As has become usual, Alan Greenspan's speech last Friday at the gathering of the world's central bankers in Jackson Hole, Wyo., has been ardently scrutinized by both the financial press and investors anxious to figure out whether the Federal Reserve is planning to raise interest rates anytime soon. What's occasioned the most notice, fittingly enough, was Greenspan's argument that central bankers needed to pay attention to asset prices--like, oh, the stock market--in addition to the prices of normal goods and services if the bankers want to have a handle on what may drive inflation in the future.
Some commentators have also remarked that Greenspan's speech, far from being "a stark warning," as Reuters termed it, was a tempered acknowledgement that even central bankers have a hard time figuring out when markets are overvalued. That, in turn, suggests that Greenspan understands now that his "irrational exuberance" speech of three years ago was precisely what it was, one person's attempt to outthink a market that it is very difficult to outthink. What's especially curious about this is that one would have thought this was a conclusion a supposedly ardent devotee of the free market would have reached a long time ago.
Greenspan, of course, has never ascribed to himself (at least not in public--who knows what he thinks as he sits contentedly in his bathtub) the level of wisdom and farsightedness that the media have come to grant him. His remarks are typically shrouded and hedged, and though it is of course the job of the Fed to restrain inflation and promote economic growth, which requires him to make at least educated guesses about the future, Greenspan generally does seem well aware of the limits of his own knowledge.
This is as it should be, since a fundamental principle of a free-market economy is that the market knows more than any individual within it. But Greenspan's comments on the stock market--including, but not limited to, the "irrational exuberance" speech--have been oddly dismissive of that principle, and oddly certain that something like a bubble was in place. In his speech on Friday, though, Greenspan acknowledged that market prices are determined by "millions of investors, many of whom are highly knowledgeable about the prospects for the specific companies" that make up the market indices.
Even more important, perhaps, he suggested that the unprecedented rise in stock prices over the past five years in particular was due to a substantive change in the way the market discounted the future. Obviously, we don't know exactly what that change is, but it does seem as if stock-market investors today think stocks are less risky than they once did, believe that inflation is not a long-term threat, and believe that the economic dominance of American corporations--and the extraordinary recent growth in corporate profits--can be extended for a long period of time. Put those things together, and you end up with a strong case for higher stock prices. Any or all of those assumptions may be wrong, of course, but in pointing to the discounting process in particular Greenspan did something important, which was get away from the simple idea of "irrationality" and move toward a more rigorous analysis of what's been happening.
The other thing Greenspan's speech signaled is that the Fed is not going to jack up interest rates just to prick a stock-market bubble, imagined or not. In emphasizing that the best, and clearest, use of monetary policy is to revive an economy in the wake of a deflationary crash by cutting rates, Greenspan seemed to acknowledge that the Fed was ill-equipped to be in the business of figuring out what stock prices should be. The point of watching asset prices for the Fed is to understand whether the wealth effect is helping rev the economy beyond sustainable growth. It's not to scold investors. We may be heading for a crash (though I don't think so). But if we are, we'll get there all on our own. Greenspan won't be giving us a push.