Speech

The Role of Finance in the Investment Bust of 2001 AnnualSouthwesternFinanceAssociationMeeting AdamsMarkHotel St.Louis,Missouri March8,2002 Arecurring topic of debate among Beforeproceeding,Iwanttoemphasizethat economists and finance experts is theviewsIexpressherearemineanddonot the role of financial markets in cycles necessarilyreflectofficialpositionsoftheFederal ofboomandbustintherealeconomy. ReserveSystem.Ithankmycolleaguesatthe This discussion has flared up once again in the FederalReserveBankofSt.Louis,especially wake of the recession of 2001. The performance FrankSchmid,fortheircomments,butIretain oftheU.Seconomyinthe1990swasremarkable, fullresponsibilityforerrors. and so was the performance of the stock market. Thelinkbetweenthefinancialsectorandthe Starting in spring of 2000, both the stock market realeconomyiscurrentlymostvisibleinthe and real economic activity weakened consider- telecommunicationsindustry.FromDecember ably. In the real economy, we observed a sharp 1990throughMarch2000,theNasdaqTelecom- drop-off in private business fixed investment. municationsIndexincreasedbymorethan816 In the financial sector, we witnessed the stock percent,comparedwithanincreaseof317percent market delivering disappointing returns for two intheWilshire5000StockMarketIndex.Then, consecutive years. The number of initial public inApril2000,theNasdaqTelecommunications offerings (IPOs) fell dramatically, and the market Indexbeganasteepdeclineinwhichitshed for venture capital dried up. In fact, given that about75percentbytheendofJanuary2002.By the financial indicators turned ahead of real comparison,theWilshire5000PriceIndexlosta investment,thereisaprimafaciecasethatfinan- muchsmaller26percentofitsvalueoverthe cial stringency contributed to the decline in sametimeperiod. physical investment spending. Of course, the Theboomintelecommunicationsstockprices financial environment does not come out of the reflectedoptimisticjudgmentsabouttheindustry, blue;weakeningprospectsofthetechcompanies andhelpedtofinanceitsexpansion.Between hadalottodowiththefinancialstringencythey 1990and2000,privatefixedinvestmentin faced starting in early 2000. communicationsequipmentasashareofGDP Realprivatenonresidentialinvestmentfell increasedby52percent,or41basispoints.In by9.2percentfromitspeaklevelin2000Q4to comparison,duringtheprior30yearstheshare 2001Q4.Toputthisdeclineinperspective,from ofinvestmentintelecomequipmentinGDPgrew thequarterinwhichinvestmentpeakedtothe byonly33basispoints. quarterinwhichithitbottom,thedeclinecon- Judgmentsabouttelecomturnedouttobe nectedtothe1991-92recessionwas7.3percent. excessivelyoptimistic.Duringthelast12months, However,therecessionsof1948-49,1957-58, eightmajortelecommunicationsservicesproviders 1973-75and1981-82allsawdeclinesof12per- wentbankrupt;asameasureofthescaleofthese centormore.Thustheinvestmentbustof2001 bankruptcies,observethatthetotalpre-bankruptcy wasnotextremeinthecontextofU.S.business bookvalueofassetsofthesecompaniesamounted cycleexperience. toabout$55billion.Itisnoteworthythatalleight 1 FINANCIALMARKETS ofthesecorporationswentpublicbetween1990 appreciatedsharply,generatingawindfallprofit and2000,atimewhenthetelecomsectorenjoyed amongthosewhohappenedtoownthem.The spectaculargrowthrates. initialcapitalgainscreatedoptimisticexpecta- Asthetelecomindustryexpandedinthe tionsabouttheprofitabilityofgrowingandtrad- 1990s,thestocksoftelecomservicesproviders ingthesestrainsoftulipbulbs.Therearereports andequipmentmakerswereinhighdemand. ofextensivetradinginderivativecontractswritten Theparallelperformanceofthetelecomindustry