Commentary: Why Greenspan Should Keep Mum About The Market

Alan Greenspan is a master at forecasting the economy, and a pretty savvy politician to boot. But when it comes to divining the mysteries of the stock market, the Federal Reserve Chairman is no Wall Street wizard.

The Fed chairman stunned the markets on Dec. 5 by asking whether "irrational exuberance" was creating a stock bubble that could burst over the economy. The immediate response was a one-day sell-off on overseas markets as foreign investors assumed Greenspan was signaling an interest-rate hike. Greenspan's musings rattled U.S. markets, too. On Dec. 6, the Dow Jones industrial average plunged 145 points before recovering two-thirds of the loss. Then, on Dec. 11--in what traders called a delayed reaction--the Dow shed 130 points before closing down 70.7 points. "Greenspan has forced people to reevaluate if there's too much risk in this market," says Ricky Harrington, an analyst at Interstate/ Johnson Lane Corp.

"WALL OF MONEY." Fed officials privately dismiss the prospect of a move to hike rates when the policymaking Federal Open Market Committee meets on Dec. 17. Greenspan's motive more likely was to try to nudge the market down with his jawboning. To be sure, stocks may be due for a rest after a breathless run of 25% off their July lows. But in the long term, Greenspan is unlikely to change market psychology. And that's largely because of his own success as a monetary mandarin: Behind investors' love affair with stocks is their confidence that the Fed boss will keep the economy humming with low inflation. That has encouraged small investors this fall to pour $4 billion a week into mutual funds. "He's going up against a wall of money that's pretty formidable," says Robert Adler, president of AMG Services Inc., which tracks fund flows.

It's also not clear that the market is as dangerously overpriced as the Fed chief suggests. Nor does Wall Street itself agree on that question. Greenspan, with little market expertise of his own, met with Wall Street strategists two days before his speech. Several argued that stocks were fairly valued. Others argued the opposite point. Economists are also puzzled by Greenspan's comparison of the U.S. to Japan's 1989 meltdown. At that time, Japan was plagued by a wildly overvalued market, inflated real estate, and overextended banks, which is not the situation in the U.S.

Still, Fed officials have been nervous about the frothy stock market since last spring. And with the Dow roughly 15% higher since then, Greenspan & Co. may fear it will be tougher to hike interest rates down the road if inflationary pressures resurface. "If we knew tightening [interest rates] would trigger a market crash, we might have to think twice," admits one Fed official.

Greenspan's real worries may spring from a sense that the Fed is losing control over the credit markets. While the central bank holds great sway over interest rates, foreign exchange rates, and lending by commercial banks, it is unable to regulate the flood of credit generated on Wall Street that accounts for an ever larger share of financing for the global economy. Fed officials realize they lack the tools to temper a manic market--even one that could jeopardize the health of the economy.

OTHER MEANS. This year, corporations will raise more than $45 billion in new funds through initial public offerings, which are financed in part by margin borrowing by investors. Overall margin lending is up a modest 8% this year, to $83 billion. While the Fed has the power to set limits on how much investors can borrow on margin, Fed officials recognize that tightening requirements would have limited impact. The reason: Investors now have too many other ways to make leveraged bets, such as options, futures, or simply borrowing against their home equity.

In the end, the Fed has only one blunt instrument to fight market froth --a boost in rates. But it has never used a rate hike to break a speculative fever in the market, and Fed officials seem unwilling to do so now.

So, Greenspan will stand on firmer ground if he returns to three decades of Fed tradition. No Fed chief had publicly voiced concern about the stock market since 1965, when William McChesney Martin Jr. noted "disquieting similarities" between the speculation of the 1960s and that of the 1920s. Martin wasn't right then, and it's likely Greenspan isn't right now.

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