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Generational Dynamics Web Log for 24-Nov-04
Why did stock prices suddenly turn sharply upward in 1995?

Web Log - November, 2004

Why did stock prices suddenly turn sharply upward in 1995?

A Wall Street Journal series on Alan Greenspan's legacy not only doesn't answer that question, but shows that Greenspan made some fundamental errors at the time.

The front-page two-part article (Part I and Part II) examines Greenspan's record in detail since he took over the Federal Reserve 17 years ago.

One of the most remarkable aspects of the article, something I've never heard before, is that Greenspan's reasoning in 1996 was based on his belief that the bubble was caused by increased productivity from hi-tech investments.

I've been in the computer industry my whole life, and I can tell you that is about the dumbest thing I've ever heard. Only someone who knew little about computer technology could possibly believe hi-tech investments were increasing productivity.

In the 1980s and 1990s, IT (information technology) was a monetary black hole. A typical development project was one or two years late -- if it didn't fail completely.

It's true that productivity was improved in some ways; for example, managers used PCs to type their own memos with word processors and their own budgets with spreadsheets. But those savings were no more spectacular than the productivity improvements from electric typewriters and Xerox machines in earlier decades.

So it turns out that Greenspan's reasoning about the 1990s bubble was partially caused by this crazy belief. In the article it says that Greenspan asked two economists to do a study, and they came back with what the boss wanted to hear. Incredible!

Here are the relevant paragraphs from the WSJ article:

Like many economists, Mr. Greenspan had long wondered why the spread of computers in the 1970s and 1980s hadn't boosted productivity, or output per hour of work. He was taken with the argument of economic historian Paul David, who noted that electricity didn't boost productivity for decades until working patterns adjusted. Mr. David suggested the same lag applied to computers.

Mr. Greenspan now saw surging orders for high-tech equipment since 1993 -- coupled with higher profits at the companies that bought the equipment -- as evidence the productivity payoff had arrived. If this effect was real, it meant economists were underestimating how fast the economy could grow before inflation reared its head. Companies could produce more without incurring the cost of hiring fresh labor.

Mr. Greenspan disagreed and told the committee he wanted to hold rates firm. An important reason, he argued, was that the government's productivity data were wrong. According to an analysis he commissioned from two Fed economists, productivity since 1990 in many services industries such as health care must have declined if the government's numbers were accurate.

This "makes no sense," Mr. Greenspan told the meeting. "The tremendous contraction in productivity, which all of our data show, is partially phony." Instead, he pointed to other government reports showing that companies were recording ever-wider profit margins without raising prices, a sure sign of productivity gains. "Productivity is indeed rising a lot faster than our statistics indicate."

Many committee members remained skeptical....

The remainder of this article is the contents of the message that I posted on the WSJ user message board:

Greenspan's analysis of the 1990s bubble simply doesn't make sense.

<b>S&P 500 Index with long-term trend line</b>

S&P 500 Index with long-term trend line

Why did the S&P index turn sharply upward in 1995? Why not 1990 or 2000? What was different about 1995?

Greenspan provides an explanation having to do with increased productivity from computer technology, but that doesn't make sense. For every little island of increased business productivity in the 1980s and 1990s, there were enormous training and development costs that wiped the productivity savings out. Greenspan ignored the data that said that productivity was decreasing, but in fact those data values were correct, and Greenspan was wrong. Productivity has only increased in the 2000s, when IT budgets were frozen.

There's only one plausible explanation for the 1995 upturn: Prior to 1995, all the senior financial managers throughout the country were from the generation of "depression babies." These risk-averse people didn't part with a cent unless they were sure they would get it back, with interest.

During the 1990s, those people all disappeared (retired or died), all at once. The new senior financial managers were from the risk-seeking Baby Boomer generation who believed that the world owed them a living. The result was an explosion of unsafe investments, causing the bubble, which was nothing more than a pyramid scheme that the widespread use of derivatives has simply prolonged

You can trace this generational pattern throughout history. There have been many stock market falls, but the ones with major international impact were: Tulipomania bubble (1637), South Sea Bubble (1721), French Monarchy bankruptcy (1789), Hamburg Crisis of 1857, and 1929 Wall Street crash. Throughout history, these follow the pattern that when the generation of senior financiers who lived through the previous crash all disappear (retire or die), all at the same time, then the next bubble occurs.

Greenspan's fundamental error was that he didn't understand that technology patterns and generational bubbles are TOTALLY SEPARATE SERIES that have to be analyzed separately, as this graph shows:

<b>S&P 500 Index with long-term trend line and technology curve</b>

S&P 500 Index with long-term trend line and technology curve

The green technology curve matches the S&P index almost precisely, provided that you ignore the generational bubbles. Once you understand that separation, then you understand what really happened in 1995, and you also see that the full impact of the 1990s bubble has not yet been felt, but only postponed.

John J. Xenakis
GenerationalDynamics.com (24-Nov-04) Permanent Link
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Generational Dynamics Web Log for 24-Nov-04 Why did stock prices suddenly turn sharply upward in 1995?

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Generational Dynamics Web Log for 24-Nov-04
Why did stock prices suddenly turn sharply upward in 1995?