ontulipbulbs.Eventually,theinteresting-looking intherealeconomyandinthestockmarketraises tulipslosttheirappealandthepriceoftheerst- acoupleofquestionsabouttheinteractionbetween whilehighlyvaluedbulbsfell,endingthespecula- financialmarketsandtherealsector.Towhat tivebubble.PeterM.Garber,whohasinvestigated extentwerethefinancialmarketsdrivingtheboom thetulipmaniamorethoroughlythananyoneelse, andsubsequentbustinthetelecomindustry? isnotconvincedthatthepricingoftheraretulips Whatdoestheinteractionbetweenthefinancial wasirrational;still,whateverthecorrectfactsof marketsandtherealeconomyimplyfortheeffi- thiscasemaybe,thestylizedstoryishelpfulin ciencyofresourceallocation? understandingtheconceptofanassetprice I’llbeginbyreviewingwhatseems,atleast bubble. inretrospect,tobeexcessivevarianceinstock TheBritishrailroadboomwascausedbya marketvalues.Then,I’lldiscussthelinkbetween majortechnologicaladvance.Therewasnotonly stockmarketvaluation,corporatefinance,and excitementaboutthenewmeansoftransporta- resourceallocation.I’llmakeafewgeneralcom- tion,buttheBritishalsowelcomedtheeconomic mentsontherelevanceofstockpricevolatility stimulusoftherailroadboombecauseitmarked formonetarypolicy.Finally,I’llfinishwithmy theendofaperiodofeconomicdepression.In thosedays,eachrailroadprojecthadtobeapproved thoughtsontheoutlookforbusinessfixedinvest- byaparliamentarybill.Asaconsequenceofthis mentspending. officialblessing,investorsmisperceivedtherisk ofrailroadinvestments.Also,asisoftenthecase inperiodsofrapidlyrisingstockprices,question- MARKET SENTIMENT ablebusinessactivitiesweretolerated—activities Thehistoryofbankingandfinancialmarkets thatwouldhavereceivedgreaterscrutinyinnor- isclutteredwithboutsofinvestoroptimismthat maltimes.Astrikingexamplewasthedubious haveledtoextraordinaryandtemporaryappre- accountingpracticesofGeorgeHudson,whoat ciationoffinancialandrealassets.Famousasset onetimewaschairmanoffourrailroads.Hudson, pricebubblesaretheDutch“tulipmania”ofthe whomaynotevenhaverealizedexactlywhathe 1630s,thefirstBritishrailwayboomofthemid- wasdoing,madedividendpaymentsoutofcapital, 1840s,andthebubbleinArgentineloansinthe apracticethatwaslegalatthetimeandhassince 1880s,tonamebutafew.Wecanalsofind,of beenprohibited.PerhapsbecauseCharlesPonzi course,casesinwhichstrongperformanceof knewthathis1920schemewasfraudulent,we individualstocksdidturnouttobejustified. nowcallanarrangementinwhichearlierinvestors Wecalltheassetpricerun-upsthatendbadly arepaidhighreturnsoutofcapitalcontributed “bubbles.” bylaterinvestorsaPonzischemeratherthana Assetpricebubblesstartwithgoodnewsand Hudsonscheme. substantialprofitsforsomeinvestorsearlyinthe ThebubbleinArgentineloansinthe1880s boom.Forinstance,the17th-centurytulipmania beganwithincreaseddemandintheworldmarket haditsorigininamosaicvirus,whichgenerated forArgentineagriculturalproducts.Risingworld interesting-lookingtulipsthatfetchedhighprices demandledtoaneconomicboominArgentina, amongtulipgrowers.Becausethevirus-infected whichgavetheArgentinegovernmenteasy tulipbulbsweredifficulttoreproduce,they accesstotheworlddebtmarket.Argentinaalso 2 TheRoleofFinanceintheInvestmentBustof2001 raisedequitycapitalthroughinitialpublicoffer- fundamentalvalue.Multi-yearperiodsofstock ingsofcompaniesthatspecializedindeveloping marketovervaluationalternatewithequally land.WhenoneoftheseIPOsfailedin1888,the extendedperiodsofstockmarketundervaluation. BaringBrothershelpedoutwithcredit.Twoyears Anexampleofaperiodofbearishmarketsenti- later,theArgentinegovernmentfailedtomeet mentwastheearly1970s,whenthefour-quarter