The Buchanan Center for Political Economy

George Mason UniversityFairfax, VA

July 1999

* I would like to thank Professor James M. Buchanan for many penetrating comments and constructive suggestions. Thanks are also due Professor Bernhard Eckwert for stimulating conversations and probing questions, Dr. Albert M. Wojnilower for insightful analysis and provocative views, David L. Littmann for many helpful discussions, and Jeremy P. Fand for research assistance. The responsibility for any errors is mine alone. An earlier version of this paper was presented to University Faculty Seminars in Dresden and Chemnitz and will appear in a Proceedings Volume on Financial Structure and Stability being published in Germany.
















"Are We Facing a Stock Market Bubble?"

David I. Fand


Table of Contents


I. Introduction

II. The New Paradigm: A History

III. An Alternative View: A Keynesian Global Economy

IV. Chairman Greenspan's Concern about Irrational Exuberance

V. Chancellor Kohl and Japanese Policy Officials: Their Role in Facilitating the American Boom

VI. The Handcuffing of the Fed: The Arbitrageurs Liberated

VII. Greenspan and the Monetarists

VIII Conclusion

IX. Footnotes


1. 1000 point milestones in the Dow-Jones index

2. Dow-Jones and S & P 500: 1980-1999

3. Growth of M2 and M3 in Percent 1991-1998

4. European Unemployment 1989-1999 (percent at year end)


1. Dow-Jones Industrials 1980-1999

2. S & P Index: (Price and P/E ratio) 1980-1999

3. S & P Returns: 1980-1999

(Calculated as percentage change in price plus dividend returns)

4. U. S. Money Growth--M2 and M3: 1980-1999 (yoy % change)

5. European Unemployment 1989-1999







The explosion of equity prices since 1995 has led some analysts to conclude we are facing an asset bubble in the stock market. In the period February 1995 - July 1997 the Dow-Jones index doubled from 4000 to 8000; in the period November 1995 - May 1999, the Dow doubled from 5000 to 10,000. Overall equity prices in the four years 1995-1998 grew at the amazing and spectacular annual rate of 28%. The stock market returns in the latter half of the 1990s are significantly higher than the average and among the highest ever recorded. (See Table 1 and Table 2)


November 1972 1000
January 1987 2000
April 1991 3000
February 1995 4000
November 1995 5000
October 1996 6000
February 1997 7000
July 1997 8000
April 1998 9000
March 1999 10,000
May 1999 11,000

Moreover, the return on equities in the last two decades--going back to the start of the recovery in 1981--has been about 19%, compared to the longer term historical average of 10%. (See Charts 1 and 2.)

TABLE 2: DOW-JONES AND S & P 500 AT YEAR END: 1980-1999

1980 963.99 134.03
1981 875.00 126.60
1982 1046.54 141.77
1983 1258.64 165.47
1984 1211.57 162.47
1985 1546.67 202.99
1986 1895.95 251.17
1987 1938.83 223.92
1988 2168.57 277.69
1989 2753.20 348.55
1990 2633.66 329.07
1991 3168.80 379.10
1992 3301.12 432.06
1993 3754.09 466.43
1994 3834.44 453.11
1995 5117.12 620.18
1996 6448.27 739.60
1997 7908.25 983.79
1998 9181.43 1176.74
1999 (7/1/99) 11,145.00 1388.12

Admittedly the above average returns in the 1980s may be viewed as a correction to the below average returns in the 1970s. But this does not explain the spectacular 28% annual growth in equity prices in the 1995-1998 period--an average growth rate that is almost 3 times the long term historical average. How do we rationalize this extraordinary performance and the stunningly high returns which are indeed continuing thus far to July 1999? (See Chart 3.)

There are basically two views of this remarkable boom in equities. New Paradigm analysts point to rapid technological advances, globalization and restructuring in recent years. They believe that policy makers have achieved a better understanding and mastery of macroeconomics, and are able to contain both inflation and the business cycle. Indeed, the New Paradigm analysts conclude that we may now achieve a relatively permanent prosperity. For them, the accelerating stock market boom since 1995 is merely recording, in accounting and financial terms, this dramatic and extraordinary breakthrough in managing the economy. This is the essence of the New Paradigm view which is rooted in the idea that we are living in a New Economy. There are many people, and especially in the financial community, who want to believe in the New Paradigm.

A second and more conventional view is that there are special factors which led to these remarkable results starting in 1995, that these factors are not permanent and, more importantly, may be reversed.

