Bubble Talk at the FED

Flashback December 21, 1999
Meeting of the Federal Open Market Committee (FOMC)

Following are some rather enlightening excerpts from that FOMC meeting.
Note: FED meeting minutes are sealed for 5 years. The December 1999 meeting minutes were only recently made publicly available.

Mr. Prell:
Once again in recent weeks, the market has defied our notions of valuation gravity by posting an appreciable further advance. Moreover, it has done so in a way that seems to highlight the risk that it will continue doing so. I refer to the incredible run-up in “tech” and e-commerce stocks, some of which have entered the big-cap realm without ever earning a buck. To illustrate the speculative character of the market, let me cite an excerpt from a recent IPO prospectus: “We incurred losses of $14.5 million in fiscal 1999 primarily due to expansion of our operations, and we had an accumulated deficit of $15.0 million as of July 31, 1999. We expect to continue to incur significant...expenses, particularly as a result of expanding our direct sales force…. We do not expect to generate sufficient revenues to achieve profitability and, therefore, we expect to continue to incur net losses for at least the foreseeable future. If we do achieve profitability, we may not be able to sustain it.” Based on these prospects, the VA Linux IPO recorded a first-day price gain of about 700 percent and has a market cap of roughly $9 billion. Not bad for a company that some analysts say has no hold on any significant technology. The warning language I’ve just read is at least an improvement in disclosure compared to the classic prospectus of the South Sea Bubble era, in which someone offered shares in “A company for carrying on an undertaking of great advantage, but nobody to know what it is.” But, I wonder whether the spirit of the times isn’t becoming similar to that of the earlier period.

Mr. Parry:
Analysis done by our staff suggests that successful IPOs have made a large number of employees wealthy, at least on paper. More than 150,000 persons are employed in the roughly 300 California- headquartered firms that have made IPOs in the last three years. About 125,000 of these employees probably have received stock or stock options as part of their compensation, giving them as a group about 15 percent ownership in their firms. Given the strong stock price performance this year, the aggregate market capitalization of these 300 firms recently jumped to about $450 billion dollars. As a result, about 125,000 Californians have seen the value of their stock or stock options jump to an average level of more than $300,000 per employee. Just as this newly created wealth is boosting demand, especially in California, it is clear that a collapse in market values would impose obvious downside risks.

Mr. Gramlich:
Herb Stein once said something that comes close to capturing the essence of economics: “Things that can’t go on, won’t.” As I think about my two years on this Committee, much of what has happened refutes Stein’s quote. Things that couldn’t go on, have gone right on! [Laughter] They may not do so forever, but they have continued much longer than anybody has forecast. The first example is labor markets. Since I’ve been here we have been talking about very tight labor markets as indicated by the unemployment rate, other measures of labor tightness, and Beigebook reports. We have all felt that at some point wages would start to accelerate but as yet they really haven’t--apart from some of the caveats that Mike Prell gave earlier. The second example is the stock market. Again, it has been seemingly overvalued since I’ve been here, but to this point stock prices have risen on balance. The third example is the dollar, which for a while now has seemingly been overvalued, if there is any limit at all on the accumulation by foreigners of dollar-denominated assets. But it is not yet falling. At the intellectual level we should, of course, keep studying these matters to see if we can improve our understanding of how the economy is operating. But studying and learning take time and in the meantime we have to know how to set monetary policy.

Mr. Ferguson: I think we are entering a period, as others have said, that is going to be somewhat challenging for us. In the short run, we clearly do not want to destabilize markets as we go into the Y2K period. One always hates to see a marathon runner trip up at the end, and we certainly don’t want to be the person from the stands who runs out and trips that runner up. In the longer run, obviously, as others have indicated, we don’t want to lose our ongoing battle with inflation expectations and inflation, or risk any damage to our own credibility.

Chairman Greenspan:
There are very evident imbalances in demand over supply, and indeed one can readily argue that virtually all of the problems stem from a wealth effect. Were it not for a significant rise in wealth-to-household income, we probably would find that the propensities to save would be relatively stable, that the unemployment rate would be very low but also stable, and that the current account deficit, while large, would not be increasing. …..
The bottom line is that the wealth effect--in line with Herb Stein’s remark--cannot continue and, therefore, will not continue.

The crucial issue for this meeting, as Don Kohn very clearly pointed out, is to recognize that we have a Y2K problem. It is a problem about which we do not want to become complacent and presume that it doesn’t matter. We want to communicate as effectively as we can that we have no intention of doing anything through the year-end and maybe for a short period thereafter. But we also don’t want to remove the general view in the market that we retain an upward bias and have not completed the tightening that we think needs to be done. We therefore face a tricky problem of trying to find a way to communicate all of that, taking into account what we think the market perceives about what we may or may not do, if our purpose is not to disturb the markets one way or the other.

Chairman Greenspan: That brings us to the end of our agenda, except for the pro forma announcement that our next meeting--as I’m sure you’re all acutely aware--is scheduled for February 1st and 2nd. Merry Christmas everybody and hopefully a Happy New Year!
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It should be readily apparent to anyone reading those minutes that Greenspan has not exactly been honest when he said that "Bubbles can not be recognized in advance". It is rather obvious that a number of FED governors as well as Mr. Greenspan himself were well aware of the heated bubble in tech stocks in 1999.

Mr. Prell hit the nail on the head by comparing it to the South Sea Bubble. Mr. Parry talked of the wealth affect distortions and Mr. Gramlich mentioned they were discussing the bubble for two years! Both Mr. Ferguson and Chairman Greenspan were aware of the problem but their irrational fear of a Y2K disaster prevented them from doing anything about it.

Following is a rough historical timeline of the Greenspan FED.
1) 1996 Greenspan warns of irrational exuberance
2) 1998 Greenspan starts loosening money in an irrational Y2K scare.
3) 1999 Greenspan declares the "productivity miracle" and thinks the boom is sustainable
4) 2000 Greenspan is finally hiking rates right as the boom was turning to bust on its own accord
5) 2001 Jan 2001 Greenspan told Congress two things: a) we could have the Bush tax cuts and still have budget surpluses and b) the economy was not heading for recession. WRONG AND WRONG
6) 2001 Greenspan declares that bubbles can only be seen in hindsight and the best way to deal with them is after they blow up
7) 2002-2003 the FED panic cuts rates to 1% when housing was already strong enough and leading us out of the slump. This stimulus on top of tax cuts by Bush, tax credits by Bush, and FNM and FRE going completely berserk with easy lending standards such as 110% mortgages and round after round of cash out refis leads to house flipping in Southern California, Las Vegas, Florida, and Chicago among other places.
8) 2004 Greenspan declares there is no housing bubble
9) 2004 Greenspan declares that debt to asset ratios for consumers (based almost entirely on housing prices) is not a problem
10) 2004 Greenspan declares victory over deflation and openly brags about it.

The combination of #1 and #6 above together with the minutes of the Dec 21, 1999 FED meeting have presented me with my own conundrum: Is Greenspan's memory that poor or is he just a poor liar?

Here was a man that saw a bubble in 1996, declared there was no bubble in 1999 even though the FED was openly discussing it, and then in 2001 declared that bubbles can only be detected in hindsight. BTW, how can he possibly know whether or not there is a housing bubble if they can not bee seen in advance? I guess that is another conundrum for historians to ponder at a later date.

All of this makes me how Greenspan has any credibility left. Oh well, we only have to wait 5 more years to find out what they are really thinking.

Mish