thesedebtobligationsbecauseoffallingpricesof trailingprice-to-earningsratiooftheS&P500 rawmaterialsintheworldmarkets.Thisdefault stockpriceindexwasaslowas7;indeed,the ledtothefamousBaringcrises,whichgaverise stockmarketremainedlowuntilasustained toanearlyexampleofthecentralbank—theBank marketrisebeganinmid1982.Duringthelate ofEnglandinthiscase—servingasalenderof 1990s,ontheotherhand,thetrailingP/Eratio lastresort. climbedwellabove30,evenbeforeearnings Allthreebubbles—andhistoryhasrecorded droppedastheeconomystartedslowingin2001. manymore—startedwithgoodnewsthatcreated Suchanelevatedstockmarketvaluationmight highhopesbuteventuallyendedintears.Ingen- beviewedasexcessivelyoptimistic,giventhat eral,bubblesaredrivenbypositivemarketsenti- themedianvalueofthepostwarP/Eratiointhe ment—thatis,widespreadinvestoroptimism. S&P500runsataround15. Positivemarketsentimentgivesrisetoasharp Therecognitionofmarketsentimentasa appreciationofassetprices,whicheventually potentforceinfinancialmarketswarrantsthe regresstotheirfundamentalvalues.Regression questionastowhyarbitrageursdon’tbetagainst tothefundamentalvalueisoftenfollowedby it.Thisquestionneedstobeansweredbeforeone unwarrantedassetdepreciationasmarketsenti- acceptsthepossibilityofstockmarketovervalu- mentturnsoverlynegative.Hence,marketsenti- ation(orundervaluation,forthatmatter)andits mentcausesbothassetmispricingandexcessive implicationfortheallocationofresources. volatility.Theproblemfortheeconomisttrying Usingtheword“arbitrage”hereispotentially tostudytheseissuesisthatmispricingandexces- misleading,andsoletmeexplainwhatismeant sivevolatilityarealwayseasytoidentifyexpost, inthecontextofthisdiscussion.Economists butrarelysoexante.However,evenwhencases thinkofaclassicarbitrageasarisk-freesetof areidentifiedexanteinvestorsmayormaynotbe transactions,suchassimultaneouslybuying abletoprofitfromtradingagainstthemispricing. wheatinKansasCityandsellingitinChicago Theconsequencesofassetmispricingand forahigherprice.Thearbitrageurthenshipsthe excessivevolatilityarenotconfinedtofinancial wheatfromKansasCitytoChicagotodeliveron markets,butcanaffectfixedinvestmentandpro- hisChicagocontract.Knowingthetransportation duction.Financialmarketsarecriticalfordirect- costs,thesimultaneouspurchaseinonecityand ingscarceresourcestotheirmostproductiveuse. saleintheotherisriskfree. Theefficiencybywhichfinancialmarketsachieve Byextension,othertypesofarbitragetrans- thisgoaldependsontheaccuracyoftheprices actionsarebasedontheassumptionthatsome thatfinancialmarketssignaltotheinvestors. relationshipwillreturntonormal.Forexample, Thepricesignalsofthestockmarketallowcor- ifthespreadbetweentheyieldonan11-year porationstocalculatethecostofequitycapital Treasurybondanda10-yearTreasurybond andevaluatetheprofitabilityofpotentialproj- becomesunusuallylarge,purchaseofoneissue ects.Althoughthefocusofmyattentioninthis andsaleoftheotherpromisesanarbitrageprofit. lectureisontheroleofthestockmarketinthe However,thiscasediffersfromtheclassicarbi- recentinvestmentbust,itisalsoclearthatbond trage,inwhichthegoodpurchasedinthecheap marketmispricingcanaffectbusinessinvestment. marketcanbedeliveredagainstthesalecontract Ina1981study,YaleeconomistRobertShiller inthedearmarket.Nothingguaranteesthatthe showedthatthevaluationoftheU.S.stockmar- arbitragetransactionbetweentwoTreasuryissues ketexhibitspronouncedfluctuationsaroundits willbeprofitable,becausethespreadcouldwiden 3 FINANCIALMARKETS andstaythatwayindefinitely.Inthefutures mighttakealongtime—possiblyyears—toregress marketsliterature,thevariablerelationship