I do not accept the New Paradigm analysis. But I will attempt to summarize, if not rationalize, the New Paradigm. First that we are experiencing an extraordinary rapid technological advance--a major breakthrough--which is revolutionizing industry and the world economy; and that these technological advances enable us to produce goods with continuously declining costs, helping us to control and ultimately eliminate inflation. Second is the great pressure on industry to become more efficient by restructuring and downsizing, another factor lowering costs and contributing to this new prosperity. Third, the global economy today is like one big country--a firm can produce and sell its product almost everywhere; and we are witnessing an important worldwide trend toward globalization. A fourth factor is that labor and management are no longer confrontational--the two sides have learned how to live together with fewer strikes and costly confrontations. A fifth factor is that we have achieved a greater understanding and mastery of macroeconomics. Finally, and perhaps most important, the Federal Reserve--the central bank--has, it is argued, learned how to control inflation.

While New Paradigm theorists may differ in their emphasis, they typically stress these factors to argue that the dramatic and extraordinary acceleration in equity prices in the 1995-1998 period--the 28% annual growth rate--is rational and not a cause for concern. 1/


There is an interesting historical note on the views espoused in the New Paradigm. If you ask who is the greatest economist that America has produced, most economists agree that it was Irving Fisher. Fisher wrote monumental books--classics--on capital theory, the theory of interest, the purchasing power of money, and introduced distributive lags in his applied research (When Milton Friedman utilized distributive lags in his empirical research, he was building on Irving Fisher.) Fisher wrote a book on the consumption tax, and another classic on the theory of index numbers. In the 1930s Hicks and Allen achieved world wide fame for introducing indifference curve analysis; Fisher's 1896 doctoral dissertation not only used indifference curve analysis but went beyond Hicks and Allen in solving the integrability conditions. I mention all this to show you what an extraordinarily brilliant and remarkably creative individual Fisher was. I should also mention that until recently we measured the GDP deflator with a Laspeyre's Index possessing a well known upward bias. Theorists constructing index numbers always faced the question "Can we produce a price index with the least amount of bias?" The closest numerical approximation to the true value is the square root of the product of the Laspeyre Index and the Paasche index, shown by Irving Fisher in the 1920s when he defined his "Ideal Index". Recently the U. S. government introduced a chain index in its GDP deflator calculations; this is Fisher's ideal index. 2/

Fisher advised Yale University to invest their endowment in equities. In the 1920s equities were not considered a prudent investment defined in the minds of most investors then as an investment in bonds. Under Fisher's prodding, Yale University put their very considerable endowment into equities and lost much of it in the 1929 crash; many cynics concluded this is what happens when you listen to an economic theorist. So Irving Fisher was often derided by those seeking to highlight and dramatize the irrelevance of economic theory. When I was a student, Irving Fisher's name was often mentioned disparagingly. Fortunately in recent years we have seen a growing respect and a very considerable increase in Fisher's stature.

Why do I relate this? In Fisher's The Stock Market Crash and After, published in 1930, each of the factors now cited in the New Paradigm: technology, restructuring, globalization, non-confrontational labor management relations and the central bank's success with price stability--is a chapter in this book. 3/, 4/ Fisher focused on these factors to explain that we had reached a New Era--a permanent plateau of prosperity and why everyone should invest in equities. 5/ Theorists of the New Paradigm have not developed any new ideas--they are repeating the hypothesis that goes back to Fisher's 1930 book.


If one does not accept the New Paradigm how does one explain the equity boom and the more basic puzzle of why we have so little inflation? We're now in the 9th year of recovery with relatively tame inflation whereas normally inflationary pressures are seen in the third and fourth year of a recovery. The combination of a reasonably strong economy in the 9th year of the recovery with very little inflation is remarkable--it's like seeing a 160 year old individual run a marathon. And one readily appreciates why many observers feel the need for a new theory and are therefore inclined to accept the New Paradigm. The question is how can we be in the 9th year of recovery, more than twice the duration of an average recovery, with such low inflation. In fact, for many commodities trading in the global economy, we have thus far been observing a decline in inflation.

In America we construct and calculate the CPI, the PPI and the ECI to obtain a monthly indicator of inflation. The CPI is the consumer price index and the PPI is the wholesale price index. Federal Reserve Chairman Greenspan is personally said to favor the ECI--the Employment Cost Index--which he monitors as perhaps a better gauge of inflation. So right now we look at all three indices and all three are behaving reasonably well. But these indices are sensitive to prices of commodities and services in the global economy, and to the extent that the European and Asian economies have considerable idle capacity--which depress many prices in the global economy--these three indices may not be telling the whole story. Further, they do not include asset prices.

To be more specific, while inflation as measured by the CPI, the PPI and the ECI has been relatively stable or even declining, some U. S. asset prices are going right through the roof. We have already noted the extraordinary post 1995 boom in equities and we also note a sharp escalation in real estate prices. Similarly, if we examine the prices of items that are not involved in the global economy--non-tradable goods and services--many are also rising rapidly.

