Generational Dynamics
	Forecasting America's Destiny ... and the World's
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Alan Greenspan's Mea Culpa

Fed Chairman Alan Greenspan's startling remarks last weekend provide new insights into his policy for saving the economy from a meltdown.

"There appears to be enough evidence, at least tentatively, to conclude that our strategy of addressing the bubble's consequences, rather than the bubble itself, has been successful. Despite the stock market plunge, terrorist attacks, corporate scandals and wars in Afghanistan and Iraq, we experienced an exceptionally mild recession, even milder than that of a decade earlier." -- Alan Greenspan to the American Economic Association's annual meeting.

Greenspan appears to be making two points here:

• He could have prevented the 1990s bubble. Recall that it was in 1995 that he made his famous "irrational exuberance" remark. He seems now to be saying that he could have taken steps to prevent the bubble from advancing, but instead decided to let it run its course.
• He dealt with the bubble's consequences by reducing the Fed funds rate to a historically low 1%, making money more available.

I always thought that, ever since he made his "irrational exuberance" remark, Greenspan knew what was going on, knew that we were in danger of repeating the 1920s bubble and 1930s Great Depression, but felt that he couldn't do much about it, something that I agreed with.

But now Greenspan is saying that yes, he knew what was going on, and he could have done something about it right at the start, but decided not to. Bad move, Alan.

You can immediately see one big problem: A lot of people were very badly hurt by the Nasdaq crash in 2000. If Greenspan could have prevented the bubble then the Nasdaq crash would have been prevented, and those people would not have been hurt.

However the real issue is a comparison of the 1990s bubble to the 1920s bubble, and the 2000s economy to the 1930s depression. Greenspan, born in 1926, remembers the depression well from his childhood, and is well aware of its history.

History of 1929

Here's the history that Greenspan undoubtedly remembers:

The 1920s bubble reached its height on September 3, 1929. The stock market had only been increasing, and every analyst was predicting that it would only keep on increasing. Business was booming, and no one had any idea that this was a momentous day -- the height of the Great Bull Market of the 1920s. Not a single headline proclaimed that fact, and not a single analyst predicted what would happen next. The only real subject under discussion was the question of which stocks were likely to go up the most, and which stocks would go up less.

After September 3, the stock market became extremely volatile, falling, rising, falling some more. No one became alarmed, because there had been brief falls before, throughout the 1920s, and a brief fall was considered an opportunity to buy cheap stocks before the next stock market rise.

Starting on Saturday, October 19, the losses became more serious. The losses continued through the next few days, but everything was still fairly orderly. Until Thursday.

On Thursday, October 24, 1929, the selling became a deluge, and the big bankers met to create a pool of money to support stock prices at their current level. News of this meeting steadied prices for a few days, and the deluge stopped, temporarily.

The greatest stock market calamity

On Tuesday, October 29, 1929, the bottom fell out. Many major stocks lost 50-75% of their value in just a single day. It was considered the greatest stock market calamity of all time. Prices continued to fall on the following days, but did not reach their 1929 bottom until November 13. The stock market had lost $30 billion -- an amount that was considered a lot of money in those days.

What caused the sharp selloff? No doubt some people just panicked or lost faith, but later analyses proved something quite different: the people who took part in the massive selling after October 29 did so not because they WANTED to, but because they HAD to. Almost everyone was in debt, and almost every investor had bought stock on margin. (Buying stock on margin means that the investor pays only, say, 25% of the price, and borrows the rest. If the stock goes up, then the investor uses the gains to pay off the loan; if the stock goes down, then the investor has to pay off the loan from other funds, usually by selling other stocks.)

The massive selling occurred because investors were being forced to sell all their stock holdings to pay off the money they had borrowed to purchase stock on margin.

Greenspan's policy

Once you understand what happened in 1929, you can understand Greenspan's policy in 2000. By lowering interest rates and flooding the banks with low-cost money, the Fed's intent is to prevent a 1929-style crash by allowing debtors to borrow more money at low interest rates. If investors aren't forced to sell their holdings, the reasoning goes, then a crash is avoided.

But this makes a dangerous assumption: That the stock market won't fall if you only you provide enough cheap money. What if that assumption is wrong -- that the stock market would have fallen anyway, because the real, intrinsic value of the stocks was not as high as the 1920s bubble had pushed it.

That's the irrational gamble that Greenspan and the Fed have been taking. They've been betting that the inflated value of the stock market will continue if there's only enough money around. But common sense says that if stock prices are much higher than the intrinsic value of the stocks, the amount the stocks are really worth, then stock prices will fall when the psychological bubble bursts.

There are some analysts today who believe that the 1990s bubble was like the 1920s bubble, but that we've avoided the worst. An article in the Wall Street Journal on Monday, 1/5/2004, expresses this precise opinion. According to this article, the stock market fall from 2001-2003 corresponds to the stock fall from 1929 to 1932, and that now stocks have nowhere to go but up, again.

However, these analysts overlook the following factors that indicate that today's situation is quite unlike 1932:

1. The most obvious indicator is the S&P Price/Earnings ratio, which fell to 5 in 1932, fell to only 25 in 2001, and is above 30 today. Historically, whenever the P/E ratio goes above 20, it falls well below 10 within a few years, and we're still far away from that today. This indicates that a sharp fall (more than 50%) is yet to come.
2. If you do a simple long-term exponential trend analysis on the DJIA, you find that the trend value today is 4500, or 530 for the S&P 500 index (gulp!). Today's index values are still well ABOVE the trend values, while in 1932, these index values had already fallen well BELOW the trend values. Once again, this indicates that a sharp fall is still to come.
3. The stock index values have a technological cycle, with new technologies driving stock price increases every 40-50 years: electricity around 1890, factory assembly lines around 1935, desktop computers around 1982, and (probably) biotechnology around 2020. In the 1930s, we were at the BOTTOM of the technology cycle, and technology aided the recovery; today, we're at the TOP of the technology cycle, and lack of new technology will hinder the recovery.
4. We haven't suffered enough pain yet. This is what I call the "crusty old bureaucracy" analysis. Every organization builds up its bureaucracy over the decades, and the same is true for the nation, taken as a whole. Every 70-80 years, there's a major economic convulsion that causes every business, school, agency, labor union, and non-profit organization to redefine itself, causing massive unemployment. This is still to come in the decade of the 2000s.

It's still 1929

When you look at all these indicators together, what you see is that we aren't in a recovery today; instead, the Fed's historic low-interest policy has actually extended the 1990s bubble for a few more years. Today's economy isn't comparable to 1932; it's still comparable to 1929.

At age 78, Alan Greenspan is undoubtedly worried about his legacy, and that was part of the reason he was bragging last weekend. Unfortunately, it looks to me that Greenspan should have stuck to a more defensible position: "I saw all this coming, but there was nothing I could do about it except soften the blow by lowering interest rates." As things stand, he's taken responsibility for everything, good or ill.

The four indicators I've listed above are not some obscure invention; they're perfectly ordinary indicators that everyone would be using and quoting today if it weren't for the fact that no one wants to believe them. Our nation's leaders should be preparing us for what's REALLY likely to happen in the next few years, rather than believing, as everyone did in the 1920s, that the stock market has nowhere to go but up.

John J. Xenakis

Note: The history of the 1929 crash was adapted from the book, Since Yesterday: The 1930's in America, September 3, 1929 to September 3, 1939, by Frederick L. Allen, originally published in 1940.