totheirfundamentalvalue.Worseyet,assetmis- betweenthepriceofoneassetandanotherheld pricingmightdeepenalongtheway.Inthemean- asahedgecauseswhatisknownasbasisrisk. time,arbitrageursthatinvesttheirownmoneymay Theissueathand,then,istheeconomic developliquidityneedsforotherreasons.Anindi- forcesthattendtoreturnpricerelationshipsto vidual,forexample,mightneedtodrawonhis someconceptof“normal”;whenwedefinenormal capitalashenearsretirement;hedgefundsmight bythehistoricmean,wearerelyingonastatistical befacedwithwithdrawalsasinvestorsbecome regularitythatcouldinfactbechangingforgood impatient.AsKeynesstated,“Marketsmaystay economicreasons. irrationallongerthanyouremainsolvent.” Inaseminaltreatmentontheroleofthestock Anotherreasonwhyinformedinvestorsmight marketforinvestmentandgrowth,JohnMaynard notbetaggressivelyagainsttheprevailingmarket KeynesintheGeneralTheoryofEmployment, sentimentisuncertaintyabouttheassets’funda- Interest,andMoneydiscussesseveralfactorsthat mentalvalues.Someapparentlyoverpricedven- bearontheaccuracyofthestockmarket’sprice turesturnoutwell,andbettingagainstthem signals.Inbrief,Keyneshypothesizesthatmarket wouldturnoutbadly.Eventhemostsophisticated sentimentiscarriedintofinancialmarketsby investorcannotruleoutthepossibilitythatthe uninformedinvestors,causingmispricingand wayhelooksatfinancialmarketsisinadequate. excessivevolatility.Althoughitappearsthatmis- Thefactthattheworldinwhichweliveisnot pricingandtheensuingexcessivevolatilityoffer well-chartedleadsinformedinvestorstotread arbitrageopportunitiesforinformedinvestors, cautiouslywhenputtingontheirtrades. arbitrageursareunabletoexploittheseopportu- nitiesduetoliquidityconstraints. Keynesattributesthepersistenceofasset THE RECENT SPELL OF BULLISH mispricingandexcessivevolatilitytoalackof MARKET SENTIMENT liquidity,whichisanotherwayofsayingthatthere isadearthoftradesthatleanagainsttheprevailing Acompellingobjectofstudyfortheinterac- marketsentiment.Whydoarbitrageurs—hedge tionbetweenfinancialmarketsandtherealecon- funds,forinstance—notputonaggressivetrades omyisthemarketforinitialpublicofferings.In thatpushthemarketbacktoitsfundamental countrieswithsophisticatedfinancialmarkets, value?Certainly,itisnotforaninitiallackof periodsofexcessivelyoptimisticmarketsenti- funds,becausearbitragetradesareself-financing, menttendtobeaccompaniedbyextraordinarily atleasttosomeextent.Forinstance,aninvestor strongactivityinthemarketforinitialpublic whogoeslongonoff-the-runTreasurysecurities equityofferings.Duringtheseso-called“hotissue” andshortonon-the-runTreasuriescanusethe markets,thevastmajorityofcompaniesgoing longpositionascollateral.However,asobserved publichavejustrecentlybeenestablishedand inthenearcollapseofLongTermCapitalManage- operateintheveryindustriesthatareexciting mentin1998,whenthepositionsarelargerelative theexuberantinvestors. tothefirm’scapitalaspreadmaywidenrather Hotissuemarketsarecharacterizedbyhigh thannarrowtosuchanextentthatcapitalis volume,unusuallyhighreturnsonthefirsttrad- wipedout.Onlyapurearbitragewherethegood ingday—knownas“initialreturns”—and,typi- heldinalongpositioncanbedeliveredagainst cally,poorlong-runperformanceinthesecondary theshortpositioniscompletelyself-financing. market.Empiricalevidenceforlong-rununder- Therearetwoanswerstothequestionof performanceofinitialpublicofferingsinthe whyarbitrageursdonotbetaggressivelyagainst wakeofhotissuemarketshasbeenprovidedina marketsentiment.First,arbitrageurshavelimited seminalstudypublishedin1991byJayRitter. wealthandlimitedtimehorizons.Assetprices Giventhedateofthisstudy,thepoorperformance 4 TheRoleofFinanceintheInvestmentBustof2001 