Second-guessing the Fed

Why should people who never benefited from the stock market boom pay the price for its having gotten out of hand?

By David Moberg

Jan 25, 2000 | It's hard to find any expert who doesn't think the Federal Reserve will raise interest rates slightly when it meets next week. It is harder still to find agreement on why the Fed should make that move. After all, the core inflation rate in December -- one-tenth of a percent -- was the lowest in a generation. Besides, the nation's central bankers usually ratchet up the cost of borrowing to control or even to try to head off inflation.

The economy's problem isn't inflation in general, but prices could be out of control in one sector: the stock market. If that's true, it makes sense for the Fed to try policies that more precisely dampen the "irrational exuberance" of some stock speculators, rather than end the good times just when more people are beginning to feel the benefit. One place to start: Make it harder to borrow money to speculate on stocks by raising what's called the margin requirement.

Nobody knows the mixture of mania and solid performance that underlies the stock market. But there's reason to be concerned about whether the boom will continue when people start to borrow heavily to buy shares in the expectation that the market will keep rising indefinitely, then using their stock gains to underwrite more borrowing and buying, which in turn drives up the market. Such borrowing "on margin" helped to fuel the rise and crash of the stock market in the 1920s.

In 1934 the Federal Reserve got the power to adjust margin requirements to regulate "the use of excessive credit to finance transactions in securities." For many years it raised and lowered margin requirements periodically, much as it changes rates charged on loans among banks. But it hasn't used the power to adjust margin requirements since 1974. Since then individuals have been able to set up margin accounts with brokers and borrow up to half of the value of stocks they buy.

A chorus of economic experts has been second guessing the Fed's plan to raise the interest rate. Many of them, including such economic luminaries as famed investor George Soros, leading Wall Street economist Albert Wojnilower and Stanley Fischer (the number two man at the International Monetary Fund), suggest changing the margin requirement, a tactic that would more directly address inflated stock prices and prevent those who have not yet benefited from the stock market boom from paying its price.

There's good reason to support economic growth by holding interest rates down for most economic activities. Unemployment is low, which is good -- contrary to a common view on Wall Street. Thanks to the tight labor market, the lowest-paid workers have finally scored some wage gains. But the gap in family incomes between the top fifth and nearly everyone else has continued to grow in all but a few states over the past two decades, according to a new report from the Economic Policy Institute and the Center on Budget and Policy Priorities. Most Americans haven't yet shared fairly in the bounty of the nation's longest boom. There's also no evidence that whatever gains some workers have made is pushing up inflation.

So why the rush to raise interest rates, a move that ultimately hurts economic growth, jobs and wages?

In a speech to the Economic Club of New York on Jan. 13, Fed Chairman Alan Greenspan argued that the "wealth effect" of the stock market boom -- the sense people have that they're much richer thanks to their stock portfolios -- has "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."

In other words, the people who got rich, at least on paper, when their tech stocks shot up by more than 1,000 percent last year are buying bigger mansions, bigger SUVs and more high-tech adult toys -- and their voracious demand may begin to drive up prices. Despite the spread in stock ownership, it's worth remembering that about 85 percent of the stock market gains over the past decade have gone to the richest 10 percent of the population.

Even when these people don't speculate on margin themselves, they benefit from the mania of those who do -- until the bubble pops.

In recent years, margin debt has been rising three times faster than household debt or overall debt. Margin borrowing from brokers rose 62 percent last year alone. There were big jumps in November and December, according to the Financial Markets Center, a Virginia-based research and advocacy group. Margin debt rose in those months to an estimated 1.4 percent of the value of all stocks. That matches the record year-end high since World War II, which was reached in 1986, the year before a big stock market crash. The accumulated margin debt is now equal to roughly 2 percent of the gross domestic product, higher than at any time in more than 60 years, according to the Financial Markets Center.

Day traders and other speculators who have contributed to the frenzied bidding for the few stocks responsible for most of the equity boom probably account for much of the rise in margin debt. Some brokerage firms have recently raised margin requirements on their own, and in December the New York Stock Exchange and the National Association of Securities Dealers tightened their regulations of margin borrowing for day trading.

Next Page: Do investors believe in the stock market boom enough to put in their own money?

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