NCPA - National Center for Policy Analysis

Will Greenspan Prick the Internet Stock Bubble?

January 19, 2000

Last week, Federal Reserve Board Chairman Alan Greenspan warned again of a stock market bubble. He said the rise in the stock market is creating unsustainable imbalances.

Says Greenspan, "Through the so-called 'wealth effect,' these gains have 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."

John Makin of the American Enterprise Institute thinks the Fed eventually will prick the stock market bubble, leaving investors with higher debts and fewer assets. At that point, there will be a liquidation and the inevitable recession.

History certainly supports Makin. In 1928, the Fed worried that a stock market bubble was undermining economic and financial stability. And, like today's Fed, it sought to engineer a soft landing by gradually raising interest rates.

Ironically, as the Fed restricted credit, it actually pushed the stock market higher: the available credit flowed into the one place where returns were great enough to cover the higher borrowing costs -- the stock market. Consequently, the real sector of the economy (manufacturing and agriculture) was even more starved for credit. When it faltered, leading to lower profits and dividends, the financial sector collapsed.

The stock market bubble may have been bound to burst with a major correction. But such a naturally occurring revaluation of stock prices would have had only a temporary economic impact. The Fed's active intervention had disastrous consequences on the economy as a whole.

There is a bubble for Internet stocks, but the market as a whole is not grossly overvalued. Traditional businesses are only beginning to reap the benefits of efficiency and productivity computers and the Internet have to offer. Thus while Internet stocks may take a big fall when expected profits fail to emerge, traditional businesses should see increased profitability.

Source: Bruce Bartlett, senior fellow, National Center for Policy Analysis, January 19, 2000.


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