Second-guessing the Fed

Why should people who never benefited from the stock market boom pay the price for its having gotten out of hand?

Published January 25, 2000 5:00PM (EST)

It's hard to find any expert who doesn't think the Federal Reserve will raise interest rates slightly when it meets next week. It is harder still to find agreement on why the Fed should make that move. After all, the core inflation rate in December -- one-tenth of a percent -- was the lowest in a generation. Besides, the nation's central bankers usually ratchet up the cost of borrowing to control or even to try to head off inflation.

The economy's problem isn't inflation in general, but prices could be out
of control in one sector: the stock market. If that's true, it makes sense for the Fed to try policies that more precisely dampen the "irrational exuberance" of some stock speculators, rather than end the good times just when more people are beginning to feel the benefit. One place to start: Make it harder to borrow money to speculate on stocks by raising what's called the margin requirement.

Nobody knows the mixture of mania and solid performance that underlies the stock market. But there's reason to be concerned about whether the boom will continue when people start to borrow heavily to buy shares in the expectation that the market will keep rising indefinitely, then using their stock gains to underwrite more borrowing and buying, which in turn drives up the market. Such borrowing "on margin" helped to fuel the rise and crash of the stock market in the 1920s.

In 1934 the Federal Reserve got the power to adjust margin requirements to regulate "the use of excessive credit to finance transactions in securities." For many years it raised and lowered margin requirements periodically, much as it changes rates charged on loans among banks. But it hasn't used the power to adjust margin requirements since 1974. Since then individuals have been able to set up margin accounts with brokers and borrow up to half of the value of stocks they buy.

A chorus of economic experts has been second guessing the Fed's plan to raise the interest rate. Many of them, including such economic luminaries as famed investor George Soros, leading Wall Street economist Albert Wojnilower and Stanley Fischer (the number two man at the International Monetary Fund), suggest changing the margin requirement, a tactic that would more directly address inflated stock prices and prevent those who have not yet benefited from the stock market boom from paying its price.

There's good reason to support economic growth by holding interest rates down for most economic activities. Unemployment is low, which is good -- contrary to a common view on Wall Street. Thanks to the tight labor market, the lowest-paid workers have finally scored some wage gains. But the gap in family incomes between the top fifth and nearly everyone else has continued to grow in all but a few states over the past two decades, according to a new report from the Economic Policy Institute and the Center on Budget and Policy Priorities. Most Americans haven't yet shared fairly in the bounty of the nation's longest boom. There's also no evidence that whatever gains some workers have made is pushing up inflation.

So why the rush to raise interest rates, a move that ultimately hurts economic growth, jobs and wages?

In a speech to the Economic Club of New York on Jan. 13, Fed Chairman Alan Greenspan argued that the "wealth effect" of the stock market boom -- the sense people have that they're much richer thanks to their stock portfolios -- has "tended to foster increases in aggregate demand beyond the increases in supply. It is this imbalance between growth of supply and growth of demand that contains the potential seeds of rising inflationary and financial pressures that could undermine the current expansion."

In other words, the people who got rich, at least on paper, when their tech stocks shot up by more than 1,000 percent last year are buying bigger mansions, bigger SUVs and more high-tech adult toys -- and their voracious demand may begin to drive up prices. Despite the spread in stock ownership, it's worth remembering that about 85 percent of the stock market gains over the past decade have gone to the richest 10 percent of the population.

Even when these people don't speculate on margin themselves, they benefit
from the mania of those who do -- until the bubble pops.

In recent years, margin debt has been rising three times faster than household debt or overall debt. Margin borrowing from brokers rose 62 percent last year alone. There were big jumps in November and December, according to the Financial Markets Center, a Virginia-based research and advocacy group. Margin debt rose in those months to an estimated 1.4 percent of the value of all stocks. That matches the record year-end high since World War II, which was reached in 1986, the year before a big stock market crash. The accumulated margin debt is now equal to roughly 2 percent of the gross domestic product, higher than at any time in more than 60 years, according to the Financial Markets Center.

Day traders and other speculators who have contributed to the frenzied bidding for the few stocks responsible for most of the equity boom probably account for much of the rise in margin debt. Some brokerage firms have recently raised margin requirements on their own, and in December the New York Stock Exchange and the National Association of Securities Dealers tightened their regulations of margin borrowing for day trading.