It would appear that there is something a little more complicated going on concerning inflation. And although I follow the monetarist framework, I am inclined to believe that America is now living in a Keynesian global economy. By this statement I mean that there is currently a large quantity of idle capacity in the global economy, because Europe, Japan, Southeast Asia and Latin America (which together account for 65% of global output) are all struggling with high unemployment.The augmented aggregate supply curve facing America consists of the domestically produced aggregate supply augmented by what can be produced in the rest of the world; and, when global idle capacity is substantial--as is currently the case--it generates an elastic augmented supply.

The hypothesis that we are in a Keynesian global economy carries the implication that the augmented aggregate supply facing America, given the considerable volume of global idle capacity, is almost infinitely elastic. It follows that an increase in American aggregate demand will lead to an increase in the U. S. trade deficit but not necessarily to any rise in U. S. prices. This may explain the absence of inflationary pressure, even though we are currently in the ninth year of our recovery.

Consider the current stock market boom: the concern that typically undermines a buoyant equity market is the fear of inflation. When traders begin to see signs of rising inflation they know (1) that the Federal Reserve will act and raise interest rates, (2) that arbitrageurs and speculators will liquidate positions, and (3) that stock prices will decline. One of the keys to the extraordinary boom in U. S. equity prices since 1995 has been--indisputably--the absence of inflation. And the hypothesis I am presenting is that America has escaped inflation in the 1990s because we are currently confronting a Keynesian global economy; and, more precisely, that the augmented aggregate supply facing America is very elastic.

There is one important proviso. In the 1930s we lived in a Keynesian world that was locally produced. More precisely, disastrously restrictive monetary policies in the U. S.--i. e. a 35% decline in the money stock--caused very high unemployment--exceeding 30%--and resulted in a vast increase in idle capacity. The present Keynesian global economy was not produced in America since we have "full" employment and "shortages" of both labor and capital. It was generated by others such as Chancellor Kohl and the economic officials in Japan. Indeed Chancellor Kohl, through his vigorous, determined and zealous support for the Maastricht agreement and the European Monetary Union has actively supported policies which resulted in a very substantial increase in European idle capacity; in this sense Kohl has contributed significantly, though indirectly, to the extraordinary rise in American equities in the 1990s; similarly, Japanese officials have contributed to our stock market boom by tolerating and accepting a stagnant and depressed recovery for the past nine years.

But, if we live in a Keynesian global economy, then, like the Keynesian economy of the 1930s, it is a temporary phenomenon; it is not a permanent feature, and we therefore reject the New Paradigm. We view the extraordinary rapid rise in equity prices in recent years as a likely asset bubble, and like all other bubbles, we believe it will burst.


Chairman Greenspan has been anxious about the possibility of an asset bubble in the equity market--evidenced publicly in his concern about 'irrational exuberance' in December 1996. Also, at the monthly Open Market Committee meetings in the spring of 1996, the Fed brought in monetary and financial experts and specialists in the equity and bond markets, and presented them with the following problem: Does the Central Bank have a right, or duty, to introduce restrictive monetary policies when it sees equity prices rising beyond where they should be--a potential asset bubble--at a time when the other macroeconomic data look reasonable? Greenspan has clearly been somewhat worried about the possibility of a stock market bubble since 1996 when Dow Jones was recorded at a little above 6000. 6/

Evidence cited to support the asset bubble hypothesis includes:

1. overvalued share prices (S&P 500 P/E ratios currently over 35) where in the past a ratio of 18-20 was considered high;

2. merger mania;

3 sharply rising real estate prices (both commercial and residential); and

4. an explosion in money growth

The monetary indicator that I think is the most important one is the monetary aggregate M2, and M2 in recent years has grown considerably above the 1% to 5% growth prescribed by the Open Market Committe. Indeed M2 has been growing at almost twice the upper range. Similarly, the recent 1998(4) growth of the M3 monetary aggregate which includes a large array of financial assets and may be a more complete measure of overall liquidity, is the highest in about 20 years. There is considerable evidence that we have enjoyed extremely rapid money growth. Table 3 summarizes the escalation in money growth from 1991. From an average growth of 1.7% in the 1991-1994 period, M2 accelerated steadily to 8.5% in 1998. The growth in M2 in the 1995-1998 is dramatically higher than the 1991-1994 range and similarly for the monetary aggregate M3 which in the fourth quarter of 1998 reached levels not seen in 20 years.

(See Chart 4)




TABLE 3: GROWTH OF M2 AND M3 (in percent): 1991-1998

Year M2 M3
1991-1994* 1.7 1.1
1995 3.9 6.1
1996 4.6 6.8
1997 5.8 8.8
1998 8.5 11.0

*the average of the values for these years

Some who question the relevance of monetary growth counter by asking if indeed money growth is so rapid, why is it that we have no inflation? Admittedly, inflation as normally measured by the CPI, the PPI and the ECI clearly has been reasonably well behaved in recent years. But if one examines prices of equities, real estate and non-tradables, there is evidence that the extremely rapid money growth has led to substantial price increases in many markets.

