Fed Street Cred Dead?

According to an op-ed in the Financial Times, last week was "the week that investors lost faith in Alan Greenspan." It's true that the stock sell-off triggered by the Fed's paltry half-point rate cut wasn't an endorsement of Greenspan's judgment. Still, I don't buy the widely shared premise of the FT piece—that financial markets had heretofore shown reverence for Greenspan's judgment. My own interpretation of Wall Street's behavior in recent years suggests something closer to contempt.

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Last week's reaction was true to a longstanding pattern: The bigger the rate cut Greenspan announces, the more Wall Street likes it. If he exceeds the expected cut, he is cheered, and if he falls short, he is jeered.

What does this pattern signify? Let's do a thought experiment.

Suppose the chairman of the Federal Reserve Board really were considered a demigod—credited by Wall Street with unique insight into the economy's health. Now suppose this demigod Fed chairman came out with a bigger rate cut than analysts had predicted. Financial markets, if rational, would react negatively. After all, this strong medicine would signify a dire diagnosis—that the economy was in worse shape than mere mortals had realized; the market's digestion of this new predictive information would lower stock prices. If you go to a respected doctor complaining of internal pains, and she prescribes chemotherapy, you don't go out and celebrate.

But with Dr. Greenspan, the stronger the prescribed medicine, the happier financial markets are. Apparently they don't think his diagnosis adds anything to what they already knew. They're just waiting to see if he has the brains to write the prescription they've already decided is in order.

In fact, they're so doubtful of his judgment that they actually hope the economy will worsen so that he'll finally get the picture. At least, that would explain those routinely perverse business-page lead paragraphs: "Markets rallied yesterday as an unexpectedly weak job report made a rate cut more likely"—or "as unexpectedly low consumer confidence made a rate cut more likely"—or whatever.

Actually, there are two other explanations for these perverse market reactions. One is the conventional explanation, which I will casually dismiss in a mere footnote. The other, which may have real merit, I'll call the Prozac Nation explanation: American investors increasingly prefer synthetic cures over simple health. We're like the prisoner I saw on one of those Fox reality shows two weeks ago: When the prison guard asked him why he had intentionally burned his chest with flaming toilet paper, he said he did it to get painkillers from the prison infirmary.

The guard laughed and explained (not in so many words) that on balance the prisoner had increased his suffering. I'm pretty sure most economists would say roughly the same thing to investors: Staying healthy is better than getting sick and treated, both because sickness hurts and because treatments can have bad side effects. Yet the markets often cheer news of growing sickness (news of growing aggregate sickness, though of course bad earnings reports from individual companies straightforwardly lower stock prices).

So which is the right explanation for Wall Street's frequent celebration of bad news—the Prozac Nation explanation, or the Contempt for Greenspan explanation? I don't know. But regardless of which interpretation you choose, the implication is that when stock prices rise after a big rate cut, the patient is cheering the drugs, not the doctor.

In light of either interpretation, the jillion-watt spotlight focused on Greenspan's routine congressional testimony starts to seem comic. Legislators pay rapt attention as the Fed chairman lets them observe a great mind at work, delving into the arcana of macroeconomic theory. But, however sincere the legislators, investors are treating the whole thing like a particularly mercenary college date. They don't care how Greenspan's mind works. They just want to know whether, after a couple of hours of intellectual flattery, he's going to put out.

So why does all this matter? Who cares whether America's capital markets have ever truly respected Greenspan—whether they think he's a good doctor or just know that he has the key to the pharmacy? Well, as you may recall, such is his alleged stature as a diagnostician that once he endorsed a big tax cut, the only question left was precisely how big the tax cut would be. My question is: If we don't even trust him with monetary policy—and in fact haven't really trusted him for a long time now—why have we put him in charge of fiscal policy as well?

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