I
The rise of stocks like America Online, Netscape, and Yahoo! was part of a broader phenomenon. In the first four months of 1996 alone, American households deposited about $100 billion in stock mutual funds.1 As recently as 1990, these funds had taken in just $12 billion during the entire year. With all this money pouring into the stock market, prices were rising sharply. Between the beginning of 1995 and the end of May 1996, the Dow climbed from 3,837.10 to 5,643.20, a rise of 45 percent. Meanwhile, the Nasdaq rose by about 65 percent, from 751.31 to 1,243.43. A fierce debate developed on Wall Street about whether a speculative bubble was emerging, not just in Internet stocks but in the market at large. On one side were the traditionalists, who believed that stock prices had already risen well beyond levels that could be justified on economic fundamentals. On the other side were the “New Economy” enthusiasts, who argued that the time-honored methods of valuing stocks no longer worked and should be discarded.
Two of the most prominent bears, Barton Biggs, the chairman of Morgan Stanley Asset Management, and Byron Wien, Morgan Stanley’s chief U.S. investment strategist, could have been typecast for the role of skeptical elders. They were both sixty-three years old, with gray hair, lined faces, and fashion clocks that appeared to have stopped during the Eisenhower presidency. At the start of 1996, Wien predicted a thousand-point decline in the Dow, and Biggs advised investors to lighten up on U.S. stocks. Given that the market had climbed so sharply during 1995, these calls were understandable, but they were also ill timed. In the first two months of 1996, the Dow rose another 500 points. Wien and Biggs refused to change their views. “I believe that U.S. stocks are overheated, overvalued and vulnerable to a cyclical bear market,” Biggs wrote to his clients. “The longer the craziness in the United States goes on, the higher the price we will have to pay.” Both Biggs and Wien were willing to accept that there were gradations in the collective insanity they spied around them. The rise in technology stocks, such as Microsoft, Dell Computer, and Intel, they saw as bordering on irrational. The rise of Netscape, Yahoo! Excite, and the rest of the Internet sector they viewed as inexplicable.
“You’ve got stocks selling at absolutely unbelievable multiples of earnings and revenues,” Biggs told a visitor to his office in May 1996. “You’ve got companies going public that don’t even have any earnings. You’ve got people setting up Internet pages to reinforce each other’s convictions in these highly speculative stocks. This is wild stuff out of the past. In every market where it has happened—from the U.S. to Japan to Malaysia to Hong Kong—it always ends in the same way.”2 Biggs pulled out a set of charts to support his case. They showed the history of stock prices relative to profits, dividends, accounting values, and several other things. According to every single one of the charts, valuations were higher now than at any point since the 1920s. In several cases, they appeared to be higher than they were in 1929. “The sociological signs are very bad too,” Biggs continued. “Everybody’s son wants to work for Morgan Stanley. Worthless brother-in-laws are starting hedge funds [risky, unregulated investment funds]. I know a guy who is fifty and he’s never done anything. He’s starting a hedge fund. He’s sending out brochures to people. I’ve got one here somewhere.”3
Biggs and Wien worked at the same firm as Mary Meeker and Frank Quattrone, two of the leading promoters of Internet stocks, a fact that hadn’t gone unnoticed on the rest of Wall Street. It hadn’t gone unnoticed inside Morgan Stanley either. As one of the leading underwriters of stocks in the country, Morgan was making vast profits from the bull market. In the second quarter of 1996 alone, Wall Street firms earned about $3 billion in underwriting fees. “Believe me, the investment bankers would love me to be wildly bullish,” Wien admitted. “But I do this job because I can express the truth as clearly as I can understand it. That’s the strength of the product.”4 To Morgan Stanley’s credit, Wien appears to have been speaking the truth. The firm’s senior executives apparently took the view that its clients were intelligent enough to appreciate a range of views, even if some of them were diametrically opposed. Biggs, Wien, and Meeker often wrote for the same investment circular. In the same issue, a reader might well find a doom-laden essay by Biggs, a note of measured caution from Wien, and a buy recommendation for Netscape or America Online from Meeker.
