Most of the press coverage of Federal Reserve Chairman Alan Greenspan’s appearance before the Senate Banking Committee yesterday focused on Greenspan’s comments about whether the Fed was thinking about the stock market when it determined monetary policy. And that makes sense, because while last week Greenspan said things that sounded as if the stock market was, in fact, at the center of his thinking about the sustainability of the current economic expansion, yesterday he appeared to back down some. Greenspan said that while the Fed is paying close attention to the size of the so-called “wealth effect”–boosts in the value of people’s financial assets leading to an increase in consumer spending–the wealth effect “is not that closely tied to the stock market,” and that the Fed’s fundamental concern is the real economy, not Wall Street.
It’s not clear what we’re really supposed to take away from this, and while normally Greenspan’s words are difficult to decipher because he’s being cryptic, in this case I think they’re difficult to decipher because he may not be sure himself about what the actual connections between the stock market, the wealth effect, and the real economy are. But what was interesting about yesterday’s appearance, though it drew little notice, is that Greenspan was perfectly clear about whether the Fed should raise its margin requirements for investors as a way of taking a little air out of the supposed stock-market bubble.
Since 1973, investors have had to put up 50 percent of the value of their investments in real cash. In other words, if you put $100,000 into a brokerage account, you can buy $200,000 in stocks. Margin requirements were one of the important regulations put into effect after the Crash of 1929, ending the days when people could buy stocks on 90 percent margin. (Of course, people who trade stock-market futures today can effectively still do that.) Margin requirements have moved up and down in the past, but have never fallen below 50 percent.
In the past few months in particular, we’ve heard suggestions from both Wall Street and Capitol Hill that raising margin requirements is the best way for the Fed to defuse any speculative frenzy in the market. If the Fed wants, as it sometimes seems to, to bring the market off its lofty levels, the way to do so is not by raising interest rates and thereby slowing the economy as a whole. The way to do it is by cutting back on investors’ borrowing and, therefore, their buying.
On its face, the argument seems plausible, especially since margin debt rose 13 percent in November, 11 percent in December, and another 6.5 percent in January, to a total of $243.5 billion. By some accounts, the ratio of margin debt to GDP is as high as it’s been since the 1920s. Implicit in this argument is also the idea that the people buying on margin are mostly day traders and individual investors, who will be the first to run for the doors when someone screams “Fire!” Raising margin requirements, even if would cool the market off, is thus a prudent way of averting a sudden crash.
What Greenspan said yesterday, though–echoing comments he made the week before–is that actually there’s very little evidence that changing margin requirements has any meaningful impact on stock prices. Responding to a question from Sen. Charles Schumer, who’s been one of the key advocates of a margin increase, Greenspan said that while margin requirements affect where people borrow their money from, they have not historically had a real impact on market values.
In other words, Greenspan is not willfully ignoring the obvious answer to the question of how to deflate speculation. Instead, he’s decided that the obvious answer is wrong. And, at least if history is any guide, he’s right. Since 1950, margin requirements have been raised or lowered eight times, and with only one possible exception, the changes had no meaningful impact on stock prices, even though it was probably harder to borrow money from alternative sources then than it is now. At the same time, although $243 billion sounds like a lot of money, relative to the size of the U.S. stock market as a whole it’s small. It’s probably true that raising margin requirements would reduce the size of individual investors’ investments, but it’s far from clear that this is a good thing, since markets work better the more people there are in them. At first glance, raising margins seems like a simple answer to a complicated question. At second glance, it seems more like a gimmick.
