In December 1996, with the Dow Jones Industrial Average just above 7,000 and the technology-dominated Nasdaq Composite index under 1,500, Alan Greenspan made his famous pronouncements about “irrational exuberance” on Wall Street and “unduly escalated asset values.”
In the ensuing five years, this statement came to haunt the Fed Chairman. Until 2000, stocks kept climbing, with Nasdaq more than tripling in value and the Dow adding more than 50 percent. Naturally, Greenspan was ridiculed for missing a fundamental change in U.S. financial markets, which was going to catapult the Dow to 60,000, and even 100,000, and make everybody in America rich beyond their wildest dreams.
Then, when the crash finally came and by late 2002 stock market indices returned, uncannily, to roughly where they were on the day of the “irrational exuberance” speech, Greenspan was roundly criticized for not deflating the Wall Street bubble when it was still possible.
It was a unique statement in Greenspan’s 19-year career at the Fed. Never before — and certainly never after — did he say anything else about the economy or financial markets that could be so unambiguously interpreted. That slip of the tongue stands out among countless hours of his Congressional testimonies, Federal Open Market Committee minutes and other speeches, in which he honed his formidable skill of saying something without saying anything.
This ability to obfuscate is what made Greenspan so successful — so much so that by the end of his stay in office he became virtually irreplaceable. When he finally retired just before turning 80, it was probably to avoid dying in office.
Crisis of the Science
It was, however, a deep crisis of economics that prompted Greenspan to turn Delphic, making statements that could mean anything or nothing at all. To be sure, economics continues to flourish as an academic discipline at colleges and universities. But its usefulness as a guide to policy, or a means of predicting economic developments and movements in financial markets, has become suspect.
There has certainly been a sea change since the 1950s and 1960s, when tremendous hopes were associated with the application of economics in government policy. Economics was expected to ensure world peace, defeat poverty and eliminate or smooth out economic downturns. Bright academic economists from the left were drafted into the Kennedy administration, whereas conservative and monetarist luminaries were brought in by Nixon and Reagan. The pinnacle of public recognition for economics was reached in 1969, when a Nobel Prize for Economics was awarded for the first time, placing it into the same exalted category as physics and chemistry.
The Nobel Prize for Economics had a similar fate to that of the Nobel Peace Prize, which was first awarded in 1901 — in time for the advent of history’s bloodiest wars. Since about the 1970s, economists have been consistently proving their inability to provide rational policy prescriptions or to predict the future. Their reputation both in Washington and on Wall Street has been in a freefall.
On Wall Street in particular, trading and investment models based on economic forecasts or regression analyses have gone out the window even as mathematics-based trading models which purposefully ignore economic analysis have flourished. Economists are still called upon to interpret economic data, but they are not expected to provide accurate forecasts. Fewer of them are employed at financial institutions, with considerably less visibility and far lower salaries.
Ironically, even as economic fine-tuning and forecasting has gone out of fashion, the most important job in the economy remains that of the Fed Chairman — who is expected to be a top-notch economist and to base his monetary policy decisions on analysis and forecasts.
A harder job
Over the past decade, the task of figuring out what is going on in the economy has become, if anything, even more difficult. That’s because seemingly ironclad macroeconomic relationships discovered by economists in the early postwar decades have largely disintegrated.
Take, for instance, inflation, which has been especially difficult to pin down. It would seem that after the experiences of the 1970s and 1980s, when inflation first got out of control and then was throttled by draconian interest rates in the early 1980s, economists would have come to grips with what makes inflation tick.
In reality, it has not happened at all. Economists have blamed the advent of inflation on President Johnson’s efforts to finance his Great Society programs and the Vietnam War at the same time, and on the impact of oil price hikes in 1973 and 1979. Today, the situation is very similar. Washington has been funding both tax cuts and an extremely costly foreign war with a massive budget deficit, and oil prices have spiked six-fold from their 1999 nadir. However, there is no sign of inflation, and after two years of interest-rate increases, U.S. long bond yields — the gauge of market expectations of future inflation — remain at the same level as two years ago.
True, in each case you can find a special explanation why traditional relationships failed to hold. The problem is that in “hard” sciences such as physics, when an existing theory starts relying on too many special explanations, it is usually time to look for another, better theory. The problem in economics is that none has emerged since Milton Friedman developed his monetarist creed.
Wall Street Boy
Small wonder that when people tried to pin down Greenspan on his economic forecasts, he resorted to vague pronouncements. This stance proved remarkably reassuring for financial markets and for bond and equity investors. They liked the obscure pseudo-intellectual talk as well as a generally loose monetary policy that provided enough money for the U.S. economy to grow and for financial assets to appreciate steadily. But then again, Alan Greenspan was a product of Wall Street. He was no academic, having completed his doctorate in economics pretty late in life. Most of his career before being appointed to the Fed was spent as a consultant on Wall Street. He understood its psychology very well.
Ben Bernanke comes from a completely different background. He is an academic economist, and a very good one at that. But that could end up being a serious drawback in his new position. The problem is that he believes in economic indicators and in relationships between, say, money supply and consumer price inflation. Instead of telling the market that he watches some secret unconventional indicators — such as global output of left shoes, as Greenspan used to do — Professor Bernanke has already candidly admitted that he doesn’t know how many more times he will have to raise U.S. interest rates, and whether or not long bond yields will continue to rise.
That’s dangerous talk. Since he assumed his duties at the start of March, major Wall Street indices have revisited their five-year peaks, but they have also showed more day-to-day volatility. The new Fed Chairman will have to learn to speak enigmatically and project an air of omniscience — in other words, become in part a snake-oil salesman — or else lose credibility in financial markets.