Elsewhere on Wall Street, the environment was less liberal. One by one, most of the bears either changed their views or found themselves shunted aside. David Shulman, an investment strategist at Salomon Brothers, was one of those to recant. Throughout most of 1995 Shulman warned that stocks were dangerously overvalued, but in December he admitted that he had been mistaken and advised investors to buy more stocks. “The powerful 1995 rally in stock prices is not a bubble but rather a signal that the valuation paradigm has changed,” Shulman wrote.5 The crux of his argument was that investors were now willing to pay more for stocks because they no longer feared a resurgence of inflation. This was a reasonable argument, as far as it went, but Shulman’s conversion also had a lot to do with the old Wall Street truism that trying to resist a strongly rising (or falling) market is folly. “The tape has a way of telling you,” Shulman said a few months later. “If the tape keeps going up every day, something’s wrong with the bear’s case.”6 Shulman conceded that he was worried about speculation in Internet stocks, and that he still believed the stock market to be overvalued on economic grounds, but he added: “We are going to go higher before we go lower.”
Abby Joseph Cohen, Shulman’s opposite number at Goldman Sachs, didn’t harbor any such ambivalence. A short woman with brown curly hair who favored conservative gray suits, Cohen had been bullish since 1991. The grounds for her long-standing optimism, she explained in the spring of 1996, were “the wonderful things going on in the U.S. economy,” such as lower inflation, corporate restructuring, and the aging of the baby boomers.7 The most important development, Cohen argued, was that American workers and firms had become a lot more productive, thereby dramatically increasing the economy’s capacity to generate higher wages and profits. If Cohen was correct, it was a truly monumental change, and not only for shareholders.
Productivity determines standards of living. If a tailor makes two suits a day and sells them for $200 each, his productivity is $400 a day. If he raises his output to three suits a day and sells them for the same price, his productivity increases to $600 a day. The rate of productivity growth determines how fast living standards increase. Between 1948 and 1973, productivity grew at an annual rate of more than 3 percent. After 1973, for reasons that were never fully explained, the growth rate fell to about 1.5 percent. When compounded over long periods, even small discrepancies in productivity growth rates add up to big differences in living standards. Between 1948 and 1973 the standard of living of most American families doubled. Between 1973 and 1995, living standards stagnated.
In early 1996, the productivity figures tracked by the Commerce Department and the Bureau of Labor Statistics were showing little signs of improvement, but that didn’t worry Cohen, who knew her way around the official statistics, having once worked as an economist at the Fed. “I believe that the government’s productivity figures are wrong,” she said bluntly. “Take a look at Goldman Sachs, for example. We have invested heavily in sophisticated voice-mail systems and word processing systems and so on. I know that the productivity of the technical staff is multiples of what it used to be. I just know that to be the case, but it doesn’t get measured anyplace.”8
Cohen’s optimistic views would eventually make her famous, but at this stage she was still largely unknown. She wasn’t even a partner at Goldman Sachs. Nonetheless, she displayed the certitude of a math teacher instructing her pupils in calculus. When it was put to her that the good economic news might already be reflected in stock prices, she replied that the positive changes in the economy were “so dramatic that one cannot expect them to be quickly incorporated by investors.”9 In the long term the only thing that mattered for stock prices was growth in corporate profits, Cohen insisted, and profits were rising faster than anybody had thought possible. “The people who say the stock market is up x percent and therefore is overpriced are not looking at the right thing. Stock prices should reflect growth of earnings or some other fundamental standpoint. Our conclusion is that the market is reasonably priced; in fact, I would argue that it is undervalued.”10
II
The debate about the stock market continued throughout 1995 and 1996. Toward the end of that period, it seemed clear that the bulls had won. Every time the stock market took a tumble, as it did several times, it came back stronger than ever. The market’s rise silenced most of the remaining voices of caution on Wall Street; anybody who persisted in questioning it was seen as hopelessly antiquated. Some of the most famous investors in the land found themselves cast into this category. In April 1996, Warren Buffet, “the Sage of Omaha,” issued a new class of stock in his company, Berkshire Hathaway. Regular Berkshire Hathaway shares were trading at $34,000 each—Buffet had always refused to split the stock—and the new stock, which was priced at $1,100, was designed to appeal to small investors. In a letter to shareholders, Buffet warned that neither he nor his longtime partner, Charlie Munger, “would currently buy shares” in Berkshire Hathaway, “nor would they recommend that their families or friends do so.”11
Jeffrey Vinik, the manager of the biggest mutual fund in the country, Fidelity’s Magellan Fund, was another stock market skeptic. During 1995, Vinik placed a big bet on technology stocks, which paid off handsomely, but at the end of the year he became concerned by what he saw as “euphoria” among investors and shifted some money into bonds.12 In early 1996, the Magellan Fund’s performance suffered compared to rival funds that had remained fully invested in the stock market. In May, Vinik announced that he was resigning from Fidelity and setting up his own money-management company. He insisted that he hadn’t been fired, but the lesson other fund managers took from Vinik’s departure was unambiguous: taking money out of the stock market could be a career-ending mistake. “It sent a message that you had better be right or else your job is on the line,” Barton Biggs commented. “He was early, and there’s no difference between being early and being wrong.”13
Many mutual fund managers carried on buying stocks even though they believed them to be overvalued, which was not necessarily irrational. At the end of every quarter, fund managers are assessed relative to their peers in a series of published league tables. In this environment, following the herd is often the optimal strategy, especially during a bull market. If stock prices continue to rise during a given quarter, the fund manager who keeps all his money in the market will look clever at the end of it. Even if the market crashes, and the fund manager’s stocks do badly, most of his competitors will look equally stupid so he will probably retain his job. Only by stepping out of line and selling, which is what Vinik did, does the fund manager risk his position. Trapped in this logic, the vast majority of fund managers tend to keep buying stocks regardless of their prices, which makes the market even more overvalued.
