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strategy and business
 / Winter 2008 /Issue 53(originally published by Booz & Company)


The Thought Leader Interview: Allan Meltzer

S+B: How important is that final change?
I think it is essential. You have to ask yourself — as I have asked myself: Here are my stu­dents, and students from other quality institutions five or 10 years into their careers, and they are selling pieces of paper that they have to know aren’t worth much. Why are they doing that? The answer is that they make a lot of money doing it, and if they don’t make the money, they get fired. It’s a rare firm — though there are a few — that resists the temptation to control the risky behavior that leads to eventual losses.

We have to remember in thinking about all of these things that the financial markets, for the most part, lend long and borrow short. So there are always going to be periods, unavoidably, in which expectations change for one of a million different reasons and you find people in a position where it’s hard to renew short-term loans to finance long-term debt. But we can reduce those problems by improving the in­centives of the people who work in those markets.

Hindsight and Resilience

S+B: Turning to the Fed’s conduct of monetary policy, some critics trace the problems we are experiencing back to the 1990s, blaming the Fed for allowing the dot-com bubble to form by keeping monetary policy easy and interest rates too low for too long, and in turn creating the conditions for the housing bubble.
I don’t like the idea of bubbles, especially applied to the dot-com episode. I know it’s a very common view of the episode, but here are two reasons I disagree: First, it didn’t affect all stocks. It affected stocks of new companies that were using the new technology. Second, for every buyer there was a seller. So if a buyer was enthused by the prospects of the future, there was a different attitude on the part of the sellers, right? I think a better explanation of what happened in the dot-com period was that people saw a new technology, and at least some people decided that new technology was going to be highly profitable. It turned out it wasn’t. Entry was too easy, and the dot-coms were squeezing each other out. It took years for Amazon, which is one of the most successful dot-coms, to ever make a profit. That awareness eventually dawned on people in the market.

What could the Fed have done? Can you raise the interest rate enough to stop this, or do you just kill the economy in the process? And I guess the Fed’s answer, or at least Alan Greenspan’s answer, was, “Well, we’re not going to kill the economy. We’re going to let these people make these mistakes.” And as he said at the Jackson Hole conference at one point, “Then we’ll mop up the problem that remains.”

There are many who criticize Alan Greenspan for not taking more action. I’m a bit less sure that there was much the Fed could have done. People said, “Well, you could have put on margin requirements” to limit borrowing used to buy stocks. First of all, the stock purchases weren’t heavily margined. And this is not 1929. There are so many ways that people can borrow to finance stock purchases today. Margin requirements have no chance of stopping that kind of activity.

The Fed has only a very blunt tool for dealing with problems like that. And as far as I’m concerned, there’s nothing terrible about letting the people who make mistakes pay for them.

S+B: In effect, that’s what happened when the dot-coms crashed. Many of the people who invested in the dot-coms lost a lot of money, but it didn’t cause a serious economic downturn.
There was a short period in 2001 and 2002 when the econ­omy was slow because people were uncertain about what was going to happen, but that’s in the nature of the market economy.

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