If I Were the Fed Chairman....

By Robert M. Liu


In late May or early June of this year, I met with a man in a library. He told me that he was a pilot, but apparently, he had a strong interest in economic issues. So we came to discuss the falling stock market. When I mentioned the stock bubble that burst in spring of 2000, he began to blame Fed Chairman Alan Greenspan. Instead of blaming the Fed chairman for raising interest rates in 1999 and 2000, he blamed Alan Greenspan for "creating the bubble". While I couldn't disagree more, I kept quiet, knowing the best way to win a debate is to avoid starting one.

His reasoning: In order to avoid the Y2K (year 2000) liquidity crunch in the banking system which never materialized, Fed Chairman Greenspan pumped too much liquidity into it, which in turn flooded the stock market, creating a stock bubble. Some folks on Wall Street hold the same view. But is it true that when there is an excessive amount of liquidity in the banking system it must flow into stocks? In my opinion, it is not. People buy stocks because they expect stock prices to rise, not because they have excessive liquidity. If they expect stocks to fall, they'd rather keep liquidity under mattresses, than in stocks, no matter how much liquidity they have.

In fact, the Federal Reserve began to tighten in spring of 1999. It raised the Fed Funds rate six times between spring of 1999 and spring of 2000 — from 4.75% to 6.50%, pricking the stock bubble and plunging the economy into a recession. Chairman Alan Greenspan did not create the bubble. "Irrational exuberance" did. The U.S. economy was doing very well from 1994 to 1999. It was the envy of the world. After long years of budget deficits, the United States began to have a budget surplus in 1997. The U.S. dollar was strong. Inflation was low. Unemployment was low. Why shouldn't Wall Street have some exuberance?

The problem is the exuberance of the 1990s grew out of proportion and became irrational when stock promoters disguised as Wall Street "analysts" fed the gullible investing public with theories that served to rationalize the irrational valuations of stocks with no earnings. They kept issuing "Strong Buy" recommendations for their own IPO's with exorbitant price targets, generating more and more irrational investor expectations. In the words of Chairman Greenspan, Wall Street "analysts" were "discounting the hereafter". Based on my own observations during the late 1990s, some very big market players might have manipulated the price movements of certain stocks with the help of Wall Street "analysts". These stocks could jump to irrationally high levels overnight on "analyst" "Strong Buy" recommendations and strong price targets.

The strange thing is that in the face of such obvious and blatant stock market excesses, the Securities and Exchange Commission of the late 1990s issued little warning to alert the public. If Chairman Greenspan saw "irrational exuberance" and realized that Wall Street "analysts were discounting the hereafter", there is no reason to believe that the SEC of the late 1990s couldn't see the problem in the same light. Today, there are claims to the effect that the SEC of the late 1990s did not have enough manpower and resources to crack down on the above-mentioned stock market excesses because the Republican-controlled Congress did not provide enough support for the SEC.

In my opinion, the SEC of the late 1990s should at least have issued serious warnings about the aforesaid market excesses and IPO "Strong Buy" frauds in a timely manner, so as to alert Congress and the public in order to get enough resources and support for an SEC crackdown. It does not take a lot of manpower and resources to issue warnings. It takes good judgement, competence, courage and political will.

Unfortunately, it was the SEC of the late 1990s itself which allowed so many worthless, loss-making dot com IPO's to be listed on the market in the first place. The SEC of the late 1990s had enough manpower and resources to approve such disastrous IPO's to bilk sucker investors but "did not have enough manpower and resources" to even issue warnings about the irrational valuations of those loss-making IPO's approved by itself. The SEC of the late 1990s knew these dot com IPO's had no earnings, but it watched Wall Street "analysts" issue "Strong Buy" recommendations and exorbitant price targets without protest. For lack of manpower and resources? The SEC of the late 1990s did not do a very good job at protecting the interests of the investing public, to say the least.

Like they say, where there is a will there is a way. The SEC of the late 1990s lacked the political will to issue warnings like Fed Chairman Greenspan did. Everybody on Wall Street wanted the good time to continue. Warnings were unpopular. If politicians had issued warnings about stock market excesses in the late 1990s, they would have become unpopular with investors and their opponents would have jumped upon them, accusing them of "talking down the economy". Thus, the SEC of the late 1990s was really "smart" in keeping its mouth shut. As to Chairman Greenspan, at the time he issued his warnings, he appeared to be out on a limb. In retrospect, he was perfectly correct in saying Wall Street "analysts" were "discounting the hereafter". No one can blame him for not warning the investing public.