The idea that rational behavior on the part of individual investors can lead to an irrational outcome—a speculative bubble—dates back at least to Charles Mackay’s Memoirs of Extraordinary Popular Delusions and the Madness of Crowds. In his account of the South Sea bubble of 1720, Mackay stressed that most of those involved knew that the promise of riches from the South Sea trade was a myth, and that many of the bubble companies were fraudulent, but they saw the chance to make some quick money and took it. In the memorable words of an English banker who took part in the bubble: “When the rest of the world is mad, we must imitate them in some measure.”14
Until the middle of the twentieth century, most economists took it for granted that stock markets were dominated by herd behavior. Keynes’s “beauty contest” model of investing is a good example of how economists used to think. But following the Second World War, a new economic theory became popular, which viewed investors as ultrarational and financial markets as ultraefficient. According to the so-called Efficient Markets Hypothesis, the stock market is an enormous calculating machine, which always sets the “right” prices, taking account of all the relevant information available. Between the mid-1960s and the mid-1980s the vast majority of American financial economists believed in the Efficient Markets Hypothesis. It wasn’t until the stock market crash on October 19, 1987, that they started to question it seriously. If stock prices are always right, why did the Dow fall by 508 points in a single day for no apparent reason? According to most of the evidence, the only reason that many investors were selling on Black Monday was because they saw other people doing the same thing—a classic case of herd behavior.
During the 1990s, building mathematical models of herd behavior turned into a growth industry among economists. The models vary in detail, but they share one important attribute: at some point, people stop thinking for themselves and start copying others because they have decided it is in their self-interest to do so. It is this behavior that generates speculative bubbles. And once the bubbles get going, they tend to feed on themselves, with the increases in stock prices drawing ever more people into the market. “A fad is a bubble if the contagion of the fad occurs through price; people are attracted by observed price movements,” Robert Shiller, an economist at Yale, explained in his 1989 book Market Volatility. “In the simplest bubble model, price increases themselves thus cause subsequent price increases until price reaches some barrier; then the bubble bursts and price drops precipitously, since there are then no further price increases to sustain the high demand.”15
Models of herd behavior are not confined to the stock market. They have been used to explain everything from crime waves to fashion fads to the collapse of the communist regime in East Germany. (In the latter case, millions of people copied each other and took to the streets.) One economist used a model of herd behavior to explain why so many television shows look the same: network programmers, instead of trying to make the best shows they can, simply copy the most successful shows on the other networks. Another economist pointed out how, during the middle of the nineteenth century, herd behavior led to the construction of more than 10,000 miles of plank roads. The first wooden road was built in Salina, a small town in upstate New York, where an entrepreneur named George Geddes had persuaded people that the planks would last about eight years. Word of the exciting innovation quickly spread, and almost three hundred plank road companies were incorporated, many of them claiming that the planks would last between ten and fifteen years. After just four years, however, the wooden road in Salina had decayed to such an extent that the entire idea was discredited. Construction elsewhere came to a rapid halt.
