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Insight | TIMES BOARD OF ADVISORS / ROBERT EISNER

Is Greenspan Sure Investors Are Irrational?

March 23, 1997|ROBERT EISNER | ROBERT EISNER is William R. Kenan professor emeritus of economics at Northwestern University in Evanston, Ill. He is the author of "The Misunderstood Economy: What Counts and How to Count It."

Twice in recent weeks, Federal Reserve Board Chairman Alan Greenspan has warned about "irrational exuberance" in the nation's stock markets. Not surprisingly, when the man viewed as second in power only to the president speaks, the markets listen.

With a key Federal Reserve panel to vote this week on whether to raise interest rates, stock and bond prices have been fluctuating wildly with every new hint or bit of data suggesting how Greenspan and his associates may act. When there is good news about employment or construction, some investors think that means the Fed will raise rates, so stock prices dive. When new evidence shows low or nonexistent inflation, the markets bounce back.

But just what does Greenspan mean by irrational exuberance, and is he right?

The economy as a whole, by most measures, has been doing relatively well. Unemployment has been below 6% for 2 1/2 years and averaged 5.4% in 1996. The preliminary figure for the final three months of 1996 indicates that real gross domestic product growth has come in at an annualized 3.9% and that core inflation is almost nonexistent.

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But Greenspan--along with others--warns that if the economy continues to grow rapidly, wages may finally begin to rise significantly. And the stock market has been zooming--at least until the chairman spoke--at a considerably faster pace than the growth in the economy and underlying "fundamentals" would seem to warrant.

How much of this is true, and how much is really bad?

John Maynard Keynes, certainly the most influential economist of the 20th century, pointed out that investors are concerned not with long-run values but with capital gains from a rising market. And as long as the market is expected to rise, they propel it higher. Keynes worried about real capital development becoming "a byproduct of the activities of a casino" and the "crises of confidence" that could bring the market crashing down and the economy with it. But he also argued that real investment and progress are propelled largely by "animal spirits" and "irrational psychology." Then, "if the animal spirits are dimmed and the spontaneous optimism falters . . , enterprise will fade and die--though fears of loss may have a basis not more reasonable than hopes of profit had before."

Is Greenspan's "irrational exuberance" the same sentiment as Keynes' "irrational psychology," and, if so, can one safely combat it without curbing the basic growth of the economy?

One has an uneasy feeling that Greenspan not only sees the danger of a collapse if the market continues to rise "irrationally," but that he also appears ready to curb real investment and economic growth and see unemployment rise. This would occur, if necessary, to prevent the market from getting to heights he perceives as dangerous and to stifle the genie of inflation that might emerge with higher wages.

Aside from his jawboning, a toothless exercise in the long run, Greenspan's one real tool is the control of credit and interest rates. If the market rise could be attributed to huge "margin buying" and purchases based on excessive credit, there would indeed be a need to act.

But that is hardly the case. Greenspan's threat is to raise interest rates when real interest rates--the nominal or market rates minus inflation--are already high. Carrying out that threat would not only bring down the Dow, it would also curb consumer purchases of durable goods, slow business investment and badly damage the housing market. It would raise the value--and cost--of the dollar, thus injuring our exports.

And all this would occur in the face of the Fed's own forecasts of growth in the range of 2% or a little higher in 1997--a measly amount. If the purpose of the interest rate rise were not to slow that growth, it would clearly be intended to prevent it from getting higher. That means unemployment would inch up.

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The costs of lower economic growth to the federal budget are enormous. A difference of 1 percentage point in growth will change the nation's GDP by $75 billion in the first year and by $75 billion or $80 billion more the next year. In that year 2002, when we talk of "balancing" the budget, the annual difference would be roughly $465 billion. Think of what that means in resources for education, health care, infrastructure, housing and all the private goods and services we care about. And think how it would take care of all of the problems, real or imagined, of shortages in Social Security trust funds and budget deficits.

So my advice to Dr. Greenspan, my fellow economist, would be to be pretty careful about trying to spook a "crazy" market. I would not offer the guns of credit excess to those who may turn out to be irrational lunatics. But beyond that, laissez faire may be a good general policy for the market, as it is for the economy, unless we are pretty sure we really know better.

Robert Eisner, professor emeritus at Northwestern University and a past president of the American Economic Assn., is the author of "The Misunderstood Economy: What Counts and How to Count It."

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