Now, we are facing a completely different situation. The stock bubble has burst. The Dow Jones Industrial Average, which closed at its all-time high of 11722 on January 14, 2000, has since been in a down trend. It closed at 8684 Friday (July 12, 2002). There is a lot of pessimism. And why shouldn't people have some pessimism at this moment? The economy is not growing fast enough to allow companies to rehire the workers they laid off last year. Millions of retirement portfolios, including 401(k)'s and IRA's, are down in value, whereas nearly half of American households now depend on such retirement portfolios for their future needs.

Besides, thousands of Americans lost their lives in New York City and Washington D.C. on September 11, 2001. The sadness is still in the air. There is very little to celebrate, especially when people hear all the bad news about disappointing corporate earnings, corporate malfeasance (at Enron, Worldcom etc.) and possible terrorist attacks. While President George W. Bush says there are a few bad apples in corporate America, the Democrats want the public to think the problem of corporate malfeasance such as improper accounting practices is "wide spread". I have yet to see evidence to believe the problem is "wide spread".

However, amid all this pessimism, there are signs that the economy is recovering from the recession, though not fast enough. Some blue chip companies have recently reported good earnings. For instance, General Electric (GE) said Friday (July 12, 2002) that its second quarter earnings were up 14% from the same period of last year and that it expected to earn $1.65 to $1.67 per share in 2002, up from $1.41 per share for 2001. Some Wall Street professionals believe the stock market is now undervalued, even according to the Federal Reserve's valuation model yardstick, which is the 10-year Treasury bond yield.

The 10-year Treasury bond recently traded at a yield of about 4.60%. That is equal to a P/E multiple of 21.74 times. [100/4.60 = 21.73913 times] If you invest $100 in 10-year Treasury bonds now, you receive about $4.60 a year in interest. At Friday's close of $28.60 per share, General Electric (GE) now fetches a P/E multiple of only 17.33 times its 2002 earnings per share of $1.65. [$28.60/1.65 = 17.33 times]

Another example: the stock of America's largest local and wireless phone company Verizon (VZ) closed at $35.30 Friday. It is expected to earn $3.10 per share in 2002 and pays an annual dividend of $1.54 per share. So, its P/E multiple (i.e. its price-earnings ratio) is only 11.387096 times. [$35.30/3.10 = 11.387096] Whereas its yield is as high as 4.36%. Of course, stock investment involves more risk than Treasury bond investment.

Also helping the bulls' case are the comments made recently by Morgan Stanley's global investment strategist, Barton Biggs, a long-time bear on U.S. stocks. In late November of 1999, Mr. Barton Biggs warned that investors might be witnessing the biggest speculative bubble ever in the stock market and that they should get out of technology, telecom and Internet stocks before the end of the year. He was right. The tech bubble burst in spring of 2000. But recently, he turned bullish on U.S. stocks, saying he was seeing some early signs of market capitulation. That means that U.S. stock valuations have fallen to levels attractive to even a long-time bear like Barton Biggs.

Well, before I tell you what I would do in order to revive the U.S. economy if I were the Fed chairman, I would like to say a few words about Chairman Greenspan's retirement portfolio. According to a report I read in the late 1990s, Chairman Greenspan has a retirement portfolio that is 100% in Treasury bonds.

While I have heard commentators say that there is little the Fed can do to help the economy, I have a completely different view. I strongly believe the Fed has the power to quickly revive the economy. Remember the economy is about money and the Fed has the power to create as much money as the economy requires. As long as the Fed is willing to inject sufficient liquidity (i.e. money) into the economy, demand will grow and the economy will come back to life. So, if the above-mentioned Fed valuation model is valid, if Mr. Barton Biggs of Morgan Stanley is again right about the valuations of U.S. stocks this time, and if I were the Fed chairman with a responsibility to revive the U.S. economy, I would do a few things as follows:

First, I would tell the public that I would switch 60% of the assets in my retirement portfolio to best-quality U.S. blue chip stocks. Then, I would call my broker to invest 60% of the value of my retirement portfolio in Diamonds Trust, Series 1 (DIA). Diamonds (DIA) is a trust fund that contains the 30 Dow component stocks. Each DIA share is worth about one hundredth of the Dow Jones Industrial Average. It closed at $86.65 per share Friday. This gesture of mine would send a signal to the investing public that the Fed has confidence in corporate America and the direction of the U.S. economy.

Secondly, I would call President George W. Bush and say, "Mr. President, here's my recipe for enhancing investor confidence in the stock market and the U.S. economy:

"A. Go to Wall Street and make another speech there. This time, please carry your cellular phone in your pocket. Tell Wall Street again that you have confidence in corporate America, the U.S. stock market and the direction of the U.S. economy. At the end of your speech, take out your cellular phone and call your broker to purchase Diamonds (DIA) shares. Actions speak louder than words. This dramatic move of yours would cheer up Wall Street and convince investors that the problem of corporate malfeasance is not wide spread as the Democrats claim.

