Greenspan vs. Inflation: A Debate

When Alan Greenspan frets, people take notice. So it was no surprise that the Federal Reserve chairman attracted widespread interest with recent comments about productivity increases being a potential harbinger of inflation. His line of thinking runs this way: Gains in productivity (the same number of workers producing more goods and services) can lead investors to believe that corporate earnings will continue to grow. Stock prices are bid up, thus increasing the "wealth effect." If people feel they will have more money in the future, they consume more today, and may take on a lot of debt in doing so. If demand outstrips supply, prices can shoot up.

Is Greenspan right to be worried? Should the Fed continue to raise rates? Are those high-flying technology stocks headed for a come-uppance? Are consumers overextended?

To find out, Knoweldge@Wharton interviewed three members of Wharton’s finance department and a well-known investment strategist. The faculty members are Jeremy Siegel, Marshall Blume and Nicholas Souleles. Siegel is author of the bestseller Stocks for the Long Run (second edition, 1998). In addition, Blume and Siegel are co-authors of Revolution on Wall Street (1993). Souleles teaches a course in macroecononics and researches consumer spending, borrowing and investment. Joseph Battapaglia, a Wharton alumnus, is chief investment strategist at Gruntal & Co. and one of Wall Street’s most prominent bulls.

Jeremy Siegel:
Greenspan is completely right. He’s saying if people think that in the future they’re going to be richer, they’re going to want to borrow against everything today. No economist contradicts that. The more that people want to borrow, the higher interest rates go.

It manifests itself indirectly through the wealth effect. People think there will be more profits in the future. A more promising future engenders increased borrowing against the future. If I told you that you were going to get $1 million tomorrow, would you spend more today? Sure.

There’s no controversy. He’s saying the market is actually raising interest rates and he has to follow that along. If not, he’s going to have to add a lot of liquidity to the economy, which means inflation. If you’re going to get productivity increases, you’re going to have to get rates up.

Why do you think the unemployment rate is going down? The only way we’re producing all the goods that are being demanded is we are drawing down on the resources that produce those goods. As good as productivity is, it’s not going up dramatically. It’s probably around 3% on an annual basis, and real GDP is growing faster than productivity. There is no disagreement about that either.

The Fed would be right to continue to raise rates. It’s not going to take major increases in rates to slow the economy and bring stock prices down. The market already appears to be in kind of a correction now. This is without all of the rate increases being fully implemented. My outlook right now is it’s possible that two to three rate increases [of a quarter point each] will be enough.

The divergence in the market between the price of Nasdaq stocks and the rest of the market is a reason for concern. I’ve never seen such a wide divergence. I don’t think it’s a healthy development at all. I think the two are more intertwined than many think. Trend followers, momentum players, are moving the sectors that are hot. There could be a very sharp break in prices of these momentum stocks. Now when I see sectors moving in opposite directions, I can see a fall in the new economy stocks being accompanied by a rise in old economy stocks.

I think there is a bubble in many technology stocks, and no one can say when it will break. Tech stocks are still relatively strong. I think that Greenspan believes tech stocks should correct to more reasonable levels.

The boom today is much more substantial than the Nifty Fifty boom in the early 1970s. It’s affecting bigger stocks that have a bigger chunk of the market. Microsoft is No. 1 in market value and Cisco Systems is No. 2. There is a degree of magnitude today that we haven’t seen before.

Joseph Battapaglia:
Greenspan’s argument is very elegant because you could say that Americans, as a rule, always feel positive about the future. If you look at it from a life-cycle point of view, you’re fairly certain you’ll be successful in the future. Therefore, you can take on a larger mortgage payment today because it will be easier to pay over time. So in building your economic model with the premise that tomorrow is better than today, his remark is not too far away from that.

But you could run into trouble in saying the ability of the economic infrastructure to meet rising demand may come up against real constraints and create shortages. Today, we should be looking at our economy in a global perspective and not what I call a regional perspective. The goods we can’t create here can be supplied globally.

I just don’t see capacity constraints coming to the fore anytime soon to make Greenspan’s comments a reality. In addition, I would give more credit to the consumer and the businessman for rational behavior.

We believe productivity is growing. We believe it will make companies more profitable. I think what the Federal Reserve is trying to do is remind everyone that good economic times get interrupted. At some point, expansions become recessions. But, fortunately, it won’t be any time soon.

When it comes to the stock market, which is an evaluation of future corporate performance, the concentration of ownership in the market is among the more affluent. The wealthy are less likely to be affected by declines in stock prices. We had very good evidence of this in 1987, in that the real economy continued to expand even though we had a sharp, sharp contraction in stock prices. So I think there is some truth to what Greenspan is saying, but there is little evidence that we’re at some dangerous inflection point on that issue.

Banks have been very disciplined in the kinds of loans they’re willing to take on and the debt-to-asset ratios they can tolerate. And although the delinquency rate may be up, the dollar value of such [delinquent] loans is small. Margin debt [used to purchase stock] is about 2% of outstanding stock value, versus 18% in the late 1920s. Also, we’re talking about an economy that creates $9 trillion of GDP. So if the wealth effect is $25 billion to $50 billion, it’s not a lot.

