Greenspan Issues A Warning

Alan Greenspan gave investors another warning Wednesday that the bull market cannot continue unless profits perk up.

The Federal Reserve chairman said the Fed is watching the markets closely, but is not trying to prop them up or knock them down.

The Dow Jones industrial average gained more than 100 points in the two hours after Greenspan's speech.

"Our objective is the maximum sustainable growth of the U.S. economy, not particular levels of asset prices," he told the House Ways and Means Committee.

In the question-and-answer session, Greenspan said he could not support President Clinton's proposal that the government invest about $600 billion of the Social Security trust funds in stocks.

Without an increase in the total amount of savings in society, switching the form of those investments would be a "zero-sum game," he said. "I'm hard-pressed to find any benefits."

The chairman said he would prefer that the surplus be used to pay down the federal debt rather than to cut taxes and that he'd prefer cutting taxes to raising spending.

Greenspan has periodically warned of excessive optimism since he first delivered his "irrational exuberance" speech more than two years ago. The markets have often reacted negatively in the short run to Greenspan's words, but seem to recover quickly.

Greenspan said the three interest rate cuts in the fall were a response to "abrupt stringency in financial markets" that could have stalled economic growth. "We were not attempting to prop up equity prices, nor did we plan to continue to ease rates until equity prices recovered, as some have erroneously inferred."

The rate cuts set off the latest leg of the bull market. Most analysts surveyed by CBS MarketWatch believe the Federal Open Market Committee will not change interest rates at its Feb. 2 meeting. Greenspan said little Wednesday to alter that view.

Greenspan insisted that the Fed is not trying to fine-tune the bond or stock markets. "While asset values are very important to the economy and so must be carefully monitored and assessed by the Federal Reserve, they are not themselves the target of monetary policy."

"We may question from time to time whether asset prices may not embody a more optimistic outlook than seems reasonable, or what the consequences might be of a further rise in those prices followed by a steep decline," he said. "But many other forces also drive our economy, and it is the performance of the entire economy that forms our objectives and shapes our actions."

In written testimony ahead of his appearance, Greenspan reported that the U.S. economy has "continued to perform in an outstanding manner," in part because the Fed has driven inflationary expectations out of the economic psychology and allowed capital and labor to go to work in their most productive uses.

While the Fed chief said the Brazilian recession remains a "possible soure of downside risk" to the U.S. economy, he spent the bulk of his prepared testimony detailing the risk that falling corporate profits will hurt the U.S. economy by curtailing business spending and ultimately by slamming the brakes on consumer spending when the flood of capital gains stops.

Greenspan said the tremendous rise in stock market valuations reflects, in part, a real transformation in the productivity of capital. The booming stock market, in turn, has lowered the cost of capital and spurred consumption. That's been good.

But if investors become overoptimistic about profits, that source of consumption could dry up if stock prices revert to historic price-to-earnings ratios.

Greenspan said the recent rebound in stock prices has been "unusual" because it's come as profits have sagged under pressure from tight labor markets, lower commodity prices and intense competition. Businesses would raise prices to maintain profit margins if they could.

"But, to date, businesses' evident pricing power has been scant." The likely result is a scaling back of new investment. But, so far, investors have not scaled back their expectations of profits from those investments.

Greenspan raised the "possibility" that "the recent performance of the equity markets" can't be sustained. "The level of equity prices would appear to envision substantially greater growth of profits than has been experienced of late."

Little has changed from his assessment of December 1996 that the markets were showing "irrational exuberance." Since then, Greenspan has toned down the heated rhetoric and stepped up the intellectual argument that the economy may yet pay for Wall Street's wild ride.

"A flattening of stock prices would likely slow the growth of spending," and a decline in equity values, especially a severe one, could lead to a considerable weakening of consumer demand, he said. Strong consumer spending in the United States has been maintaining the U.S. economic boom and has supported what little recovery there has been in East Asia and Japan.

Greenspan said he would welcome a moderate slowdown in the U.S. economy, which he said "continued to grow more rapidly than can be currently accommodated on an ongoing basis, even with higher, technology-driven productivity growth."

Written By Rex Nutting, CBS MarketWatch