ofIPOsinthesecondarymarketwaspublicknowl- drewupthefollowingexamples.Assumethe edgelongbeforethefranticIPOactivityinthe P/Eratioofacompanytakestenyearstorevert U.S.stockmarketinthelate1990s.Consistent from100to20,whichisstillasomewhatgener- withRitter’sfindings,theIPOswiththehighest ouslevelgiventhathistoricallytheP/Eratioof initialreturnsduringthehotissuemarketofthe theS&P500hasaveragedabout15.Ifweassume late1990swereamongtheworstperforming thattheannualizedreturnonthisstockoverthe stocksinthesecondarymarket.From1998to nexttenyearsiszero,thenthecompany’searn- early2000,thetoptenIPOs—rankedbyinitial ingshavetogrowatanannualrateof17.5percent return—climbedbetweenroughly400to700 tobringitsP/Eratiobackto20.Alternatively,if percentonthefirstdayoftrading.AsofAugust theinvestordemandsa10percentannualreturn 2001,nineofthese10stockshaddepreciatedby onthestockoverthenexttenyears,theearnings atleast80percentfromtheirofferingprice;one ofthiscompanyhavetogrowbyanaverage29.2 stockwasdelistedafteracompetitoracquired percentperyear. thecompany. Thesesimplecalculationsraisewarningflags. Therecurrenceofhotissuemarketsleadsto Unlesstheearningsofacompany,oragroupof thequestionofwhyhistoryrepeatsitselfinsuch companiessuchasthoseintheNasdaq100index, anobviousmanner.Tobetagainstovervalued areabnormallydepressedforreasonsthatcanbe stocks,theinvestorwouldhavehadtosellthe investigatedandunderstood,aP/Eratioof100 issuesshort,maintaintheshortpositionsinthe seemsunlikelytobejustified,becausefuture faceoffurtherpriceincreasesforthesestocks earningsgrowthhighenoughtoprovideareason- andbewillingandfinanciallyabletowaitfor ablerateofreturnareunlikely.ButIdothinkit sometime,severalyearsinsomeofthesecases. importantthatwelookbehindthenumbersand Theshortpositionscouldbepartiallyhedged,by notrelyontheP/Eratiooranyothersimplenum- goinglongonanS&P500Indexfund,forexample; berinreachingthesejudgments.Investorsare butinthelate1990sandonotheroccasionsthe willingtoholdstockswithhighP/Eratiosifthey spreadbetweenthetwopositionswouldhave expectthesecompaniestogrowatanabove- increasedforquitesometime,andthatriskcould averagerate.Giventhatinvestorsdisagreeabout notbediversifiedaway. whichcompanieswillbethefast-growingones, Whateverthemechanismormechanisms manycompaniesmaytradeatelevatedpricesat creatingthemispricing,itissimplynoteasyfor thesametime.Thisbringsustothequestionof arbitrageurstotakepositionstheotherway.More- howpredictableearningsgrowthatthecompany over,informedinvestorswhounderstandthis levelreallyis.Inarecentacademicstudy,ithas processmayfinditmoreprofitabletotradewith beenshownthatthereisvirtuallynopredictabil- ratherthanagainstthemispricedstocks.Thisway, ity,basedonpubliclyavailableinformation,in marketsentimentcreatesitsownspace,obtaining earningsgrowthratesatthecompanylevelat thecapacitytodistortassetpricesinasustained thefive-andten-yearhorizons.Thus,unlessan manner. investorhassomespecialtalentorinsideinfor- Avaluablegaugeofmarketsentimentinthe mation,heisnomorelikelytopickthenextIBM stockmarketistheP/Eratio.InMarch2000,the orthenextMicrosoftfromthepopulationoffast- Nasdaq100—whichaccountedformorethan10 growingcompaniesthroughrationaldeliberation percentoftheU.S.stockmarket—tradedataP/E thanbychance. ratioofabout100.Certainly,therehasalwaysbeen Theunpredictabilityofearningsgrowthhad ahandfulofstocksthattradeatelevatedlevels. beenknownlongbeforetheNasdaq100tradedat However,when10percentoftheentiremarket aP/Eratioof100.Keynes,intheGeneralTheory, tradesatsuchaloftylevel,somequestionsmight said,“Theoutstandingfactistheextremepre- beinorder.Agroupoffinancescholarswho