Interest rate increases are not necessary. However, the Federal Reserve, by its own action, has gone to 6% or 6.25% in the federal funds rate as being equilibrium and has cut rates as necessary, as it did during the Gulf War and a few years ago in response to the Asian crisis. But as far as going beyond those levels, I don’t see the need.

If the Fed pursues this line of reasoning, it would have to keep raising rates to the point of oblivion. Would Greenspan risk recession to curb the wealth effect? I don’t believe he’s going there. I think he will raise rates once [at the Federal Open Market Committee meeting on March 21], then again at the May meeting, a quarter point each time, then he will stop. Then he will have evidence that we are not moving to higher levels of inflation and that the global economy still has a supply and demand balance.

The market has been very rational in rewarding companies that have earnings growth. I don’t believe [the divergence in the market] is an issue of old economy and new economy. It’s just that many of the manufacturing and business categories are relatively mature. What is in the NASDAQ composite? Four thousand companies are traded over the counter but only 1,900 of them comprise most of the market value. When you look at those 1,900 companies and look at their market values, you find them trading at 56 times earnings. Those earnings are growing at 35%. [By contrast, stocks in the Standard & Poor's 500 index] are trading at 25 times forward earnings and their earnings growth is only 12.5%.

Marshall Blume:
You could make the argument that when corporate earnings go up people become more excited about the market, and as the market goes up they get more wealth and want to buy more. But I’m not sure it necessarily has to do with productivity. It has to do with the prices people are willing to pay for stocks. It creates a wealth effect when stock prices rise. That wealth effect encourages people to spend, which ultimately can lead to inflation.

The Fed’s argument about productivity is really an argument that the market is overpriced. Greenspan is saying that people are mistaken in expecting earnings to grow 18% to 20% forever and that earnings growth will be fueled by productivity growth. Productivity growth can’t do that. There’s concern that some people’s expectations about the market are totally unrealistic.

I think additional interest-rate increases are necessary. But to get the market down is a hard job. I worry about how high the Fed may have to have to raise rates to cause a realization on the part of the public that the market is too high. Maybe the Fed can’t do that without putting us in a serious recession.

There’s no real mechanism for bringing down the prices of those stocks that are overvalued in this market. As long as people are willing to participate in this type of game—it’s almost a Ponzi scheme—then these stocks can remain high for many years. Then they’ll drop.

What’s going to cause the collapse, we don’t know. It could be because some dot-com company doesn’t get financing and goes bankrupt. The market could collapse on its own. The business strategy of many dot-coms is to float new equity and use the proceeds on advertising and development. Then they go to the market again when they need more money because they’re not making profits. Well, at some point nobody will be willing to give money to those companies anymore and one of them could go bankrupt. Right now the market is like musical chairs. I worry that all the chairs will get removed at the same time.

The steep rise in the stock market over the last 12 months has been very uneven. Some stocks are now selling at very high price/earnings ratios. Thus, the vast wealth creation comes from only a limited number of stocks. When the market corrects, it is likely that these stocks will fall the most, and the holders of these stocks may see large drops in the value of their wealth. If the holders have increased their borrowing, either for margin or for consumer spending, in response to their increase in wealth, they may be in a difficult financial condition and we could see a rapid decrease in consumption expenditures. This could send ripples throughout the economy.

Nicholas Souleles:
To understand Greenspan’s argument you need to distinguish between aggregate supply and aggregate demand. A rise in supply brings down prices. A rise in demand increases prices and leads to inflation. What’s important is whether the supply or demand curve shifts out more.

What Greenspan is saying isn’t a new argument. Everyone agrees productivity is increasing, but the questions are how much and how permanent will the increase be? In economic expansions, productivity often rises but it’s not always a permanent increase. Greenspan’s argument turns on whether most of the productivity gains are happening now or in the future.

At one end of the spectrum, suppose much of the current increase in productivity is temporary, and it’s not going to raise the long-term economic growth rate much. In this case, in terms of supply, firms can still currently produce more for the same number of workers. That means the supply curve has shifted out. As for demand, if we get just a temporary increase in productivity, national income goes up but only temporarily. If so, consumers will not spend much out of that income. The wealth effect will be small. In this case the demand curve does not shift out much. Now, putting supply and demand together, if supply increases more than demand, prices come down and it’s not inflationary.

Here’s the opposite case. Increases in productivity continue or perhaps even accelerate. This means current supply is not increasing that much, relative to future supply. But if consumers expect productivity increases in the future, they will expect their wealth will be even higher in the future; and the kicker is that they will start consuming some of that future wealth now, in advance. In this case the wealth effect will be strong and the demand curve will shift out a lot. We see this in the data. Not only have stock prices gone up, consumers are taking on a lot of debt. The personal savings rate is at a record low and consumer debt relative to GDP is at a record high. Again putting supply and demand together, if demand shifts out more than supply, we would get inflation. This is the case Greenspan is worrying about.

Greenspan seems to be assuming that although productivity is going up now, consumers must be expecting it to continue to go up in the future. Whether this happens or not isn’t as important as the public perception. This would lead to a strong wealth effect now. It’s not that novel an argument. It’s the kind of question I can ask on an exam.

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