A recent analysis in The London Economist, (April 18, 1998) concludes there's an asset bubble in the U. S. equity market and stresses the four factors just summarized. First they cite that stock prices are rising very rapidly, evidenced by the spectacular growth in the S & P 500 since 1995. Second, they focus on the recent merger waves and especially the bank mergers as a typical characteristic of a bubble economy. The Economist points out that the four previous big merger waves of this century--in the early 1900s, the 1920s, the 1960s and the 1980s--all coincided with three related characteristics: strong economic growth, rapid credit expansion and a stock market boom. Obviously a stock market boom provides the wherewithal for some companies to buy other companies; and, not surprisingly, the first three merger waves and booms ended in crashes in 1904, 1929 and 1969. The 1980s boom led to a crash in 1987 and the recession of 1990-1991. The Economist suggests that the current merger mania is evidence of a stock market boom and also, potentially, of a forthcoming crash.

The third symptom of an asset bubble is the sharp escalation in rents for commercial property. In 1997 commercial rents rose by 20% in one year alone in three major cities: San Francisco, Boston, Dallas. New York bidders offered $180/square foot, twice the price paid 6 month before. The Economist concluded that rents and property values are getting out of control.

Less dramatic than the explosion in commercial property rents is the rapid acceleration of house prices. The returns accruing to home owners in the past 60 months are almost on the scale of stock market yields. According to a recent report 7/:

"The typical house in Utah is worth nearly 50% more than it sold for 5 years ago. Michigan, the turn-around phenomenon state of the decade--has seen the value of its average home grow by almost 41% since 1994. Oregon homes have gained about the same--41.3% Colorado has also sizzled, with average gains in resale value of 39.1% during the last 5 years." This report which tracks "the appreciation rates of millions of individual homes reveals that the average gain nationwide during the past year has been close to 5%. . . or about four times the underlying rate of inflation in the economy overall".

And the fourth reason cited by The Economist is the extremely rapid money growth in recent years. The data in Table 3 are from Chairman Greenspan's monetary report to Congress--to the House of Representatives and to the Senate--which he presents twice a year. 8/ In this report, he has a chart which indicates that, while the FOMC guidelines for M2 growth are 1% to 5%, it is growing about 9%. Similarly the M3 monetary aggregate is growing at a much faster rate than the FOMC range of 2% to 6%, and, as previously noted, in 1998(4) it was growing at the highest rate in 20 years. There is absolutely no denying that money growth is extremely high.

Admittedly, there is, as yet, no inflation pressure. But allowing money growth to continue at its recent pace will cause an explosion in prices when the temporary factors that are currently keeping U. S. inflation relatively benign--the large volume of global idle resources and the resulting elastic augmented aggregate supply curve--are no longer operative factors.


Let us now consider other influences contributing to the extraordinary growth rate of U. S. equities since 1995. Chancellor Kohl, as we indicated earlier, played an important role in igniting this stock market boom, assisted also by Japanese officials and the Japanese banks. First consider Chancellor Kohl's role. His strategic and powerful support for Maastricht and the European Monetary Union (EMU)--which required that members limit fiscal deficits and link their currencies to the mark--resulted in deflationary monetary and fiscal policy in Europe. The Maastricht agreement directly imposed fiscal restraint by limiting their deficits to 3% of the GDP and, indirectly, monetary restraint as the other currencies sought to maintain some kind of parity with the mark. The combination of fiscal and monetary restraint led to the underutilization of resouces; the European increase in idle capacity is indicated by the double digit unemployment rates in France, Germany and Italy (relative to the low rates in the U.S. and U.K.).

The evidence shown in Table 4 and Chart 5 may be briefly summarized. The pre-Maastricht (1990) unemployment rates are 6.6% for Germany, 8.9% for France, 11.3% fpr Italy and 16% for Spain. The post-Maastricht unemployment rate increases in all countries. For the four years 1995-1998 in which U. S. equities reached stratopheric heights, the German unemployment rate is approximately twice the pre-Maastricht rate. Similarly, the unemployment rates rise substantially in France and Spain, with only a modest rise in Italy. The substantial increase in European unemployment and the associated increase in post-Maastricht idle capacity support our hypothesis that, since 1995, the global economy is Keynesian and that the augmented aggregate supply facing America is fairly elastic. Similarly, the decline of manufacturing capacity utilization for Germany, France, Italy and Japan from 1990 to the 1995-1998 period supports the Keynesian global economy hypothesis.