The models of herd behavior predict that large numbers of people, in a wide variety of circumstances, will coverage on the same actions. This is exactly what happened during the Internet boom. Those mutual fund managers that eschewed Internet stocks, and there were many of them to start with, found their funds sliding down the performance league tables. Even the most cautious fund managers couldn’t ignore what was happening. “We’re all looking at the performance of Internet companies that have come out since Netscape,” Lise Buyer, an analyst at T. Rowe Price Associates, a Baltimore-based mutual fund company that is famously conservative, told The New York Times shortly after Excite’s IPO. “While they have been incredibly volatile, people who participated in the initial public offerings are better off than those who didn’t.”16 Every quarter, the pressure grew on fund managers to find the Internet religion. In the end, few were able to resist the call.
III
The real coup was marketing Internet stocks to individual investors: doctors, dentists, cab drivers, and all sorts of other people. A critical element in individual investing in Internet stocks was the Internet itself, which created a virtual community of risk takers where none had existed before. In the past, the typical individual investor was a fellow sitting at his kitchen table with a copy of The Wall Street Journal and, perhaps, an annual report. If he wanted to discuss his portfolio, he would call his broker, who, assuming he was honest, would advise against dramatic gestures. In the Internet era, this picture was as outdated as black-and-white television. Armed with an account at E*Trade, Ameritrade, or any of dozens of other online brokerages, the individual investor had the information, the technical capacity, and the moral support to become a professional speculator. A click of the mouse and he could display his portfolio. Another few clicks and he could buy and sell stock, with electronic confirmation of his trades dispatched within seconds. If he wanted reassurance about his investment strategy, or simply to swap gossip about his trades, he could go to financial Web sites like The Motley Fool and Ragingbull.com, where he could exchange notes with thousands of like-minded souls.
E*Trade, which was based in Palo Alto, pioneered online trading. Compared to most Internet companies, it had a long history. Bill Porter, a physicist and inventor with more than a dozen patents to his credit, founded the firm in 1982. In its formative years, E*Trade then called TradePlus, provided electronic quote and trading services to other brokers, including Fidelity, Charles Schwab, and Quick & Reilly. In July 1983, a Michigan doctor placed the first online trade using E*Trade’s technology; but in commercial terms Porter proved ahead of his time. It wasn’t until the early 1990s that online trading started to catch on. In 1992, Porter adopted the name E*Trade and started offering accounts through CompuServe and America Online. As the online services grew in popularity, so did E*Trade. By the end of 1995, it had about 40,000 accounts and was handling more than 4,000 trades a day. Unlike most online firms, E*Trade was even making profits: $2.6 million in 1995.
In February 1996, E*Trade moved to the Internet, allowing investors to buy up to 5,000 shares for less than twenty dollars. (The exact fees were $14.95 for stocks listed on the New York Stock Exchange and the American Stock Exchange, and $19.95 for stocks on the Nasdaq.) This was a fraction of the commissions levied by full-service brokers, such as Merrill Lynch, and it was also considerably less than discount brokers, such as Charles Schwab, were charging. By May 1996, E*Trade was processing about 11,000 Internet trades a week, and it announced plans for an IPO. In its prospectus, filed in early June, it pointed to the ongoing “shift in demographic and societal norms” that was transforming American finance. “Increasingly, consumers are taking direct control over their personal affairs, not simply because they are able to, but because they find it more convenient and less expensive than relying on financial intermediaries.”
E*Trade hired Robertson, Stephens to be its lead underwriter, filling out the roster of investment bankers with Hambrecht & Quist and Deutsche Morgan Grenfell. The latter firm was new to the Internet scene. A few months earlier, it had poached Frank Quattrone from Morgan Stanley, reportedly agreeing to pay him at least $20 million over three years, plus a big share of any profits he made. Quattrone took most of his fellow investment bankers with him from Morgan Stanley, but Mary Meeker stayed behind. Despite Quattrone’s efforts, the E*Trade IPO was far from trouble free. In the run up to the offering, the online brokerage’s trading system crashed, rival Charles Schwab cut its prices, and Internet stocks fell sharply. The IPO had to be postponed, but on August 16, 1996, E*Trade finally issued 5 million shares at $10.50. The stock opened at $11.75 and closed at $11.25, valuing the firm at more than $300 million. This was hardly a repeat of the Netscape or Yahoo! IPOs, but it opened the way for other online trading firms to follow E*Trade’s lead and go public.