cariousnessofthebasisofknowledgeonwhich studiedtheearningsgrowthofU.S.corporations ourestimatesofprospectiveyieldhavetobe 5 FINANCIALMARKETS made.Ourknowledgeofthefactorswhichwill capitaloverhanghaddeveloped,atleastinsome governtheyieldofaninvestmentsomeyears sectors.AsInotedearlier,bythefourthquarter henceisusuallyveryslightandoftennegligible. oflastyearrealprivatenonresidentialfixed Ifwespeakfrankly,wehavetoadmitthatour investmenthaddeclinedby9.2percent.Real basisofknowledgeforestimatingtheyieldten investmentininformationprocessingequipment yearshenceofarailway,acoppermine,atextile andsoftwarewashitparticularlyhard,withan factory,thegoodwillofapatentmedicine,an annualrateofdeclineof19.5percentinthesec- Atlanticliner,abuildinginthecityofLondon ondquarter,10.4percentinthethirdquarterand amountstolittleandsometimestonothing;or 2.8percentinthefourthquarter.Asestimated evenfiveyearshence.”Giventhatthereisno bytheCouncilofEconomicAdvisors,in2001 predictabilityinearningsgrowthbeyondthevery thereducedrateofinvestmentmeantthatthe shorthorizon,itisnotsurprisingthatstocks growthrateoftherealcapitalstockdroppedto withhighP/Eratiostendtounderperformthe 2.6percent. market,asacademicstudieshaveshown. Likeotherinvestmentboomsinhistory,the rapidexpansionofthecapitalstockinthe1990s followedontheheelsofamajortechnological STOCK MARKET VALUATION, advance—thedigitalrevolution.Intheearlystages oftheboomincomputersandcommunications, INVESTMENT, AND GROWTH therewereextraordinarycorporatesuccessstories Themedianratioofstockmarketvaluation asepitomizedbytheriseofMicrosoftandIBMin tonominalGNPintheperiod1920to2000runs anearlierera.Onthefinancialside,theseadmir- at48percent.In1990,theratiowasataboutits ablecorporateachievementswerereflectedin long-termmedianlevel,butbythefirstquarter equallyimpressivecapitalgainsinthestock of2000hadincreasedtoanunprecedented186 market.Inrecentyears,thenewtechnology,which percent.Bycomparison,inthethirdquarterof gaverisetonew,fast-growingcorporations,cre- 1929,theratioofstockmarketvaluationtoGNP atedexpectationsabouta“newera”inthereal amountedtoonly68percent.Thehistoricpeak economyandhighreturnsinthestockmarket. beforetherun-upofthe1990swasrecordedin Duringaboom,investorsrarelyremember thefourthquarterof1972atavalueof78percent. Schumpeter’sdictumofcreativedestruction. Itappears,certainly,thatthehighstockmarket Eventually,thebenefitsoftechnologicaladvances valuationinthelate1990sleftitsmarkonthe arepassedontotheconsumer.Bustsarethe realeconomy.Byreducingthecostofcapital,the inevitableconsequenceoftheerosionofcorpo- stockmarketappreciationofthe1990sfueled rateprofitsthroughcompetitionandmean- thelongestinvestmentboominpostwarhistory. revertingratesofgrowth. Fromatroughinthefirstquarterof1990,thefrac- Clearly,nocompanycanindefinitelyofferan tionoffixedprivatenonresidentialinvestment earningsgrowthratethatexceedsthesumofthe inGDPincreasedfrom9.7percenttoapeakvalue dividendyieldandthegrowthrateofpotential of13.2percentinthethirdquarterof2000.This GDP.Inevitably,earningsgrowthratesofindi- peakwasjustabitbelowthepreviouspeakof vidualcompaniesmustreverttomeansreflective 13.9percentinthefourthquarterof1981.By comparison,themedianpostwarvaluewas10.5 oftheaggregateeconomy’srateofgrowth.Against percent. thisbackground,aP/Eratioof100intheNasdaq Asaresultoftheinvestmentboomofthe 100isdifficulttoexplainwithoutsomekindof 1990s,therealcapitalstockoftheeconomy newerathinking.Theriskinnew-erathinkingis expandedsharply.Therateofincreaseinreal thatitisanattempttorationalizehighstock capitalstockclimbedsteadilyfromatroughin