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January 26, 2000

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Subject:  Does Greenspan have a plan?
Author:  GFPE

Or is he just winging it? I think he's just winging it. He's looking at history and worrying. He acknowledges that economy might have become irrevocably different, in large part due to technology. But the Fed keeps issuing warnings and hints about an overheated economy. Fears of inflation. Fears of too much money flowing out of the US to buy imports Fears of the bogeyman.

I am worried about self-fulfilling prophecies. One of the readouts the Fed wants to see is a cooler stock market, probably the Nasdaq in particular. There is a huge amount of resistance to this in the markets, since we're at a very optimistic time, new money is flooding into the markets, and there is a feeling out there that stocks might well be as safe and as sound as bonds. With a re-evaluation of risk downwards, the prices of stocks could justifiably be higher (the Dow at 36,000 argument).

Okay, we know that more interest rate hikes are coming. The Fed's goal is to slow growth, fearing we may be a speculative frenzy and getting ahead of ourselves. Inflation, skilled labor shortage, trade deficits, etc. could all bring this house down, they say. The Fed watches all these numbers and indicators of the health of the economy, but what they really want to clamp down on is the stock market's rate of growth.

The dangers of the wealth effect? Remember when the supply-siders thought the wealth effect and trickle down would cure all of ailments and genital herpes too? The truth is, none of the economists know what's going on.

At some point, though, the Fed's policies will be fulfill themselves not because there is a problem with the economy but as a consequence of those policies themselves. Who hurts the most when interest rates get super high and the stock markets finally do cool because of this? The small investor and first-time home buyer, that's who.

The Fed uses these blunt instruments to try to change things to what their prejudices tell them is healthier. If they have worries, though, why don't they invent finer instruments to target those areas that are causing the problems. I guess that would require major reform of the banking system too, but broad increases in interest rates seems a blunt instrument indeed.

I'm not saying the Fed is being reckless. They are being responsible according to the historical context they are acting in.

My thoughts, however, is that a Nasdaq at 4000+ growing at 40% a year (sure, 80% is unsustainable) and a Dow at 11000+ is not a problem at all. The underpinnings of our society are changing as a result of technology and that creates enormous opportunity for new and old businesses. Are the valuations crazy? For some companies, I beleive so, but not for the majority. I don't see an across-the-tech-board bubble at all. I see some specific companies as bubbling, but in general I don't think the valuations for tech as crazy as the old greyheads seem to think. There are huge opportunities for so many strong tech companies in the future, that high forward-based valuations for them are reasonable, if you ask me.

It is also possible that with increased rate of change in society and the economy, and with more money in the markets, that old valuation models don't apply any more. Valuation in the textbooks is based on all future earnings and capital costs. By these criteria, many of the tech companies may not be overvalued at all, considering future opportunities (guesswork at best, though). However, it is also possible, although I'm not saying this but just suggesting it, that that meaning of valuation could be obsolete. Valuation is really a market price to earnings (or some other measure of company performance). If the markets (people) change how they view prices, seeing it more as just a price to be comfortable with rather than having to reflect something rigidly intrinsic to the company, then the old models of valutation would no longer apply. This could be similar to the psychological effect of going off of the gold standard. Currency has not real value backed up by gold any more. Currency values are determined by supply and demand, exchanges (value relative to other currencies), psychological factors (e.g., the dollar is safe, the Botswana whatever-their-currency-is is not), etc.

I think the Fed needs to accept that unless it raises interest rates to some insane level (one that will really hurt everyone, even creditors, as fewer loans are taken out and some existing ones are defaulted), the Fed cannot control or engineer the economy and the stock markets. If it is too Draconian, it will produce a self-fulfilling prophecy, really impacting the rate of technological progress and prosperity and hurting a lot of small people too.

Raise the rates and be done with it. All this threatening and innuendo just creates uncertainty. Is a volatile and uncertain market more healthy than a crazy growth one? Not necessarily. Raise the rates, and if that doesn't slow the growth of the markets, then maybe the Fed should re-evaluate its position. Maybe, just maybe, for strong companies with strong technology, it is a new economy. The losers that may be part of a limited bubble will cool down (and fail) without any help from the Fed, but too much use of these blunt instruments hurt the strong companies too (since the cost of borrowing for expansion goes up), as well as the little guy. 'Nuff said.

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