By the summer of 1996, about 800,000 Americans had online trading accounts, and the number was increasing daily. Online investing wasn’t just cheaper than traditional investing; it was a lot easier. Investors could place orders twenty-four hours a day, seven days a week. They could also get access to up-to-the-minute news, real-time stock quotes, and analysts’ reports—the sort of information that used to be restricted to Wall Street professionals. If they had the time and the inclination, they could also do their own stock research. The Securities and Exchange Commission’s Web site contained earnings reports, proxy statements, and other legal filings from every public company in the country. Before the advent of the Internet the only way to see these reports was to trek to the SEC’s reading rooms in Washington or New York and grapple with a microfiche reader. Many companies also set up their own Web sites and posted all of their press releases and financial reports for shareholders to look at.
The financial chat rooms were important because they placed individual investors in a group setting, where they were more likely to take risks and act like copycats. Many online traders frequented The Motley Fool on America Online. David and Tom Gardner, two twenty-something brothers from Alexandria, Virginia, started the site in August 1994, taking its name from Shakespeare’s As You Like It. The Gardners had a refreshingly irreverent approach to investing. They poked fun at the Wall Street establishment and the financial press, whom they dismissed as the Wise. Just like in a medieval court, they argued, the only people who could be relied on to tell the truth were the outsiders, the Fools. The Gardners set up their own model stock portfolio, which more than doubled in the first eighteen months. They advocated investing in companies with strong market positions and holding for the long term, but many of their followers took a more short-term approach.
In April 1995, The Motley Fool set up a bulletin board devoted to Iomega, a small firm based in Roy, Utah. Iomega wasn’t an Internet start-up, but from an investor’s perspective it was the next best thing: a technology company with a nifty new product, the Zip drive, a storage device with many times more capacity than a floppy disc. Between May 1995 and May 1996, Iomega was one of the bestperforming stocks on the Nasdaq, going from less than $5 to more than $50. The Motley Fool chat room wasn’t the only factor behind this precipitous rise—Iomega’s Zip drive received strong reviews from the computer press—but it surely played a role. The bulletin board provided a forum for investors to exchange news and discuss Iomega’s future. Whenever anybody had the temerity to post a message questioning Iomega’s valuation, or mentioning the fact that bigger, better-financed competitors were moving into the same market, they were quickly drowned out with upbeat counterarguments. The Iomega fad provided a textbook case of how a speculative bubble can form. The stock became one of the most talked about in the country. Even journalists were not immune to the hype. One New York magazine writer, a seasoned reporter with enough gray hairs to know better, was talked into investing a good deal of his savings in Iomega by a fellow commuter on the Metro North. The bubble burst in June 1996, when, in just a few days, and for no apparent reason, Iomega’s stock fell by more than half. “Is there a reason for concern here that some of us don’t know about? HELP,” an anguished investor wrote on The Motley Fool.17
Iomega wasn’t the only stock with a bulletin board of its own. Before long, Netscape, Yahoo!, and many other speculative issues had similarly devoted bands of followers. People read about Internet stocks on the Internet, talked about Internet stock on the Internet, and bought Internet stocks on the Internet. The technology at the center of the speculative boom helped to facilitate and sustain the speculation. It was almost as if the Dutch tulips had doubled as personal digital assistants, allowing the Amsterdam speculators to key in their trades. The only historic parallel was the development of radio technology in the 1920s, which allowed people traveling on transatlantic liners to wire in their buy orders for Radio. In the Internet age, anyone with a computer and a modem could behave like a passenger on a luxury liner—at least for a while.