marketvaluation.Althoughtheproductivity 1992at1.5percentto4.2percentin2000.When growthoftheU.S.economyhasbeenimpressive theeconomyslowed,itbecameevidentthata overthelastcoupleofyears,includingthemost 6 TheRoleofFinanceintheInvestmentBustof2001 recentperiodofrecession,burstsofproductivity cussingtheroleofmoneyandcreditinfinancial growthhavehappenedbefore.Moreimportantly, bubbles.Thedebatehasbeenrekindledbyevents evenapermanentlyhigherlevelofproductivity inJapan,whereanassetpricebubbleinthelate growthintheneighborhoodoftherateenjoyed 1980shasbeenfollowedbymorethanadecade from1995to2000doesnotjustifyoutsizedP/E ofsub-pargrowthanddecliningassetprices.It ratios.Pasttechnologicalinnovationshadno hasbeenarguedthattheBankofJapancouldhave lastingimpactonthegrowthratesofcorporate prevented—oratleasttempered—thebubble earnings,whichinevitablyconvergetothegrowth throughaggressivemonetarytighteninginthe rateoftheoveralleconomy. secondhalfofthe1980s.Wewillneverknow Overthelastcoupleofyears,thedeclinein whethersuchpolicyactionwouldindeedhave corporateprofitshasbeenaccompaniedbyarise alleviatedtheconsequencesofthebubbleonthe incorporateleverage.Theratioofcreditmarket realeconomyinJapan.Wecansaywithsome debttonetworthfornonfarmnonfinancialcorpo- confidence,though,thatsuchaggressivemonetary rationsrosefromatroughof47.4percentinthe tighteningwasnotwarrantedatthetimebased thirdquarterof1997toapostwarhighof59.1 onstandardinflationgauges.Infact,in1987, percentinthethirdquarterof2001—thelatest Japan’srateofconsumerpriceinflationwasclose numberavailable.Bycomparison,themedian tonil. postwarvalueisonly34.2percent.Notethatthe ReturningtotheUnitedStates,apertinent currentnumbermightunderestimatetheactual questionmightbetowhatdegreehasmonetary riseofdebtobligationsatthecompanylevel policycontributedtoexcessivevaluationinthe becauseoftheincreaseduseofleasingandthe U.S.stockmarketandtheensuingmisallocation proliferationofspecialfinancingvehicles.The ofresources.Isitpossiblethattherewasexcess riseofcorporatedebtisinpartaconsequenceof moneygrowththatmadeitswayintoassetprices, thesoaringstockmarketofthe1990s.Asthe ratherthanthepricesofgoodsandservices? equitycapitalofcorporationsappreciated,their Paradoxically,itseemsthatthemoresuccessful borrowingcapacityincreased.Corporationsthat acentralbankisinkeepingtherateofinflation dippeddeeplyintotheirborrowingcapacityin lowandstable,themorelikelymonetaryover- thedaysoftheboomfoundthemselveshighly hangwillleadtoappreciationofassets.When leveragedaftertheirequitydepreciatedinthe expectationsaboutlowandstableratesofinflation stockmarket.Excessiveuseofdebt,alongwith aredeeplyingrained,assetpricesmightserveas overcapacity,contributessignificantlytothe aventforexcessmoneygrowth. currentwaveofbankruptcies—inparticularin Howcanwetellwhetherastockmarketboom thetelecomsector.Anotherimplicationofthe isinternaltothestockmarket—amarketbubble— riseofhighleverageistheincreasedshareof oraconsequenceofexcessivemoneygrowth? interestpaymentsoutofcurrentincome.Ata Excessivemoneygrowthshouldspilloverto timeoftighteninglendingstandardsanddebt assetsingeneral,andnotjusttooneclassof downgradesinthebondmarket,highdebtobli- assets.IntheUnitedStatesinthelate1990s,we gationsmightputadragoncapitalspendingas didnotseeoutsizedincreasesinresidentialand corporationsfinditdifficulttofinanceinvestment commercialrealestatevalues,orinbondprices, projectsoutofcurrentcashflow. orinpricesofforeignexchange.Indeed,thedol- larwasstrongratherthanweakintheforeign exchangemarkets.Thefactthatthestockmarket boomwassomewhatconcentratedinparticular MONETARY POLICY segments—especiallyhightech—andwasnot IMPLICATIONS echoedinotherassetmarketssuggeststomethat Sincethebeginningofthe19thcentury,aca- thestockmarketboomwasnotprimarilyamon- demicexpertsandpolicymakershavebeendis- etaryphenomenon. 