denouement of the imploding

stock-market bubble. With a bit of luck, it is also likely that the economic

recovery, while bowed, will not be broken under the weight of the collapsing

market. Investors are learning quickly from recent events, and hopefully so too

will policymakers.

Policymakers must have the courage of their convictions, and not be bound by

the intellectual fetters that have shaped policy in recent years. Markets are

not perfect, and policymakers have a vital role in reining in those animal

spirits that appear no less potent today than at anytime in our past.

Policymakers must forcefully weigh against future potential bubbles, regardless

of how unpopular this will be, well before the developing bubbles have

measurable economic consequences.

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MARK ZANDI is the Chief Economist of Economy.com in West Chester, Pa.

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