In FED We Trust (10 page)

Greenspan long prided himself on understanding housing prices and their role in the economy better than almost anyone; it was a subject he had studied for decades. He saw early that Americans treated their homes as ATM machines, refinancing or taking home-equity loans to turn a home’s value into spending money, and he worked with a Fed staff economist to measure this effect. Researchers inside and outside the Fed cautioned that house prices were rising unsustainably. A 2004 Fed working paper by staff economist Joshua Gallin, for instance, said that housing prices had risen 70 percent over the previous ten years while rents had risen only half as much. The strong suggestion: house prices couldn’t keep rising. Greenspan himself liked to point to a closed-door November 2002 Fed meeting in which he said the “extraordinary housing boom” and “very large increases in mortgage debt cannot continue indefinitely into the future.” (Of course, no one outside the room knew he had said that until transcripts were released five years later.)

But Greenspan thought and said publicly that a nationwide bubble in housing prices was nearly impossible because housing markets — unlike, say, the market for copper — were local markets. “I would tell audiences that we were facing not a bubble but a froth — lots of small, local bubbles that never grew to a scale that could threaten the health of the economy,” he recalled, accurately, in his book. After all, he reasoned, housing prices had soared in Britain, Australia, and other countries but then stopped rising without falling across the board. In
the United States, housing prices hadn’t actually declined across the country since the Depression. A national decline in house prices was extremely unlikely, Greenspan thought — and so did many others. Indeed, this was an assumption on which an entire financial house of cards rested. And it was wrong.

Greenspan’s unwillingness to attack the housing bubble wasn’t only about misreading signs. It also reflected a philosophical view about central banks targeting rising asset prices. In an approach Bernanke backed at the time, Greenspan argued that central banks shouldn’t increase interest rates to attack possible market bubbles because they can’t always distinguish a transitory bubble from a sustainable rise in prices. Simply put, the Fed was as likely to aim at a false bubble and kill economic growth as it was to prevent one from inflating.

Greenspan also argued that the central bankers’ other tool — talking investors out of their euphoria — was extremely limited. His famous “irrational exuberance” warning came in December 1996 when the Dow Jones Industrial Average was at 6,500. After that headline-making comment, stocks rose for more than three years, by a cumulative 75 percent, before they finally collapsed, as Greenspan frequently reminded those who chastised him for not using his bully pulpit more aggressively.

Greenspan thought the Fed should preach prudence, pounce only if the rising asset prices were pushing up prices of goods and services, and prepare to protect the economy from harm if a bubble burst. Bernanke and his frequent collaborator, Mark Gertler, put intellectual heft behind this doctrine at a Fed conference in Jackson Hole, Wyoming, in 1999. The two argued vociferously that the Fed cannot reliably identify bubbles in assets such as stocks or housing and, therefore, shouldn’t use interest rates to try to burst them. Raising rates in response to rapidly rising stock or house prices, Bernanke once said, is like “doing brain surgery with a sledgehammer.” He instead argued that the Fed should focus on inflation and helping the broad economy with rate cuts after any bubbles do burst.

“We cannot practice ‘safe popping’ at least not with the blunt tool of monetary policy,” said Bernanke, who cited his Princeton colleague Alan Blinder’s quip that doing so is like “sticking a needle in a balloon; one cannot count on letting out the air slowly or in a finely calibrated way.”

After the speech, Greenspan quietly showed his support. “He didn’t say
anything during the session,” Gertler recalled. “But after it was over he walked by and said, as quietly as he could, ‘You know, I agree with you.’ That had us in seventh heaven.”

Waiting for a bubble to burst before the Fed responded was called the “mop up after” strategy and was largely deemed a success after the tech-stock bubble burst. “The biggest bubble in history imploded, vaporizing some $ 8 trillion in wealth in the process,” observed Blinder and Ricardo Reis in their laudatory 2005 report card on Greenspan’s tenure. “It is noteworthy …that the ensuing recession was tiny and that not a single sizable bank failed … and even more amazingly, not a single sizable stock brokerage or investment bank failed either.”