1989 7.6 9.0 12.0 16.5
1990 6.6 8.9 11.3 16.0


6.3 9.9 11.0 17.1
1992 8.9 10.9 9.6 20.4
1993 10.6 12.4 11.1 24.0
1994 10.2 11.9 11.9 23.5
1995 11.0 11.7 12.1 22.6
1996 12.0 12.5 12.2 21.7
1997 13.0 12.3 12.4 20.1
1998 11.9 11.5 12.6 18.0
1999* 11.7 11.4 12.1 17.3

* 1999 data for end of May

Japan--the second largest economy in the world--has been stagnating with very little growth since 1990 and has a considerable stock of idle capacity. As a consequence, an increase in American aggregate demand can be supplied by the idle capacity in both Europe and Japan. Indeed, the growing volume of imports from Europe and Japan, measured by the merchandise trade deficit, is a very powerful force which keeps prices relatively stable in the U. S. Ironically, if prices are relatively stable, the Fed cannot easily tighten monetary policy even if money is growing considerably above the FOMC upper band. And, if money growth continues at a high rate it will fuel additional growth in stock prices. 9/

Japan has another, direct, impact on the U. S. stock boom. Japanese banks have been lending large amounts of money to the U. S. It is estimated that during the 1995-1998 period they were lending at the rate of $25 billion a month--another factor fueling the boom. Japan, with its large stock of idle capacity, can export and satisfy American demand for goods, keeping inflation tame and preventing the Fed from tightening policy. And by lending money at very low interest rates--less than 1%--the Japanese banks finance the speculators and the arbitrageurs who buy stock with these borrowed funds.

The combination of global idle resources in facilitating an asset bubble in America may be gauged by the growing merchandise trade deficit of approximately 4%. This quantity, which excedes a full year's growth of GDP, is what we obtain from the global economy. In addition, the cross elasticity of supply (the percentage change in the quantity of imports to the U. S. relative to the percentage change in U. S. prices) is, I believe, fairly elastic, so it doesn't take much of an increase in the U. S. price to significantly increase imports (especially from countries with considerable idle capacity).

Now, why is a relatively elastic cross elasticity important? Although U. S. unemployment is now down to 4.2%, wage rates are nevertheless stable with only modest acceleration. While there have been some recent significant productivity gains, one still wonders why labor costs are so stable in a climate of labor shortage? Is it that unions have become less demanding? I think the answer is that the unions recognize that if they attempt to push up wages, the employer could produce these goods in Europe or Asia. The unions do understand the relevance of an elastic cross elasticity of supply.



I would like to consider another important factor fueling an asset bubble. The Federal Reserve, and especially Chairman Greenspan, have been concerned about the danger of an asset bubble for more than 2 years. Greenspan knows that high money growth rates can fuel an explosive boom in equities. And in his December 1996 address he publicly expressed his concern about "irrational exuberance". Why has he allowed money growth to continue at these very high levels? 10/ And why is it he can't act to restrain this explosion of money? I am referring here to what I call the handcuffing of the Fed. 11/

I define handcuffing as a situation where, in the absence of inflation, the Federal Reserve will not restrain money growth. I believe the handcuffing of the Fed has been an important, indeed critical, facilitator of the boom since 1995. 12/

Suppose you are a Wall Street professional and you have learned that the Federal Reserve will not raise interest rates for the next two or three quarters. What would you do? The market professional has a green light to speculate and to leverage his investments. This is precisely the situation since 1995: (1) the growing idle capacity in Europe, Japan and southeast Asia keeps U. S. inflation benign; and (2) the absence of inflation prevents the Fed from restricting money growth by raising interest rates. 13/ More precisely, the idle resources in the global economy and the elastic cross elasticity of supply, absent U. S. inflation, provide a signal for professionals to leverage and speculate.

To recap: What the market professionals fear most is that the Fed will raise interest rates forcing them to liquidate a position. But if the Fed appears to be handcuffed--unable to raise rates--the stock market professionals are energized as though they are on an adrenaline high. Learning that the Fed will not raise rates is the best news they can hope for. They are free to borrow, to leverage and to speculate. The handcuffing of the Fed and the liberation of market professionals are, I suggest, critically important factors in fueling the post 1995 stock market boom.

As I have indicated in Section II, I doubt that the technological advances and productivity breakthroughs that the New Paradigm theorists attribute to the current economy are all that different from earlier boom periods such as the 1920's. 14/ If there is something uniquely different to the current boom, it is, I suggest, the extent and duration of the handcuffing of the Fed.


A second factor that handcuffed the Fed since 1995 is that Greenspan is in a bit of a trap--one that he himself set. He cannot easily, or readily,

raise interest rates even though money growth is excessively high so long as inflation is quiescent Let me explain. Greenspan is limited by his 1990-1991 victory over the monetarists. During the recession of 1990-1991, many observers, and especially monetarists, questioned Greenspan since key monetary aggregates, and especially M2, were not growing sufficiently: the M2 aggregate grew by only 1% whereas the midpoint of the Federal Open Market Committee (FOMC) recommendation for that period was approximately 2 1/2%. Using that FOMC midpoint, by 1992 "the M2 money stock would have been approximately $200 billion larger and the GDP perhaps $350 billion higher". 15/ Many economists questioned why Greenspan was so niggardly in expanding the money supply in 1991 and 1992. And the criticism that money growth in the 1990-1991 recession was much too low came not only from Milton Friedman and other monetarists but also from Paul Samuelson.