7 FINANCIALMARKETS Whenthebehaviorofassetprices,along Businessinvestmentlastyearwasdrivenby withotherinformation,suggeststhatmonetary areassessmentoflong-runprospectsincertain policyisexcessivelyeasyortight,thenobviously sectors,especiallytelecom,andbyadjustmentto itmakessenseforpolicymakerstochangecourse. excesscapacityresultingfromthepriorexuberant Butitdoesnotmakegoodsense,Iamconvinced, investmentboom.Thatadjustmentisnowwell foracentralbanktotakeapositionontheappro- along.Assumingfinalconsumptiondemandcon- priatelevelofthestockmarketandattemptto tinuestogrow,excesscapacitywillbeabsorbed guidethemarkettothe“right”level.Acentral overthenextfewyears.Itisimportanttoremem- bankhasonlyoneindependentpolicyinstrument, berthatmuchoftheinformationtechnology whichyoucanthinkofintermsofmoneygrowth capitalstockhasarelativelyshortlife,duetothe ortheinterestratedependingonyourpreference. rapidrateoftechnicalchangeinthisarea.Desktop Attemptingtousethatinstrumentformultiple computersandserversarereplacedeveryfew purposesmuddiesthepolicydirectionandrisks years,whichmeansthatreplacementdemand losingcontrolovertherateofinflation.Com- placesahighfloorundertotalinvestment. promisingonthegoaloflowandstableinflation Itappearsthattherateofreturnfrominvest- isarecipefortrouble—sustainedinflationor menttoenhanceefficiencyisstillhigh.Thuswe deflationcreatesproblemsfargreaterthatthose canexpecttoseecontinuedcapitaldeepeningin likelytoarisefrommispricinginanassetmarket. firmsthathavenotyettakenfulladvantageofthe newtechnologies.Asprospectsforfinaldemand growthbecomeclearerandtherecessionincor- THE OUTLOOK FOR BUSINESS porateprofitscomestoanend,wecanexpectto seefirmsonceagainresumeheavyinvestmentin FIXED INVESTMENT informationtechnology.Inshort,thereisevery Thecurrentrecessionisthemostpersuasive reasontobelievethatwehaveaheadofusa exampleinthelast50yearsofaneconomiccon- healthyrevivalofinvestmentandthecontinued tractionthatoriginatedfromabusinessinvest- productivitygainssuchinvestmentwillbring. mentbustratherthanconsumerretrenchment. Thisoutlookispredicatedonmybeliefthat Recessionstypicallyexhibitmajordeclinesin theFedwillbesuccessfulinadjustingpolicyin housingconstructionandconsumerdurables. timelyfashiontomaintainaclimateoflowand Thistime,therecessionwasledbyadeclinein steadyinflation.Pricestabilityisaprerequisite businessinvestmentspendingandaccompanied forsustainedeconomicgrowth;ifinflation byasharpdropinfactoryordersforcapitalgoods, expectationsbreakoutonthehighside,allbets bothnewandunfilled.Thelatestnumbers, areoffaswewouldthenseeaclassicperiodof releasedtwodaysago,fornewordersofnonde- unsustainableexuberancefollowedbytheusual fensecapitalgoods,excludingthevolatileair- inflationhangover.ThatisnotthefutureIsee, craftorderscomponent,showanincreaseof1.5 buttheFedwillhavetostayalertandonthejob. percentinJanuary;shipmentsofcapitalgoods, excludingaircraft,roseby2.5percent.These datasuggestthatthecapitalspendingpartofthe economyisonthemend. 8

William Poole (2002, March 7). Speech. Speeches, Federal Reserve. https://whenthefedspeaks.com/doc/speech_20020308_poole

@misc{wtfs_speech_20020308_poole,
  author = {William Poole},
  title = {Speech},
  year = {2002},
  month = {Mar},
  howpublished = {Speeches, Federal Reserve},
  url = {https://whenthefedspeaks.com/doc/speech_20020308_poole},
  note = {Retrieved via When the Fed Speaks corpus}
}