Paul Krugman:
Should the Fed Care About Stock Bubbles?
SHOULD THE FED
CARE ABOUT STOCK BUBBLES?
It was
a time of unprecedented prosperity. And it was also a time
of soaring stock
prices, a time when the market became a national
obsession. As
more and more ordinary Americans began buying stocks,
many responsible
people became worried. True, some market gurus
argued that
changed fundamentals made the higher price levels
reasonable--and
those optimists had, of course, been right so far.
But still there
was a sense, almost a consensus, among sober heads
that this was
a classic bubble.
Even if stock prices had gone crazy, however, what if anything
should be the
policy response? Should the Fed raise interest rates
and pop the
bubble? Or would this simply bring on a recession?
Anyway, if consumer
prices are stable, should the central bank even
care about asset
inflation?
Like most debates in which nobody really knows the answer, this
one became peculiarly
intense and bitter. Those who wanted the
bubble popped
accused the other side of irresponsibility, warning
that continued
financial excesses would inevitably lead to a painful
hangover. Their
opponents argued that as long as there were no signs
of inflation,
to raise interest rates would be an act of pure spite
and would itself
bring on a gratuitous recession.
So even in times of prosperity, a central banker's lot is not a
happy one. The
funny thing is that 70 years later the great debate
about the market
and monetary policy, the one that raged in 1928 (bet
you thought
I was talking about current events--well, those too)
remains unresolved.
What, if anything, should the Fed do when it
thinks the market
has gone mad?
You can tell that this question has gotten Greenspan upset: He's
so worried that
he's become--it scares me to say this--
comprehensible.
Everyone knows he believes stock prices are too
high. But the
market is no more convinced now than it was the first
time he warned
about "irrational exuberance," back when the Dow was
around 6500.
So he can't seem to talk it down. Should he do more?
The answer, I'm almost convinced, is no: leave the economy alone.
But I'm not
totally sure, so let me give both sides.
To start, let's assume Greenspan is right, that this is a bubble--
that it isn't
just the Internet stocks with infinite P/E ratios
(because they
haven't got, and may never get, any E) but stocks in
general that
are way out of line. Eventually the bubble will burst,
and the "wealth
effect" of that burst will pull down consumer
spending. At
that point we will have a recession if the Fed either
doesn't or can't
cut interest rates enough to keep the economy going.
Now, we know Greenspan will be fast on the trigger if it looks as
if a recession
is brewing, so the main danger is a collapse in
consumer spending
so deep that interest rate reductions are
ineffective--sort
of what happened to Japan. You might think that
the big question,
then, is whether this is at all likely for the U.S.
Actually, that's the wrong question. Say you're worried that
after the Big
Meltdown, Americans will be so discouraged that even
zero interest
won't keep them spending. That still doesn't mean
things would
necessarily have been better had the Fed raised rates
when the market
was high.
The thing to understand is that a stock market boom is not like a
boom in physical
investment--say, a boom in condominium construction.
That kind of
boom depresses future spending because it leaves behind
a landscape
littered with unsellable condos. But that isn't quite
what happens
when stocks surge: When the market value of Croesus.com
doubles, that
doesn't mean there will be an overhang of vacant dot-
coms weighing
down rental rates two years from now. It's paper gains
today, paper
losses tomorrow; who cares?
Advocates for pricking the market bubble have a few favorite
scenarios. First,
there's the "harder they fall" hypothesis: The
higher stocks
go now, the lower they will go--or the lower consumer
spending will
be for any given level of stock prices--when people
return to reality.
But that's more amateur psychology than serious
analysis, and
a poor basis for economic policy.
Ah, they say, but what about debt? Shouldn't Greenspan act to
counter the
defaults that could accompany a market crash? If
consumers go
deeply into debt to buy stock or to buy consumer goods
because their
market gains make them feel rich, this could depress
spending later
on. But really bad debt overhangs come when
businesses (especially
real estate developers) overborrow, which is
not, as far
as I can tell, a big problem in America right now.
Perhaps the most seductive argument for Greenspan's intervention
in the market
is the lesson that the past would seem to teach us:
Didn't America's
bubble in the 1920s, and Japan's in the 1980s,
prepare the
way for the economic crises that followed? Maybe--but it
turns out that
in both cases the central banks raised rates in an
attempt to let
the air out of markets, and thus may have helped
precipitate
the very slumps they feared.
So what should Greenspan do? Probably what he does best--i.e.,
nothing--and
deal with the bubbles if and when they burst. Oh, and I
wish he wouldn't
worry so publicly: It makes me nervous when I
understand what
he's saying.