Yes, It may Avert Disaster

By Robert Shiller

The stock market is in its most dramatic boom ever. Despite last week's declines in tech stocks, the Standard & Poor's composite price-earnings ratio (real prices divided by the 120-month average of trailing real earnings) stands at 46. Until the present boom, the highest it had ever been (the data go back to 1871) was 33, in September 1929 -- the month before the crash. The dividend yield on the Standard & Poor's index stands at 1.1%, the lowest ever. The previous low was 2.6% in January 1973, just before the 1973-74 crash. Margin debt is soaring; it has increased 87% in the past year.

In the midst of this record-breaking boom, the Federal Reserve Board remains silent about the speculative level of the market, neither commenting that the market is too high nor using its powers over margin requirements to dampen the markets. This inaction is unfortunate. Distortions of saving and investing behavior, driven by the public's illusion of stock-market wealth, are rampant, and the risks of economic dislocations and massive wealth redistribution are very serious if the market continues to soar and then crashes.

There are, of course, some who assert that the market is rationally high because of new technology that makes the outlook for future corporate profits very bright. But people have hailed "new eras" before -- in 1901, they cited the formation of giant corporations that would supposedly produce economics of scale; in 1929, it was electrification, chain stores and the spread of automobiles; in 1973, advancing productivity and technology. All of these "new eras" turned out not to be so revolutionary after all, and odds are today's market won't be any different.

The Fed used to change its margin requirements actively as a tool against speculative movements in the stock market, raising the requirement when the market got too hot and lowering it when things cooled. Between 1934 and 1974, the Fed changed this margin requirement 22 times, often with explicit statements that its aim was to restrain "speculation" in the stock market. But for 26 years the Fed has kept the margin requirement constant, at 50%.

The best policy for the Fed lies somewhere between these two extremes-between the hyperactive pre-1974 policy and the static policy since. The Fed should probably not attempt to fine-tune the level of the market as it once did. But it should occasionally make adjustments in margin requirements in times of major market misalignments, such as the speculative situation we see in the market today.

Why did the Fed abruptly abandon its active margin-requirement policy in 1974? An important factor was the influence of efficient-markets theory, the idea that markets always work extremely well. Eugene Fama's highly influential academic article "Efficient Capital Markets" appeared in 1970, and Burton Malkiel's efficient-markets book, "A Random Walk Down Wall Street," was first published in 1973. Ever since, the efficient markets theory has been a powerful influence. Most of our leaders who might feel like commenting on the level of the market have retreated from doing so, thinking such an action might be viewed as rash and irresponsible.

The efficient markets theory, unfortunately, is only a half-truth. The theory is right in the sense that it is indeed extremely hard to predict changes in the market over the next few months or a year. But the theory is wrong when it asserts that it is impossible for careful observers to detect that the market is a historic speculative bubble, as it has been in recent years.

Another factor making the policy of changing margin requirements look less attractive after 1974 was the rapid increase in sophistication of our financial markets since around that time, which created many new opportunities other than margin credit for investors to leverage their investments. Notably, the Chicago Board Options Exchange opened trading in stock options in 1973. Now individual investors can easily take speculative options positions in stocks without using margin credit. Yet this does not mean that the Fed should not take the limited action that raising margin requirements represents, for such an action will still be an important signal to the markets.

When the Fed actively managed margin requirements before 1974, it was following a fairly consistent policy of attempting to restrain speculation. Each of the 12 times margin requirements became more restrictive, stock prices had increased over the prior six months, often dramatically. In nine of the 10 times margin requirements were relaxed, stock prices had declined over the prior six months. Thus, it appears that the Fed was attempting to lean against prior stock market price changes. Moreover, there was some tendency for the Fed to keep margin requirements relatively high in times when the market price/earnings ratio was high, and relatively low when the P/E ratio was low.

At Times Erratic

Though the Fed's changes in the requirements were invariably controversial, and at times erratic, on balance the policy probably made some sense. If the Fed were to follow the same procedures today, then. given both very high price/earnings ratios and recent price increases, margin requirements would probably be over 90% now. The absence of such a reaction from the Fed board members today, the abandonment of their old concern about speculation, and the reluctance of national leaders to say anything about speculation in the market, must be part of the reason why the current boom is bigger than any before.

While the Fed should be very wary on principle of intervening in markets, in-creasing the margin requirement today would stand as a warning to investors not to leverage themselves up excessively and would work in the direction of cooling the market. Increasing margin requirements a little, to 60% say, and grand fathering existing margin credit so as not to induce an immediate crisis, would send a healthy caution signal. It is the most important step the Fed can take at this time of historic misvaluation in the stock market.