Greenspan's defense in the 1990-1991 period was that one cannot gauge the thrust of monetary policy by examining money growth rates, thus generating the problem he has faced since 1995. By propounding this view in 1991-1992, testifying in Congress, and arguing against money growth as the proper variable to gauge the thrust of monetary policy, he can not, in the post 1995 boom, cite rapid money growth as a basis for Fed restrictive action. So he is in a difficult position.

The markets and Wall Street can readily point to the lack of inflation, and argue that the Fed has no basis to tighten. They can cite Greenspan's 1990-1991 testimony concerning the inappropriateness of focusing on money growth to gauge the thrust of monetary policy, especially when prices are stable. They will also point out that we now have a 4.2% unemployment rate, that many former welfare clients have finally found jobs, and that if he tightens these former welfare recipients may lose their jobs. Greenspan will be charged with racism--they will not only call him a bad central banker, they will also charge him with other transgressions. So his basis for action has been taken away. Greenspan was too successful in fighting the monetarists in 1991. He downplayed the significance of high monetary growth--the one argument that he could have used in the 1995-1999 period.. I conclude that Greenspan's 1990-1991 victory over the monetarists is limiting his current policy options.

Greenspan's June 1999 testimony at the JEC suggests that he may now feel that he could raise interest rates and limit money growth even though current inflation is still relatively benign. 16/


In this paper we argue that the extraordinary boom in the U. S. equity market results from a number of special factors and we reject the New Paradigm and the notion of a New Economy. The special factors facilitating this extraordinary boom in which P/E ratios have reached an all time high in excess of 35 are summarized below.

First we note the large volume of idle resources in 65% of the Global Economy--in Europe, Japan, Asia and Latin America. Second, the global idle resources and unused capacity ensure that America faces an elastic aggregate supply that can be readily augmented by the global idle resources. Third, the resulting elastic augmented aggregate supply guarantees that inflation rates in the U. S. are fairly tame. Fourth, the absence of inflation in the U. S. tends to handcuff the Fed since Chairman Greenspan finds it difficult, in light of his prior public position, to restrict the accelerating growth of the money supply in the absence of inflation. Fifth, the perception that the Fed is handcuffed liberates the market professionals to borrow and leverage their portfolio positions, knowing that the Fed is handcuffed.

We suggest that this mechanism explains the relative absence of inflation in the U. S. in the face of a recovery in its ninth year, extremely high monetary growth rates, an extraordinary boom in equities and real estate, and the highest P/E ratios in recorded history.

The boom in America is directly related to high unemployment rates and low capacity utilization rates in Europe, Japan, Asia and Latin America. The post-1995 U. S. boom is dependent on the idle resources in post-Maastricht Europe, on the stagnant Japanese economy of the 1990s and on the considerable idle capacity in Asia and Latin America. In short, America's spectacular boom--its ability to grow for over nine years without inflation--is dependent on the very substantial volume of idle resources in the global economy--on the fact that we are currently living in a global economy that is Keynesian.

Greenspan's June 1999 and July 1999 testimony to Congress may indicate that he is now ready to raise interest rates and limit money growth--take the handcuffs off--even though inflation is still relatively benign.

We do not deny that there have been spectacular breakthroughs in computer technology and advances in telecommunications with corresponding increases in productivity in the 1990s. But as our citation from Schumpeter suggests, similar claims were made for the motor car in the 1920s. Indeed Schumpeter describes this period as the "industrial revolution of the twenties".

If the secret of our post-1995 boom is that we are living in a Keynesian global economy, then, like the Keynesian world of the 1930s, it is a temporary phenomenon and not a permanent feature. We therefore reject the New Paradigm; and we conclude that the extraordinary rise in equities since 1995 is a likely asset bubble. 17/

August , 1999




1/An exposition of the New Paradigm and the New Economy view is presented by Steven Weber "The End of the Business Cycle"; Foreign Affairs, July-August, 1997, volume 76 #4 pp. 65-82. For a critical analysis of the New Paradigm see Paul Krugman "Seeking the Rule of the Waves" Foreign Affairs, op cit, pp 136-141 and his "How Fast can the U. S. Economy Grow?" (Harvard Business Review, July-August 1997, pp. 123-129) Ugo Sacchetti "Whither the U. S. Economy?" (Banca Nazionale del Lavoro Quarterly Review #208, March 1999, pp 69-94) argues that the trends which have sustained the current boom cannot continue, and are bound to be reversed. He suggests that the U. S. economy may enter a period of significant recession.

