Federal Reserve Chairman Alan Greenspan said Friday that Fed policy-makers could not have deflated the stock market bubble that emerged in the late 1990s without raising interest rates to such high levels that it would have pushed the United States into a severe recession.
Greenspan used an address to an annual Fed economic symposium to defend the central bank against critics who have contended that the failure to deflate the high-flying stock market in the late 1990s was a major policy error.
Greenspan, who famously warned in December 1996 that investors could be in the grips of "irrational exuberance," said it was very difficult for policy-makers to know when a stock market bubble was developing.
And he said even if the Fed felt it should substitute its judgment for the actions of millions of investors, it would be very hard for the central bank to curb stock market euphoria.
"The notion that a well-timed incremental tightening could have been calibrated to prevent the late 1990s bubble is almost surely an illusion," Greenspan said.
To support that view, Greenspan cited previous instances when the Fed raised interest rates by more than 3 percentage points in the late 1980s and mid-1990s but stock prices, after initially retreating, resumed their upward advance.
He said that to have the impact of deflating an unjustified rise in stock prices, the Fed would have had to push rates up by such large amounts that it would almost inevitably trigger an economic recession, the very outcome the Fed was seeking to prevent.
"Such data suggest that nothing short of a sharp increase in short-term rates that engenders a significant economic retrenchment is sufficient to check a nascent bubble," Greenspan said in remarks prepared for an economic conference at Jackson Hole, Wyoming. Copies of his remarks were released in Washington.
Greenspan spoke at the start of two days of discussions involving top academic economists and Fed officials, who this year were examining the topic of how Fed interest rate decisions and budget and tax policies can be used to deal with recessions.
He used his remarks to defend the Fed's actions in the late 1990s when investor euphoria over the developing Internet economy and high-tech telecommunications companies sent Wall Street on a dizzying ride that peaked in the spring of 2000.
Since that time, investors have seen their portfolios shrink by more than $7 trillion. The technology-heavy Nasdaq composite index hit a peak of 5,132 on March 10, 2000, and since that time has shrunk to a Thursday close of 1,336, a loss of 74 percent of its value.
Wall Street's worst bear market since the mid 1970s was dealt another blow this summer when a number of formally high-flying companies such as Enron and WorldCom became embroiled in accounting scandals.
President George W. Bush, in an effort to keep the plunge in stock prices from bringing on a double-dip recession, recently signed into law tough new regulations governing corporate reporting requirements, hoping to restore investor confidence.
The Fed, seeking to bolster an economy that fell into its first recession in a decade last year and then was jolted by the terrorist attacks, has pushed interest rates to their lowest levels in four decades.
At its most recent meeting two weeks ago, the Fed signaled that it was ready to push rates even lower if necessary to keep the fledgling recovery from faltering.
Greenspan made no mention of current economic conditions or the future course of interest rates in his prepared comments.
In addition to defending the Fed's decision not to raise interest rates in an effort to influence stock prices, Greenspan said that other possible Fed actions, such as raising margin requirements, would not have worked either. Greenspan the actual amount of stocks that are purchased on margin — meaning the investor uses a percentage of the stock's value as collateral for a loan to buy the stock — is very small relative to overall stock market activity.
After he first raised the issue of whether the stock market was overvalued in his "irrational exuberance" speech in December 1996, Greenspan was criticized by some conservative Republicans for attempting to influence the value of stocks.
Various Republican members of Congress questioned why Greenspan, a believer in free markets, was attempting to talk the market down.
Greenspan said in discussions inside the Fed, central bank policy-makers realized it was very hard to determine when a bubble was actually developing.
"We recognized that despite our suspicions it was very difficult to definitively identify a bubble until after the fact - that is, when its bursting confirmed its existence," Greenspan said.
By Martin Crutsinger