"B. Ask Vice President Dick Cheney to visit Wall Street with his cellular phone, make a speech and purchase Diamonds (DIA) shares at the end of it. Wall Street regards the Vice President as a figure of great credibility. If he commits his funds to the stock market, there is no reason to believe improper accounting practices are wide spread. Ask Secretary of Treasury Paul O'Neill to do the same. Wall Street trusts the Treasury Secretary. Purchases of U.S. stocks by Republican officials at this critical moment would enhance investor awareness that the GOP is a real pro-business, pro-economy party. That would help Republican candidates win support from the vast investor class in America in the November Congressional elections.

"Extraordinary times call for extraordinary measures. People in high places should be allowed to purchase U.S. stocks to boost investor confidence without being blamed for conflicts of interests. Anyway, Diamonds (DIA) contains 30 Dow component companies. It reflects the overall condition of the U.S. economy. For a high-ranking official to purchase Diamonds (DIA) is a personal act of commitment to the U.S. economy, not a conflict of interest involving a particular business organization.

"C. Call Senator Tom Daschle and Rep. Dick Gephardt, the two leading Democrats, and ask them to purchase U.S. stocks in a symbol of American patriotism. If they hesitate, they would reveal their true colors as anti-business, anti-economy demagogues only good at spooking investors and destroying investor confidence. They would appear to be lacking in commitment to the U.S. economy and become as unpopular as short sellers with 401(k) and IRA portfolio holders. Mr. President, it's time to put them on the defensive in front of America's vast investor class."

Thirdly, if all the purchases of Diamonds (DIA) shares made by President George W. Bush, Vice President Dick Cheney and Treasury Secretary Paul O'Neill fail to restore investor confidence, I would indicate clearly to investors and short sellers in particular that they should never fight the Fed and that interest rates would stay low in the foreseeable future or even fall further to help boost corporate earnings because inflation is well contained, because trading below $320 per ounce, gold continues to point to commodity disinflation.

Fourthly, if short sellers ignore such indications by myself, I would then conduct serious "open market operations". But instead of purchasing Treasury securities as the Fed usually does to inject liquidity into the banking system, I would instruct the Fed to purchase Diamonds (DIA) shares (provided the law permits) at levels that reflect distress and "irrational pessimism", so as to provide a floor for the market and to stop panic.

If stocks rise, it is because some big market players are buying. If stocks stop falling, it is because some big market players are accumulating at the bottom. If stocks stop rising, it is because some big market players are distributing. Only the big players know where the bottom is and where the top is. But make no mistake on this planet called Earth no market player is bigger than the Federal Reserve Board, which has the power to create as much liquidity as it wants. If the Fed is willing, it can easily determine where the bottom of the market is, because it can easily stop the market falling by accumulating shares at the bottom.

Would this lead to high inflation? Not likely, because I would instruct the Fed to accumulate Diamonds (DIA) shares only at undervalued levels to warn short sellers to ensure that the amount of liquidity thus flowing into the economy is limited. Once a floor is established, investors would come in to buy. To the Fed, liquidity is nothing but a commodity which it can create by simply writing a check against itself. As long as such practices do not lead to rampant inflation, I (i.e. if I were the Fed chairman) would be happy to use the liquidity created by the Fed at virtually zero cost to purchase the best-quality U.S. industries contained in Diamonds (DIA). Anyway, right now, there is little inflation to worry about.

Fifthly, I would hold the Diamonds (DIA) shares purchased by the Fed as a weapon to fight stock market "irrational exuberance" in the future, should it re-emerge. If "irrational exuberance" does re-emerge, I would issue no warning. Nor would I raise the Fed Funds rate to prick the bubble. Instead, I would sell the Fed's holdings of Diamonds (DIA) shares through the Fed's "open stock market operations" to cool the market mania. What about the dividends income from the Diamonds (DIA) shares and the profits earned through such "open stock market operations"? I would transfer the dividends income from the shares and the profits from the Fed's "open stock market operations" into the Social Security Fund and other welfare programs for the elderly and the less fortunate. That would be my way to save Social Security and reform Social Security.