Chairman Greenspan takes an intermediate position. He states: "The 1990's have witnessed one of the great bull stock markets in American history. Whether that means an unstable bubble has developed in its wake is difficult to assess. A large number of analysts have judged the level of equity prices to be excessive, even taking into account the rise in 'fair value' resulting from the acceleration of productivity and the associated long-term corporate earnings outlook.". . . . . "But bubbles are generally perceptible only after the fact. To spot a bubble in advance requires a judgement that hundreds of thousands of informed investors have it all wrong. Betting against markets is usually precarious at best." See Alan Greenspan: "Monetary Policy and the Economic Outlook." Joint Economic Committee, U. S. Congress, June 17, 1999.

In subsequent testimony he states:"Premptive policy making requires that the Federal Reserve continually monitor economic conditions, update forecasts, and appraise the setting of its policy instrument. Equity prices figure importantly in that forecasting process because they influence aggregate demand. As I testified last month, the central bank cannot effectively directly target stock or other asset prices. Should an asset bubble arise, or even if one is already in train, monetary policy properly calibrated can doubtless mitigate at least part of the impact on the economy. And, obviously, if we could find a way to prevent or delate emerging bubbles, we would be better off. But identifying a bubble in the process of inflating may be among the most formidable challenges confronting a central bank, pitting its own assessment of fundamentals against the combined judgement of millions of investors." Alan Greenspan: Statement before the Committe on Banking and Financial Services, U. S. House of Representatives July 22, 1999, p. 13.

For a novel interpretation of the New Economy, see J. Bradford DeLong "What 'New' Economy?", Wilson Quarterly, Autumn 1998, pp14-26.

2/Irving Fisher, The Nature of Capital and Income. (New York, Macmillan, 1906.)

ibid. The Theory of Interest. (New York, Sentry Press, 1930).

ibid. The Purchasing Power of Money. (New York, Macmillan, 1931).

ibid. Constructive Income Taxation (New York, Harper, 1942).)

ibid The Making of Index Numbers. (Boston, Houghton-Miflin, 1927).

ibid. Mathematical Investigations in the Theory of Value and Price. (New Haven, Yale University Press, 1925).

3/Irving Fisher The Stock Market Crash and After. (New York, Macmillan, 1930).

4/ The factors stressed in the New Paradigm are very similar to those stressed by Fisher. On technology, see Fisher's Chapter 8 on SCIENTIFIC RESEARCH AND INVENTION; on globalization and restructuring see Chapter 7 on THE AGE OF MERGER and Chapter 9 on INDUSTRIAL MANAGEMENT. On the non-confrontational labor relations, see Chapter 10 on LABOR'S COOPERATIVE POLICY; and on the central bank success with price stability see Chapter 12 RELIEF IN SEVEN YEARS OF STABLE MONEY.

5/ Fisher, in the fall of 1929, stated that "Stock prices have reached what looks like a permanently high plateau." See J. K. Galbraith The Great Crash (Boston, Houghton Miflin, 1961) , page 75.

6/ "Clearly, sustained low inflation implies less uncertainty about the future, and lower risk premiums imply higher prices of stocks and other earning assets. We can see that in the inverse relationship exhibited by price/earnings ratios and the rate of inflation in the past. But how do we know when irrational exuberance has unduly escalated asset values which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade? And how do we factor that assessment into monetary policy?" See Alan Greenspan "The Challenge of Central Banking in a Democratic Society", December 5, 1996 (Washington, AEI), p. 14.

7/ See Kenneth R. Harney: "The Nation's Housing". The Washington Post, July 13, 1999, pp. G1, G2.

8/Alan Greenspan "Monetary Policy Report to the Congress Pursuant to the Full Employment and Balanced Growth Act of 1978", February 23, 1999, p. 25. This report by the Fed Chairman, which he delivers twice annually to both the House and the Senate Banking Committees is sometimes referred to as the Humphrey-Hawkins Report.

9/ Greenspan, in a sense, created this problem when he downplayed the significance of monetary growth rates in his testimony on the 1990-1991 recession. See Section VII, below, on GREENSPAN AND THE MONETARISTS.

Buchanan and Fand, in discussing Greenspan's testimony during this period, write "One argument offered by Greenspan himself is that the public did not want to hold more M2: thus there was a need to "work down the debt excess", "restructure the balance sheet", "work off the debt overhang" and "work off the excess of the 1980s". But these statements expressed an elementary fallacy. Any nominal target can be achieved by the Fed through central bank operations, especially a target as wide as the low end of the range from 2.5 to 6.5% that was set in 1992.....We may sum up this section by asking defenders of Federal Reserve monetary policy in 1990-1992 three questions: 1. Could the Fed have produced more M2 in the three years 1990-1992? 2. Would more M2 have increased output, employment and income? 3. Would such increases have been desirable?". James M. Buchanan and David I. Fand: "Monetary Malpractice: Intent, Impotence, or Incompetence?". Critical Review volume 6, number 4, pp 465-466.