Mr. Shiller is a professor of economics at Yale’s International Center for Finance and author of "Irrational Exuberance" (Princeton University Press, 2000)

No, Meddling Makes Things Worse

By Bruce Bartlett

Last week's turmoil in the Nasdaq Stock Market is raising anew the question of margin requirements. Many observers blame the market's near collapse last Tuesday on margin calls that forced stock sales in an already failing market. These critics also argue that margin buying had been a major factor pushing the market up to an unsustainably high level. Hence, the argument goes, higher margin requirements would have moderated both the market's rise and subsequent fall.

Federal Reserve Chairman Alan Greenspan has expressed concern about the level of margin debt, which has rocketed upward since October. In February it hit $265.2 billion, up 45% in just four months. Anecdotal evidence suggests that much of this increase came from increased borrowing through online brokers and was channeled into the high-flying Nasdaq. As long as that market kept rising, it was a win-win situation for everyone. Investors achieved higher gains by leveraging their investments, while online brokers made much of their profit from margin loans.

Congress in 1934 gave the Fed power to control initial margin requirements, in the belief that margin calls had been largely responsible for making the 1929 stock market crash so severe. At that time margin debt equaled 30% of the market's value. Between 1934 and 1974 the margin requirement was changed 22 times. But for the past 26 years it has been fixed at 50%, meaning that investors may borrow no more than half the purchase price of equities directly front their broker. (The margin requirement has been as high as 100%, meaning no margin debt at all was allowed.)

No Impact on Volatility

Historically, the Fed has raised margin requirements to curb volatility, rather than to reduce overall growth of the stock market. However, considerable research shows that margin requirements have no impact on volatility. The latest study, by Fed economist Paul Kupiec, concludes that "there is no substantial body of scientific evidence that supports the hypothesis that margin requirements can be systematically altered to manage the volatility in stock markets."

Advocates of higher margin requirements, such as economist Robert Shiller of ale, nevertheless argue that they are a significant weapon in the Fed's arsenal. Mr. Shiller (whose article appears alongside) believes that higher margin requirements can be an important signal that the Fed is serious about cooling an overheated market that could lead to higher inflation.

Mr. Greenspan has often warned about the inflationary potential of the so-called wealth effect. According to this theory, as the stock market rises and people become wealthier, they increase their consumption. A common estimate is that a $1 increase in wealth translates into four cents of additional consumption. Using this rule of thumb suggests that last year's $2.8 trillion increase in the value of equity shares owned by households raised their consumption by $110 billion, enough to add 1.2% to the gross domestic product in 1999. Therefore, restraining growth of the stock market is key to the Fed's strategy of slowing economic growth to avoid inflation.

This theory has several problems. First, there is no evidence that increases in the stock market portend increases in inflation. A December 1996 study by the Federal Reserve Bank of St. Louis concluded: "The pace of increase in stock prices is not itself inflationary, nor are stock prices particularly useful in helping to gauge inflation trends." Indeed, during the 1970s inflation was associated with a stock market that was falling.

Second, the Fed's record of taking "direct action" to reduce stock prices it believes are too high does not inspire confidence. Economist Timothy Cogley of the Federal Reserve Bank of San Francisco recently looked at the Fed's actions in the late 1920s, when it both raised interest rates and sought directly to curb funds flowing into the stock market. Although it succeeded in doing so, it contributed to the onset of the Depression, in Mr. Cogley's view: "The lesson of the Great Depression is not about the dangers of allowing a speculative bubble to develop unabated, but about the difficulty of identifying speculative bubbles and about the risks associated with aggressive.

In any case, new financial instruments blunt the effectiveness of higher margin requirements. San Francisco Fed economist Simon Kwan points out that unlike in 1934,investors now may leverage themselves through options and financial futures. Also, investors can borrow against home equity and from other sources to purchase stocks regardless of margin requirements. They may also borrow on margin for reasons other than stock purchases.

Mr. Kwan further notes that despite the recent run-up in margin debt, it is still quite low, as a share of market capitalization. In February it was just 1.5% of the combined market value of the New York Stock Exchange and the Nasdaq markets. Moreover, his statistical tests indicate that margin debt tends to rise in response to an increase in the stock market, not the other way around. Increased margin borrowing is not a cause but a consequence of a rising market.

And although the Fed sets initial mar-gin requirements, maintenance requirements are set by brokers and exchanges, and they may be lower than 50%. They can also set higher margin requirements without Fed action and many are doing so for highly speculative stocks and known day traders. Thus insofar as there is a problem with margin debt, markets are dealing with it.

The idea that the Fed should target the stock market and raise margin requirements is flawed. Although a stock market bubble poses risks-if indeed one exists-Fed market tampering is even riskier.

Mr. Bartlett is a senior fellow with the National Center for Policy Analysis. He was deputy assistant Treasury secretary for economic policy during the Bush administration.