There has been a lot of talk about Social Security reform, because the Social Security program will go bankrupt in the next few decades if not reformed. One idea is to invest part of the Social Security money in stocks. But Fed Chairman Alan Greenspan says that could cause bureaucratic interference in America's free enterprise system. Another idea is to allow young employees to invest part of their Social Security money in stocks under government guidelines. The Democrats don't like the idea. They say it is too risky. So, the above-mentioned Fed "open stock market operations" involving the purchase and sale of Diamonds (DIA) shares could be a third option to reform Social Security. It would ensure a steady dividends income and a decent profit for Social Security over the long term. It could also provide help for other welfare and entitlement programs for the elderly and the less fortunate. A safe way to kill two birds with one stone! That is, a safe way to stabilize the stock market and to ensure future profits for Social Security.

I don't want to sound as if I were a socialist. I definitely am not. I strongly believe in free- market capitalism that gives the individual the incentive to create wealth under the free enterprise system. I don't believe in excessive government regulatory intervention that could screw up the economy. For instance, government regulation has created excessive competition in the telecommunications industry, where dozens of telecom service providers compete in every single telecom market, selling their services below cost while their respective telecom systems and infrastructures overlap each other. This "war of attrition" wastes resources and scares off investors. It is certainly not in the best interest of capital formation, since it creates an imbalance between the interests of consumers and the interests of investors.

Not very long ago, the telecommunications industry was regarded as a stable public utility sector where widows would feel safe enough to invest, because while telecom service providers could not raise prices without prior permission from the Federal Communications Commission, they used to have a steady cash flow enabling them to pay regular dividends to widow investors. Now, look at Worldcom. Of course, it was wrong for Worldcom to cook its books. But the fact that it cooked its books to cover up its losses means Worldcom has been selling its telecom services below cost for a very long time.

Can such destructive, irrational competition or "war of attrition" artificially created by government regulation continue forever? At a certain point, excessive competition has to end with consolidation, so as to allow the winners to prosper. Government regulation should not punish winners and business excellence in the name of "encouraging competition". There is already too much competition. Losers like Worldcom, Global Crossing, Arthur Anderson etc. should get lost — period.

That said, it is clear that at certain critical moments like the present, the shortcomings of free-market capitalism tend to show themselves. One example is corporate malfeasance committed by corporate executives who cover up the real financial status of their companies in order to stay in the executive office for as long as possible, because they know the longer they stay, the more they can get through their ridiculously high compensation packages and stock options — bonuses not for making money, but for losing money. Nothing could be more absurd.

Furthermore, no matter how strongly I believe in free-market capitalism, our "free-market economy" is actually not free from the impact of government fiscal policy and the Fed's monetary policy. If the government raises taxes too much, our "free-market economy" can hardly thrive as investors pull out, leaving a bunch of jobless people behind. If the Fed raises the Fed Funds rate to 14%, our "free-market economy" would be dead overnight as the burden of interest costs would crush business.

The fact is that government plays a very important role in our "free-market economy". Our "free-market economy" is actually controlled by government composed of politicians and central bankers. Like it or not, that's the reality, and I accept it. In some sense, Keynesianism reflects this reality. Government is the ultimate watchdog, the ultimate source of relief, the ultimate source of liquidity (and therefore the ultimate source of inflation if any), and the ultimate defender of the nation, though in a free society, government is not the ultimate owner of business enterprises and generally does not operate business enterprises.

Under the free enterprise system, there are winners and losers, and there are those who are honest and play by the rules and those who are unscrupulous and fail to play by the rules. While the winners can always take care of themselves, there are crowds of people who look to government for assistance. Thus, government has no choice but to play the role of the ultimate watchdog and the ultimate source of relief in order to maintain social stability. In the meantime, it must create a business-friendly environment to ensure sound economic growth, because without sound economic growth, there is no way to create enough wealth and jobs, no way to generate sufficient tax revenues to cover the government's various costs.

Since government must play a role in our "free-market economy", the question is how, when and where it should play its role. It is well known that the Federal Reserve (a government institution) adjusts monetary policy through purchases and sales of Treasury bonds in its open market operations. If this Fed practice is appropriate, then, for the Fed to engage in "open stock market operations" to purchase Diamonds (DIA) shares (merely a different type of securities) to stabilize the stock market when necessary should also be considered appropriate.

Extraordinary circumstances call for extraordinary measures, though they should only be taken as a last resort. But the benefits of such extraordinary measures are obvious. Once the stock market is stabilized by the Fed's "open stock market operations", investor confidence as well as consumer confidence will quickly increase. Then, as the demand for goods and services rises, stimulating corporate earnings and job creation, the economic recovery will pick up steam, generating more tax revenues for the government. In short, the vicious circle of "irrational pessimism" leading to more "irrational pessimism" we are witnessing right now can be stopped and reversed overnight, if the Federal Reserve has the will to step into the stock market and buy, buy and buy — with money which it can create with a mere tick of a pen!

Again, like they say, where there is a will there is a way.


The End — July 14, 2002