July 31  , 2002


A long time ago, I was taught that you learned more about industrial material under stress than you do under normal activity.  I believe the same holds true for economic systems. 

So what did we learn under the stress of collapsing stock prices in recent weeks?

Before the stock market made its remarkable reversal to the upside last Wednesday, yields on two year Treasury notes had fallen below 2 percent.  Not only did this mean that investors no longer believed the Federal Reserve would increase short term rate targets, but investors  were pricing in a probable interest rate decline.

I believe investors had sensed what needed to happen to reduce the risk of renewed recession under disorderly stock markets, even if the Federal Reserve did not. 

When investors sold stocks, they had to invest elsewhere.  Most of that elsewhere was in government bonds.  As a result, rising government bond prices pushed yields down from more than 5 percent a few months ago to less than 4.3 percent last Wednesday morning. 

This meant that the spread between short and long term rates had narrowed sharply.  Financial institutions make money when spreads are wide.  This narrowing meant that their earnings would suffer. 

Already skittish loan officers were being told to be extra careful about making loans.  Loan write offs could only add to the earnings shortfalls building at banks.  Thus, the bond market rally induced by stock market weakness was beginning to cause a squeeze on credit availability. 

(Banks made money on  rising bond prices.  However, banks were so sure that interest rates would rise, causing bond prices to fall,  that they had relatively few holdings of long term bonds.)

This means that during disorderly markets, whether upward or downward, the Federal Reserve should be more concerned about managing  interest rate spreads than the level of short term interest rates.  In other words, the investors were right to expect the Federal Reserve to lower short term rates when the stock market was in freefall.

The second lesson learned is that margin rates need to be used more frequently to help moderate disorderly stock market performance. 

Three years ago I was writing columns arguing that margin requirements should be raised to stem the tide of speculation.  Instead, the Federal Reserve chose to raise short term interest rate targets.  The latter insured substantial side effects for the entire economy (and may have been responsible, along with the speculative excesses, for the ensuing recession). 

Last week, when the stock market opened daily with margin selling from accounts that suffered losses in the previous few days and closed with mutual fund selling to raise cash for the redemptions of fund shares sold that day, we needed something to stem the tide of forced selling. 

If margin requirements had been raised at the end of 1999, as I suggested, they could be lowered to provide a respite from this margin selling a few days ago.  Failure to use the margin requirement tool has added to the instability of financial markets in the past few years. 

I grant that hindsight shows clearly what ought to have happened.  The danger in becoming more active in using policy tools is in using them at the wrong time. 

How can we forget in Georgia the governor who decided that a revenue shortfall in an election year was adequate reason to use the balances in the "rainy day" funds?  When the recession arrived a year later, government workers were laid off and taxes were raised at the height of the recession. 

Thus, the Federal Reserve must be careful to differentiate between the bull and bear on the one hand and market chaos on the other.  There are signs.

 When a company reports strong earnings and provides a dividend yield that is better than a 5 year treasury note, its stock  should not plunge in price along with the remainder of the market.  Yet, I know examples of that very result in recent weeks. 

When prices of  treasury debt instruments rise sharply or cash balances balloon without any signs of increased spending, then something may be amiss.  In short, look at what is happening elsewhere and determine whether those actions are justified by economic conditions. 

I did not see a bear last week.  I, along with those treasury bond investors,  saw market chaos.  And I did not see any policy response to sooth the troubled waters. 


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