Asymmetrical Information

From the desk of Jane Galt:

At his address to the

At his address to the annual Fed economic symposium yesterday, Alan Greenspan defended the fed from charges that the 90's bubble was the fault of Fed policies.

Many people have alleged that the motive force behind the stock bubble was lax policies of the Fed. But as Greenspan pointed out in his speech, the big tightening moves that the Fed made had no long term effect on the markets; they hiccoughed, and then just kept rising. Greenspan says that raising interest rates enough to have had an effect would also have resulted in a severe recession.

Looking back at our last great bubble, in 1925-1929, I see a similar pattern. Raising interest rates a little just fed the flames. It encouraged domestic and foreign capital to lend. But with asset prices rising by 100% or more a year, raising interest rates from 6% to 6.5% had no effect on the consumers who were borrowing money to pour it into the market. Really putting a dent in the bubble would have required raising rates high enough to cause massive cutbacks in business investment, which would have hurt everyone. And with the equity market where it was, in many cases, borrowers would just have turned to equity offerings, further fueling the boom.

It's especially problematic because many people pin the inflationary monetary policies of 1999 as the primary culprit. Well, yes, they were inflationary, and here's why: we had an Asian crisis waning, and more importantly, Y2K right in front of us. The Fed was pumping liquidity into the economy in order to prevent a crisis if people tried to withdraw all their money and stick it under their mattress.

Critics point out that no one, in fact, did this, and the resulting liquidity excess topped up the market to wild levels. Umm-hmmm. And you knew that wasn't going to happen in 1999, genius? Sure you did. So how come you're still sitting on the 4,000 shares of Webvan you bought at the height of that "excess liquidity"?

No one knew what was going to happen during the Y2K rollover. And the risk of being too illiquid during the days leading up to Y2K were simply too astronomical to take. Crunching down on credit, and then finding out that the entire public wanted to hold a lot of cash starting December 20th, would have been an unprecedented financial disaster: a nationwide bank run. In hindsight, Greenspan should have clamped down on credit in the second quarter of 1999. And in hindsight I should have sold Yahoo at 200. But there you are; if we all knew what the consequences of all of our actions would be in advance. . . well, for one thing no one would get married and have babies, and the species would die out, and then where would we be?

The other great panacea offered, raising the margin requirements, would have been no panacea. Just as generals always seem to be preparing to fight the last war, the great majority of financial commentators are prepared tp master the last economic crisis. In 1929, or better yet, 1927, raising the margin requirements would have been a swell idea. The margin requirement, for those who are confused, is the percentage of the value of a stock's price you must put up, in cash, in order to borrow the rest of the money to buy the stock. It's kind of like taking a mortgage on a stock: you put a percentage down, and as long as you make the interest payments, the loan is good, secured by the value of the stock. If the stock rises, you can sell the stock and take all the profit (less the interest you paid, of course.) If the stock falls -- aye, there's the rub. Stock prices are a little more volatile than housing prices. And when the value of your house falls, the bank can't ask you to give them back part of the money you borrowed.

With margin loans, on the contrary, they can. If you buy a stock for $10 with a 50% margin requirement, you pay $5 in your own cash and borrow the other 50% against the value of the stock. If the price of the stock drops below $10, to, say, $7.00, the bank makes you give back $1.50 of the money you borrowed so that the loan on the stock is still only half of the value of the stock, or $3.50. This is the infamous margin call, and it's one of the things that made the crash of 1929 so devastating. Each time prices dropped, the drop triggered another round of margin calls, which some people couldn't meet. Their stock had to be sold immediately to cover the loan, which flooded the market with more shares no one wanted, and caused the price to drop even further.

But 1999 is not 1929. For one thing, margin requirements are much higher than they were in 1929. Back then, margin loans were often secured with as little as 10% cash down, which made the whole thing very liable to collapse; not only were people overextending themselves, borrowing money they had no way to repay unless the stock went up, but also when margins are that low, even a moderate drop in the price means that selling the stock will be insufficient to cover the loan. Both things make the market very volatile. Margin requirements now, on the other hand, are more like 50%, which makes the whole system much less highly leveraged.

Furthermore, margin trading is much less widespread than it was in 1929. Which is not to say that people weren't borrowing money to play the market. They were; they just weren't borrowing from their broker. Take, for example, the numerous people I went to business school with who took out $100K in student loans rather than sell their Priceline stock, because it was far too valuable. Or any number of people you know who refinanced the house and dumped some of the extra money into the market. Or the ones who were holding onto credit card debt at the same time as they plowed money into their 401(k)'s. All of those people were doing pretty much the same thing a margin trader does -- leveraging up their assets in order to gamble on the market. The difference is that Alan Greenspan has the power to decree what margin requirements are. He can't issue a nationwide edict commanding you to send your money to the nice people at Mastercard instead of those greedy wretches at Merrill Lynch.

So I agree with Alan Greenspan -- he didn't do anything he shouldn't have. (I'm sure he'll be much relieved to know that). We built him up into a God in the 90's, and now we're mad at him because he couldn't wave his magic wand and get us the pretty moon. I'm constantly amazed to find that the American public is actually surprised and disappointed by the astonishing revelation that their officials are human beings, not minor deities. Where do they think we're getting these omniscient, omnipotent beings they want to make their decisions for 'em? And why do they think these superior entities would want to work for us, when all we do is give 'em grief?

After all, it's not like we can afford to pay union scale.

Posted by Jane Galt at August 30, 2002 1:14 PM | TrackBack | Technorati inbound links