The severity of the Great Panic put this doctrine on the defensive. The global consequences of the current housing market bust have already been so great that Bernanke, among others, is rethinking his previous convictions, and he has company. Blinder has amended his views. When bubbles aren’t the result of bank lending, the mop-up strategy still looks good, but the Fed should use its regulatory powers, though not higher interest rates, to respond to bubbles fueled by bank loans, he says. Volcker told Congress that policy makers needed to be “alert” to “persistent and ultimately destabilizing economic imbalances” — a condition that includes bubbles.

And John Gieve, the Bank of England’s deputy governor for financial stability, said flatly in a valedictory speech in 2009: “Mopping up after the bust is not a good strategy. …

“It’s not at all clear that the post-2000 mopping up strategy worked that well in retrospect — it just stored up more trouble for the future.” In light of the economic devastation of the Great Panic, Gieve concluded, “it is evidently not safe to rely on being able to mop up after the crash.”

The Fed does more than set interest rates and lend to banks short of cash. It regulates banks, oversees truth-in-lending laws, and, under the 1994 Home Ownership and Equity Protection Act
(HOEPA)
, has the power to prohibit abusive mortgage practices. The Greenspan Fed did not use these powers to
restrain subprime lending, nor did its platoons of bank examiners spot the enormous risks that the big banks were taking in packaging or holding securities composed of subprime mortgages.

Greenspan argued he and others at the Fed didn’t realize how quickly subprime lending exploded. In fact, he said that when he first saw estimates from a mortgage-industry trade publication in 2005, he doubted them. He didn’t believe markets could move that fast. They did.

But there were earlier warning signs that went largely ignored at the Fed. By 2002, members of the Fed’s Consumer Advisory Committee — created in 1976 to help the Fed keep tabs on consumer credit issues — saw signs of trouble. Jeremy Nowak, president of a Philadelphia community-revitalization organization, reported that foreclosures in inner-city Philadelphia were escalating significantly. It was time, he said, “to ask some questions about why that is so, and under what context is pushing home ownership too low in terms of income a problem, and under what context is it not a problem?”

At the same 2002 meeting, Agnes Bundy Scanlan, an executive at Fleet Boston Financial, warned of an alarming spread of “predatory lending,” costly loans unsuitably targeted at low-income and poor people. “There are days when I feel that the seven, eight, nine, ten years of CRA [Community Reinvestment Act] work that I’ve been doing has probably all been undone, and that’s what I’m going to be spending the next three years trying to fix,” she said, bemoaning the many cases of homeowners who had lost all their house equity because they had refinanced on onerous terms. “We have lost everything that we’ve gained. I think that is absolutely something that the Fed can play a role in, all the regulators can play a role in, and take a very hard look at what some of these financial institutions are doing.”

One issue, a big one, was that many subprime mortgages were not made directly by banks that the Fed regulated, but by financial institutions supposedly overseen by other regulators or by less tightly regulated consumer-finance affiliates of Fed-sponsored banks. Edward “Ned” Gramlich, a Fed governor, saw this loophole as a major problem. “In the subprime market, where we badly need supervision, a majority of loans are made with very little supervision,” said Gramlich, well after the subprime mortgage market imploded. “It is like a city with a murder law, but no cops on the beat.”

An earlier, failed attempt by Gramlich to prompt Fed action on the matter is instructive. A tall, soft-spoken liberal Democratic economist who had been in and out of Washington his whole career, Gramlich was named to the Fed board by President Clinton in 1997 and served as chairman of the committee that handles consumer issues for most of his eight-year tenure. Three months before he died in 2007, Gramlich told
Wall Street Journal
reporter Greg Ip that he had gone to Greenspan in 2000 and suggested the Fed send its examiners to check that the affiliates of the banks weren’t pushing abusive loans. Greenspan thought that unwise, and Gramlich didn’t press the issue. “He was opposed to it, so I didn’t really pursue it,” Mr. Gramlich said.