See also David I. Fand: "Monetarism and the United States Economy: 1990-1995" in Avi Cohen, Harold Hagemann, and John Smithin (editors); Money, Financial Institutions and Macroeconomics, (Boston, Kluwer, 1997). Chapter 12, pp 175-190.

10/ It is interesting to note that after his comments on "irrational exuberance" in December 1996, money growth almost doubled from a 4.6% growth in 1996 to an 8.5% rate in 1998. See Table 3 and Chart 4.

11/ In response to a question from former Governor Lawrence Lindsey, Chairman Greenspan states:"We are constrained by an unwritten set of rules. From where I sit, one of the toughest jobs is to know exactly where we cross the line. We are a central bank in a democratic society that functions under an existing set of laws. We have technical independence in the sense that there is nobody that has the legal capability of rescinding an action we take in the monetary area. But we cannot do things that are totally alien to the conventional wisdom in the professional community. Of course, if we simply look to the conventional wisdom to tell us what to do, we might as well go out of business and have somebody run policy by just conducting a poll." Lawrence B. Lindsey: Economic Puppetmasters (Washington, AEI Press, 1999), page 34.

12/ In the interview with Former Governor Lindsey, Greenspan also states "There is a fundamental problem with market intervention to prick a bubble. It presumes that you know more than the market. There is also a problem of timing. You might prick it too soon, in which case it comes back, and you may just make it larger the next time. There is also the very interesting question as to whether the central bank is intervening appropriately in the market. This raises some fascinating questions about what our authority is and who makes the judgement that there actually is a bubble." Lindsey, op. cit, page 50.

13/ As indicated in the next section, Greenspan's 1990-1991 arguments downplaying the signficance of monetary growth rates further limits the Fed's ability to act. See also Fand and Buchanan, op cit.

14/ Schumpeter, describing this period as 'the industrial revolution of the twenties' states: "This is what we find. The electrical, chemical, and automobile industries, which together with their subsidiaries and all that directly and indirectly hinges upon them--the motorcar, for instance, is responsible for a great part of the total of postwar construction: roads, garages, gasoline stations, suburban residences--account for 90% of the postwar changes in the industrial organism and for most of the increase in real income." See Joseph A. Schumpeter Business Cycles (Abridged, with an introduction by Rendig Fels), (New York, McGraw Hill, 1939). page 305.

15/ "Alan Greenspan's monetary deceleration during and after the 1990-1991 recession was even more stringent and restrictive than the tight money policy that Paul Volcker introduced to reverse double digit inflation in early 1980. The M2 growth rate of 2.8% and 1.9% in 1991 and 1992 fell below even the midpoint of the Fed's target ranges, which were explicitly selected to slow inflation Had the Fed hit the midpoint of its own money targets in 1991-1992, by early 1993 M2 would have been approximately $200 billion larger and the GDP perhaps about $350 billion higher." See Buchanan and Fand, op cit, pages 461-462.

16/Greenspan in his testimony states: "While bubbles that burst are scarcely benign, the consequences need not be catastrophic for the economy. . . . .The bursting of the Japanese bubble a decade ago did not lead immediately to sharp contractions in output or a significant rise in unemployment. Arguably, it was the subsequent failure to address the damage to the financial system in a timely manner that caused Japan's current economic problems. Likewise, while the stock market crash of 1929 was destabilizing, most analysts attribute the Great Depression to ensuing failures of policy. And certainly the crash of October 1987 left little lasting imprint on the American economy." Alan Greenspan: Joint Economic Committee testimony, June 17, 1999, op cit.

17/ Former Federal Reserve Governor Lawrence Lindsey, who discussed these issues in an interview with Chairman Greenspan, writes "We have one other very important consideration. The bigger the bubble in asset prices, the more dependent the economy is on the wealth-generated spending caused by the bubble. The economy will get a dose of "the higher they rise, the harder they fall".

Greenspan acknowledges as much "Of course there are dangers and to be sure, we don't want to get ourselves hung up on a very expensive bubble" Greenspan is well aware that this is the dilemma he faces: "If you had a gold standard there wouldn't be the choice. No matter what we do, we're creating potential trouble. Absent the gold standard, open market policy should endeavor to create monetary conditions in the least worst manner?" So Greenspan sits on the horns of a dilemma. On the one hand, if he tightens monetary policy he risks disturbing both the political concensus that supports the Fed's independence and the economic conditions that underpin having society making the most of a supply shock. On the other hand, if Greenspan does not act to tighten policy, the bubble simply gets bigger and bigger, until the Fed has no choice." Lindsey: op cit., p. 52.