Federal Reserve Chairman Alan Greenspan said today that the rising value of U.S. assets such as stocks and homes has created a new vulnerability to large, abrupt declines in asset prices that could hurt the American economy.
Greenspan, speaking here at the annual policy conference of the Kansas City Federal Reserve Bank, said economists don't know how to predict -- much less head off -- the type of sudden loss of confidence by investors that can cause such sharp asset price declines.
The economy's vulnerability to such a decline depends in part on how much debt consumers and businesses have taken on to buy stocks, bonds, real estate and other assets, he said. A sharp drop in prices could make such debt far more burdensome.
Greenspan also cited various factors that make it difficult to gauge asset values in today's economy, including corporate accounting methods and investors' expectations about the future.
"To anticipate a bubble about to burst requires the forecast of a plunge in the prices of assets previously set by the judgments of millions of investors, many of whom are highly knowledgeable about the prospects for the specific companies that make up our broad stock price indexes," he told the audience of economists, central bankers, financial analysts and others from around the world.
The Fed, Greenspan said, won't respond to a gradual increase or decrease in asset values, but it would respond after the fact to sharp price declines to head off significant damage to the economy.
He cited as an example last fall's worldwide financial-market turmoil that developed in the wake of a default by the Russian government on part of its debt. To ease that problem, the Fed cut short-term interest rates and made it clear that it stood ready to supply enough cash to the U.S. banking system to get financial markets functioning smoothly again. The Fed took similar action following the October 1987 stock market crash.
As Princeton University economist Alan Blinder, a former Fed vice chairman, put it, "You have to watch out when you fall off the cliff. That's when the central bank has to spring into action."
Part of the difficulty in anticipating trouble stems from the challenges in guessing how much certain assets are worth, the Fed chairman explained.
The value of all assets is rooted in what people expect in the future, he said. For instance, when someone buys a corporate stock, part of the value is determined by expectations about the firm's future earnings. But built into the current price are also assessments of the risks that could disrupt the flow of earnings, such as a recession or a bankruptcy, and a "discount factor" to compensate for the fact that those earnings won't all be received immediately but will stretch far into the future. For example, many Internet companies make no profit now, but their stock prices have soared on expectations of future profit.
The problem of valuation is compounded by accounting problems that are causing corporate earnings to be overstated or understated, he said.
Earnings are being overstated by many firms that pay some of their employees with both cash and stock options. Use of the stock options, which are not counted as a cost of doing business like regular pay, reduces payroll costs and therefore increases reported profits. The Fed staff has estimated that the use of options has increased corporate profits by 1 percent or 2 percent annually during the past five years, he said.
Also, the sharp increase in stock values has boosted the value of many corporate pension funds and relieved the firms of having to make annual payments -- another business cost. This too has increased reported earnings.
On the other hand, these effects have been more than offset by other accounting methods that have caused earnings to be understated in recent years, he said.
With a growing share of economic output represented by what Greenspan called "idea-based value," it is becoming increasingly hard to know which business purchases should be expensed or capitalized. With an expense, the cost is deducted from income in the year it occurs; when an item is capitalized, the cost is deducted over a period of years as its use contributes to the firm's revenue. Expensing an item increases immediate costs and reduces earnings; capitalizing the cost does the opposite.
Greenspan cited as an example business spending on software, which he suggested has been treated wrongly as an expense. "The major technological advances of recent years have exposed a broad swath of rapidly growing outlays that, arguably, should be capitalized so that the returns they produce would be more accurately reflected as earnings over time," he said.
However assets are valued, Greenspan said, it is unknown how a large decline in prices can affect the economy -- and therefore what monetary and budgetary policies would be appropriate. "We no longer have the luxury to look primarily to the flow of goods and services, as conventionally estimated, when evaluating the macroeconomic environment in which monetary policy must function."
Despite the increased vulnerability to asset price swings cited by Greenspan, other economists at the conference provided some cause for comfort, for now.
Economists Ben Bernanke of Princeton University and Mark Gertler of New York University said in a paper presented here that U.S. asset values have increased much faster than the amount of debt in recent years. As a result, both American businesses and households are in such good financial shape that, with the Fed's help, the economy could withstand the shock of a big drop in asset values, they said.
"A correction in the stock market of, say, 25 percent would no doubt slow the economy, but our guess is that the effects would be relatively transitory, particularly if monetary policy responds appropriately," Bernanke and Gertler said.