Greenspan said later that while he acknowledged Gramlich’s concern, he was reluctant to expand the Fed’s regulatory reach. “I told him I was worried that if we extended our reach and pretended to be able to do something about it, we were likely to make the problem worse rather than better,” Greenspan said. “I could very readily envisage that, unless we had a huge police force, if we publicly announced that we were regulating these institutions, they would have placed a sign in their window proclaiming ‘We are regulated by the Federal Reserve system,’ and egregious lenders would have then fleeced subprime borrowers at a much higher rate.”

The
Wall Street Journal
story made Gramlich a hero, celebrated by Greenspan critics for having more clairvoyance than the Maestro. In truth, Gramlich hadn’t seen the enormity of the subprime problem or the degree to which the entire financial system had bet on housing prices. But he had seen signs of abuse that warranted Fed pursuit, and believed that’s what regulators were supposed to do.

Greenspan couldn’t escape the Gramlich story. Asked about it by a congressional committee in 2008, he said that Gramlich, like any Fed governor or the Fed’s staff, could have pressed the matter — and didn’t. But that wasn’t the way the Greenspan Fed worked. Greenspan didn’t spend much time thinking about regulatory matters, and even less time encouraging new rules. He left that to others. But as Gramlich knew, it was nearly impossible to push a regulatory initiative through the Fed without Greenspan’s blessing — and Alan Greenspan gave such blessings sparingly.

Greenspan’s libertarian leanings were well known, and his skepticism about the capacity of government regulators openly expressed. He often referred to the ten years he spent as a director of J. P. Morgan before going to Washington in 1987, making a point of how much more knowledgeable the bank’s loan officers were about borrowers than Fed regulators. Greenspan generally celebrated the benefits of financial innovation and downplayed the risks. In his memoirs, he says he took the Fed job committed to enforcing the laws of the United States — even those with which he didn’t agree — but “planned to be largely passive” in matters of regulation. The surprise, he wrote, was that the Fed staff wasn’t nearly as eager to regulate as he had feared — a fact that other bank regulators in Washington often attributed to the dominance of market-loving economists at the Fed.

Greenspan did not provoke controversy or attention by attacking regulations frontally; he was too shrewd for that. He emphasized the limits of regulation. He resisted any attempt to broaden the Fed’s purview beyond the core of the banking system despite the enormous growth of financial institutions beyond banks. He insisted on the virtues of having multiple bank regulatory agencies, figuring that would prevent any one regulator from being unwisely tough. He scoffed at the counterargument that this would create unhealthy competition among regulators because financial institutions would shop for the softest one. His staff and colleagues knew where he stood.

When Democrats in Congress pressed the Fed in 2002 to use its power to write rules to define “unfair or deceptive acts and practices” in banking, Greenspan resisted. “It is effective for banking agencies to approach compliance issues on a case-by-case basis,” Greenspan said in a letter to the then-senior Democrat on the House Committee on Financial Services, John LaFalce of New York, that summed up his attitude toward regulation. “In the absence of specifics generated through case-by-case complaints and enforcement, however, it is difficult to craft a generalized rule sufficiently narrow to target specific acts or practices determined to be unfair or deceptive, but not to allow for easy circumvention or have the unintended consequence of stopping acceptable behavior,” he wrote.

In short, the Greenspan view on regulation in general was: either it doesn’t work to prevent the abuses at which it is aimed or it will have the unwelcome consequence of stopping activities that benefit the economy. (The one place where government should be more aggressive, he said often, was in fighting fraud. But, of course, that wasn’t the Fed’s job.)

It was not obvious in the early 2000s that the Fed should have been raising the interest rates it controlled more rapidly to curb the excesses that provoked the Great Panic. But it was clear then — and is more abundantly clear today — that if the Fed wasn’t using its interest rate weapon, it could and should have used its regulatory clout and rhetoric to restrain the shortsighted, excessively ebullient players in financial markets and to at least try to resist the worst of the abuses in the subprime lending market.