The remarks of Alan Greenspan at the recently concluded Jackson Hole conference were quite enlightening. The Maestro touched on what he considered the most important developments in the way monetary policy has been approached and implemented under his tenure. I was hoping, of course, that Greenspan would endorse the price rule, whereby the Fed would automatically accommodate shifts in the economy’s money demand. Instead, he articulated his “risk management” approach.
At least we were given another peak into the mind of a central banker who has kept Wall Street guessing for two decades.
The essence of Greenspan’s approach is to anticipate and accommodate possible shocks to the economy. Like the price rule, the Greenspan approach accommodates money-demand shifts. But the price rule reacts automatically while the risk-management approach launches preemptive accommodations and requires that the Fed be vigilant about potential demand shocks. In particular, Greenspan stressed the ability to adjust to events without the comfort of relevant history to guide the central bank. His most recent pet project seems to be the household-net-worth-to-disposable-income ratio, or wealth-to-income ratio.
In a forward-looking model, wealth is determined by the discounted future value of after-tax income. There are several drivers for the wealth variable: the discount rate (which generally is related to the long-term government bond plus a risk premium), the income growth rate, and the tax rate applied to income earned as well as to any reinvestment of income. Greenspan warned all of us about the dangers of a higher wealth-to-income ratio:
[the] vast increase in the market value of asset claims is in part the indirect result of investors accepting lower compensation for risk. Such an increase in market value is too often viewed by market participants as structural and permanent. To some extent, those higher values may be reflecting the increased flexibility and resilience of our economy. But what they perceive as newly abundant liquidity can readily disappear. Any onset of increased investor caution elevates risk premiums and, as a consequence, lowers asset values and promotes the liquidation of the debt that supported higher asset prices. This is the reason that history has not dealt kindly with the aftermath of protracted periods of low risk premiums.
Here the Maestro outlines a very specific mean-reversion path through which the net-worth-to-disposable-income ratio will adjust to the long-run equilibrium. In other words, things aren’t always going to be so rosy.
Greenspan first assumes that there is going to be an increase in the risk premium and a disappearance of liquidity in the economy. He is in a position to know. In fact, he offered the perfect example of this in his speech: When the fed funds rate was lowered in the aftermath of the 2000-01 recession, the Fed flooded the credit market. In light of the abundance of credit, the risk premium declined. Today, as the Fed reduces liquidity, it follows that the market will once again begin to pay attention to the risk characteristics of the different asset classes. But this Greenspan logic is only impeccable if everything else holds the same.
The Greenspan story argues for a decline in the risk premium going back to the mid 1990s. While it is true that the data point to an acceleration of the net-worth-to-income ratio, the same data point to a secular increase in the ratio dating back to the late 1970s. My interpretation of the data suggests that there is more than risk to this story. Monetary policy also plays a part, as the Maestro correctly pointed out:
I acknowledge that monetary policy itself has been an important contributor to the decline in inflation and inflation expectations over the past quarter-century. Indeed, the Federal Reserve under Paul Volcker’s leadership starting in 1979 did the very heavy lifting against inflation. The major contribution of the Federal Reserve to fashioning the events of the past decade or so, I believe, was to recognize that the U.S. and global economies were evolving in profound ways and to calibrate inflation-containing policies to gain most effectively from those changes.
Over the last twenty-five years we have seen a secular decline in bond yields and a corresponding increase in investors’ horizons, both of which have corresponded with a reduction in the inflation rate. While there have been cyclical fluctuations in bond yields, which I attribute to the Maestro departing from the price rule, my main concern here is with the secular trend. The data show that the inverse of the bond yield (a proxy for the value of a dollar in perpetuity) and the wealth-to-income ratio both trend together, and the relationship is much stronger during the 1970s when the data fits like a glove.
Beyond the 1980s, the data suggest that the increase in the wealth-to-income ratio is higher than the inverse of the bond yields would suggest. What causes this disparity at or around 1980? My explanation is that the inverse-of-the-bond-yield story focuses solely on the discount factor of a valuation model (i.e., the denominator), and says nothing about the growth of after-tax earnings (i.e., the numerator). The latter is the clue to the disparity in the two series after 1980.
Taxes matter. The Reagan tax-rate cuts of the 1980s increased after-tax income, and once both tax rates took effect, two things happened: There was a surge in earnings and the “keep-rate” increased (businesses and workers were keeping more of what they earned). In the early 1990s the U.S. experienced two tax-rate increases. However, during the same time, the Fed was lowering the inflation rate which, in effect, reduced the effective tax rate on capital gains and minimized the impact of bracket creep. The net-worth-to-income ratio moved sideways. Once the Republicans took over Congress, gridlock and Greenspan monetary policy became the elixir that the economy and financial markets needed.
These are the so-called low-risk-premium bubble years that the Maestro discussed in Jackson Hole. Did the Fed have a hand in the bubble bursting? While it is true that the Enrons of the world cheated and misstated their earnings, the Fed also provided excess liquidity in anticipation of Y2K and then rapidly withdrew it early in 2000. So the Fed may have been implicit in the bubble going “pop.” Perhaps Greenspan has learned his lesson, and has now become an advocate of “measured responses” which allow the Fed to telegraph its intentions.
The recent surge in the wealth-to-income ratio began near or around the time that President George W. Bush lowered the tax rate on dividends. Alan Greenspan seems to suggest that the risk premium and the level of long-term interest rates may in fact increase in the short term and that these two variables will, all else the same, result in a lower net-worth-to-income ratio. But all else is not the same. During the same time we have a lower-tax-rate environment and fairly strong growth. If the president’s tax commission keeps the recovery going by initiating even flatter tax rates, the strong growth that follows may offset and possibly dominate some of the negative impacts that higher risk premiums may have on the wealth-to-income ratio.
The outlook is not as bleak as implied in the Maestro’s most recent analysis.
– Victor Canto, Ph.D., is the founder of La Jolla Economics, an economics research and consulting firm in La Jolla, California.