There's been a boomlet of suggestions that the Fed should raise margin requirements. Respected establishment figures have joined the chorus, including Edward Yardeni, chief economist at Deutsche Bank Alex. "If investors are buying stocks because they really believe in a new era of perpetual prosperity," Yardeni told the Associated Press, "they should be happy to buy stocks with even 100 percent of their own money."

So far the Fed has refused to consider the option, using academic research that argues adjusting margins has no clear effect on stock market volatility. But Tom Schlesinger, executive director of the Financial Markets Center, says such studies miss the point. Adjusting margin requirements never was intended to reduce day-to-day fluctuations but rather to dampen longer term trends and to minimize the chances of euphorias and panics. Schlesinger argues that raising margin rates at least reduces margin borrowing.

Critics of adjusting rates argue that speculators will simply borrow elsewhere -- from mortgage-backed credit lines or even credit cards. That's partly true. But Schlesinger says borrowing from brokers still accounts for most speculation on margin.

The downside risks of raising margin requirements are virtually nil, and there's a reasonable chance it might work.

Former House Banking Committee chairman Henry Reuss wrote in the Financial Markets Center newsletter that the Fed should "cool the speculation before there is a crash with a rifle shot at the real culprit, stock market speculation, rather than a blunderbuss volley at growth in general."

Similarly, James Galbraith, professor at the LBJ School of Public Affairs at the University of Texas, argues, "If your objective is to take air out of the stock bubble, one should not proceed towards that choice by kicking the stuffing out of the economy as a whole. To the extent that the Fed is motivated by worries about stock market issues, let's have stock market policies." In addition to margin requirements, Galbraith would argue for a transactions tax aimed at day trading and similar situations where buyers hold a stock for a very short time. But that solution would require congressional action, not just a decision by the Federal Reserve.

Even skeptics like David Hale of Zurich Financial Services or Mortgage Bankers Association consultant Lyle Gramley agree that raising the margin requirement would have some symbolic value. "This would be a way to send a policy signal about the stock market but not in general about the economy," Hale said.

Despite his skepticism about the power of margin adjustment, Gramley indirectly confirmed the fears of Galbraith and Reuss. "How far the Fed has to go to slow the economy depends critically on whether the stock market reacts negatively," Gramley said. "If the stock market goes its merry way, the interest rates will have to go up even more." In other words, in order to curb speculative fever and control the stock-market induced profligate spending of the richest Americans, the Fed will have to throw ordinary workers out of their jobs and depress their long-stagnant wage growth. Why should people who never benefited from the stock market boom pay the price for its having gotten out of hand?

Margin borrowing isn't the only force driving the stock boom, of course.
But because it feeds the most frenzied cutting edge, tighter margin
controls might change market psychology. But investors can magnify the
speculative potential -- and risk -- of their money with other financial
instruments, like stock options and stock index figures.

These financial derivatives may partly explain why margin borrowing, despite being at post-war record levels, is still much below the rate in the 1920s, when margin debt reached 18 percent of the value of the stock market. To the extent that derivatives, like options and futures, fuel the euphoria, then there is a case for tighter regulation of those markets as well.

Critics of any Fed move to tighten margin requirements say that it's inappropriate for the Fed to substitute its judgment for the wisdom of the markets and millions of investors. But even a cursory reading of either history or financial market theory demonstrates how irrational financial markets can be and how dangerous to the real economy those irrational highs and lows often are.

"The inappropriateness argument is based on the thought that 'Who is the Fed to stick its nose into the marketplace and tell investors they know more than they do about the actual value of companies,'" Schlesinger said. "We just think that's disingenuous, given the Fed's lack of compunction about intervening in labor markets and financial crises."

In the end, all Fed policies involve judgment calls about regulation of the marketplace. If they're concerned now about a superheated stock market, then the time is ripe to try a policy aimed at the stock market and sharply limit the ability of speculators to drive up share prices with other people's money.

By David Moberg

David Moberg is a senior editor at In These Times and a fellow at the Nation Institute.

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Related Topics ------------------------------------------

Alan Greenspan Inflation Stock Market U.s. Economy