IV
Responsibility for supervising the U.S. stock market is split between the Securities and Exchange Commission and the Federal Reserve, the nation’s central bank. The SEC is supposed to look after the interests of individual investors, while the Fed oversees monetary policy and the behavior of financial institutions. Traditionally, senior officials at the SEC and the Fed have avoided comment on the level of the stock market. Since 1913, when the Fed was founded, only twice has its chairman publicly warned about excessive speculation. In early 1929, then-chairman Roy Young criticized commercial banks for lending too much money to stock speculators. In June 1965, William McChesney Martin referred to “disquieting similarities between our present prosperity and the fabulous twenties”—a statement that caused the Dow to fall sharply. McChesney Martin also came up with the most famous definition of the Fed’s role in the economy, which he said was to “take away the punch bowl just when the party gets going.”18
By the middle of 1996, many senior people in Washington were concerned that the party on Wall Street might be getting too riotous. Robert Rubin, the Treasury Secretary, was one of the worrywarts. In his long career on Wall Street, which began in the early 1960s, Rubin had never seen anything like what was happening in the stock market. To Rubin, it appeared that investors were ignoring one of the basic laws of finance: the only way to achieve high returns is to take on high risks. Despite his concerns, Rubin was reluctant to say anything publicly. The Treasury Secretary didn’t have formal responsibility for the stock market, and Rubin’s boss, Bill Clinton, was running for reelection. Trying to talk down the stock market in an election year would hardly be a smart political move. Arthur Levitt, another Wall Street veteran, who headed the SEC, was also getting nervous. Levitt believed it was his job to speak out. “I think investors can accommodate themselves to a 7 percent gain rather than a 30 percent gain, but can they accommodate themselves to a 20 percent loss or 30 percent loss?” he said to a reporter.19 A fall of the magnitude Levitt was talking about would have taken the Dow down by somewhere between 1,100 and 1,600 points. When this was pointed out to Levitt, he replied: “I’m not going to suggest that a 20 percent loss or a 30 percent loss is looming on the horizon. But what I am suggesting is that if there can be gains of that amount there obviously can be losses of that amount too.”
Levitt’s warnings didn’t have much impact. Investors were far more concerned about the attitude of Alan Greenspan, the Fed chairman. After nine years in office, the seventy-year-old Greenspan was a revered figure, widely credited with rescuing the economy after the 1987 stock market crash and engineering the long period of noninflationary growth during the 1990s. Greenspan and his colleagues on the Federal Open Market Committee (FOMC), which meets eight times a year to set short-term interest rates, certainly had the power to sink the stock market if they so wished. In early 1994, when they raised the federal funds rate for the first time in several years, the Dow fell sharply. At the next meeting of the FOMC, Greenspan congratulated his colleagues, saying: “I think we partially broke the back of an emerging speculation in equities.”20
In the summer of 1996, Greenspan was reluctant to repeat the trick. During the past year, the Fed had cut the federal funds rate from 6.0 percent to 5.25 percent, which had helped boost the market. While stock prices were now undoubtedly high, the Fed chairman, who had recently been nominated for another four-year term, was far from convinced that a speculative bubble had developed. Like many on Wall Street, he was coming to believe that higher stock prices were at least partially justified by the economy’s sterling performance. Many of the old rules of thumb didn’t seem to work anymore, especially the one that said unemployment and inflation move in opposite directions. Unemployment had fallen to about 5.5 percent, but there was still no sign of the rising prices that many economists had predicted. Some of Greenspan’s colleagues believed it was only a matter of time before inflation picked up, and they wanted to raise the federal funds rate in order to slow down the economy, but Greenspan refused to go along with this argument. Like Abby Joseph Cohen, he believed that American firms and American workers were becoming a lot more productive, even if the official statistics were failing to pick this up. If this were indeed the case, the economy should be able to grow a good deal faster than in the past without sparking inflation.
Greenspan’s willingness to challenge the conventional wisdom was the product of a lively and independent mind. He was born in March 1926 in Washington Heights, an upper Manhattan neighborhood then known as Frankfurt-on-the-Hudson because of the large number of German Jews that lived there. Greenspan’s parents separated when he was a young child, and his mother, Rose, brought him up. Economics wasn’t his first love: that was music, especially jazz. After graduating from high school, Greenspan went to Juilliard, the famous conservatory, but he dropped out and joined Henry Jerome and His Orchestra, a swing band that performed at, among other places, Childs restaurant in Times Square. Greenspan played the tenor sax and the clarinet. In 1945, he started taking evening classes in economics and business at New York University, which was then known as the School of Commerce. After getting his bachelor’s degree he did some postgraduate courses at Columbia, then took a job on Wall Street as an economic analyst. He stayed there for twenty years, creating a profitable consulting firm, Townsend Greenspan, whose clients included Alcoa, U.S. Steel, and J. P. Morgan. In the 1968 presidential campaign, Greenspan served as Richard Nixon’s economic adviser. Six years later, Nixon, shortly before he resigned, invited Greenspan to chair the White House Council of Economic Advisers. After Gerald Ford became president, Greenspan took up the post.
