FRANKFURT – Investor confidence in the 'superhuman' ability of Fed chairman Alan Greenspan to shelter the stock market contributed to its over-valuation and eventual crash, economists argued in an academic paper out this week.
In "Moral hazard and the U.S. stock market: The idea of a 'Greenspan put'," the paper from the Centre for Economic Policy Research, a respected London think-tank, calaculated that this perception had dramatically lowered stock market risk premiums.
"Investors were, we believe, lulled into a false sense of security, thinking that the Fed was providing a general downside guarantee on stock values," the paper said.
"The effect of such a portfolio insurance would be like a put option -- the reality is, however, a bubble -- because the put will not exist when it comes to be exercised," it added.
Economists argue that inappropriate monetary policy leads to bad investment decisions, fuelling a stock market boom that can turn into a nasty bust.
"The central implication is that markets will crash when investors realise that Greenspan is not superhuman," it said.
Information technology stocks have indeed collapsed since last year and this is being blamed for hitting capital expenditure and leaving the world economy with a major investment overhang.
This was already hurting growth before the September 11 attacks on the U.S. and if it takes a prolonged period to clear this investment glut, it will make the downturn more painful.
"We're suffering from a huge surge in optimism (then) and now low levels of investment...so we have had more of a boom and bust than otherwise," said co-author professor Marcus Miller of Britain's University of Warwick.
Critics of Greenspan argue that he has sheltered the U.S. stock market by initially highlighting its 'irrational exuberance' in 1996, but then failing to react when the market's advance continued unchecked.
The broadly based Standard and Poors 500 stock index managed average annual growth of 12 percent from 330 in 1987, when Greenspan took the Fed's helm, to 1,500 in 2000.
"The Fed ended up rationalising -- and tacitly encouraging -- the ensuing asset bubble by endorsing the untested and suspect theories of the New Economy," wrote Morgan Stanley's influential chief economist Steve Roach this week.
Greenspan has been a strong advocate of the New Economy and told U.S. lawmakers on October 17 that "for the longer term, prospects for rapid technological advance and associated faster productivity growth are scarcely diminished."
The paper cites two separate surveys which both clearly indicate that investors believed the Fed would react more to downside market risks than a rally. This sense of 'insurance' had slashed risk premiums from the long-run average, it argued.
"Believing the Fed can prevent the market from falling by more than 25 percent from its previous peak can raise the market by more than 50 percent and bring the observed risk premium down from 4.3 to 2.6 percent even though the underlying risks are unchanged," it said.
The paper's authors estimated the historical average of the equity risk premium between 1926 and 1997 at seven percent.
A lower risk premium implies that stock prices can be higher than would otherwise be the case for the same underlying discount, or risk-free interest rate.
"Unfortunately, when the bubble popped, the policy gambit was exposed. Almost any monetary easing would have then been too late," Roach said.