Shortly after Labor Day of 1996, Greenspan called some Fed economists together and asked them to reexamine the productivity figures.21 He wanted the aggregate numbers that the Bureau of Labor Statistics reports every quarter broken down by individual industries. Perhaps by looking at these figures—for automobile plants, aircraft production, banking, retailing, and so on—it would be possible to figure out why the government was missing the productivity upturn. A couple of weeks later, the staff economists confirmed what a number of academic studies had already found: the reason that the overall figures were so low was that the service sector, which employs about two-thirds of the workforce, had seen virtually no productivity growth at all in three decades. In some service industries, such as grocery stores, productivity had actually fallen. Greenspan thought this was incredible. How was it possible that productivity growth had stagnated in the banking industry, for example, despite the spread of automated teller machines and telephone banking?
The staff study made Greenspan ever more convinced that the official productivity figures were misleading.22 At an FOMC meeting in late September, he persuaded his colleagues to keep the federal funds rate on hold. After the Fed’s decision, the stock market resumed its upward climb. In October, the Dow raced past 6,000. A couple of months later—after Bill Clinton had been reelected to the White House in a landslide—it reached 6,500. In just two years, the Dow had risen by nearly 3,000 points. Many stocks had doubled in twelve months. Even if productivity growth had accelerated, a jump of this size was difficult to justify on economic grounds. Inside the Fed, worries about a possible speculative bubble increased.
In early December, Greenspan hosted an informal seminar on the stock market at the Fed’s art deco headquarters on C Street in Foggy Bottom. The Wall Street attendees included Byron Wien, Abby Joseph Cohen and David Shulman. Yale economist Robert Shiller, the specialist on speculative bubbles, and his coauthor, Harvard’s John Campbell, were also there. They had brought some charts to support their argument that the stock market was grossly overvalued. Shiller ran through some psychological evidence he had been collecting, which implied that crowd behavior had a lot to do with the market’s rise. Greenspan seemed interested in Shiller’s presentation but remained noncommittal. After the seminar finished, he and some of his fellow governors had lunch with the participants.
A couple of days later, on December 5, 1996, Greenspan attended a reception at the American Enterprise Institute, a conservative think tank in Washington. He was there to receive the Francis Boyer Award for notable contributions to American society. Previous recipients included Henry Kissinger, Gerald Ford, and Ronald Reagan. After receiving his award, Greenspan delivered a long address entitled “The Challenge of Central Banking in a Democratic Society.” Most of the speech was taken up with a historical discussion going back to Alexander Hamilton and William Jennings Bryan, but the Fed chairman also slipped in a brief reference to the current situation: “Clearly, sustained low inflation implies less uncertainty about the future, and lower risk premiums imply higher prices of stocks and other earnings assets. But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the last decade? And how do we factor that assessment into monetary policy?”23
Amid the economist’s jargon, the phrase “irrational exuberance” stuck out prominently—just as Greenspan had intended it to. Even before he got up to speak, the Reuters news agency sent out a one-line alert based on an advance text: “Fed must be wary when irrational exuberance affects stocks, assets—Greenspan.” In Japan and Australia, where the following day’s trading session had already begun, stock prices fell sharply. When trading started in Europe, the selling continued. The German market fell by more than 3 percent. When the New York Stock Exchange opened, the Dow slid 140 points. Shiller was driving his child to school in New Haven when he heard the news about Greenspan’s speech and its impact on the markets. I wonder if I had anything to do with that, he thought to himself.24
Greenspan had issued what was, by his opaque standards, a clear warning to investors, but it didn’t prove very effective. Later in the day, stock prices recovered. The Dow closed down just 55.16 points, a loss of less than one percent. On Wall Street, after the initial shock, the Fed chairman’s statement was interpreted as a sign of weakness. “The Fed has no intention of tightening monetary policy simply to push the equity market down,” Bruce Steinberg, an economist at Merrill Lynch, told The New York Times. “It will only tighten when it believes the inflation climate requires it.”25 Other analysts were even more dismissive of Greenspan’s intervention. “Instead of raising rates, he is going to make speeches,” Christopher Quick, a senior executive at the Quick & Reilly discount brokerage, commented.26
Wall Street had taken the measure of its man. Greenspan was concerned about the stock market, but not concerned enough to raise interest rates. A few weeks later, at the start of 1997, the Dow took off again. By the second week of February, it had topped 7,000.