In FED We Trust (9 page)

Greenspan, in contrast, was both reliably conservative — an acolyte of philosopher Ayn Rand — and politically agile. He had come to Washington in the last dark days of the Nixon White House. (His confirmation hearing to be chairman of Nixon’s Council of Economic Advisers came the same day Nixon went on national TV to resign.) He stayed on to advise Ford and later candidate Ronald Reagan. He was comfortable with politicians and, having dated TV news stars Barbara Walters and Andrea Mitchell, with the press. He was skillful at courting and manipulating both sets of people to protect the Fed’s credibility and independence and to burnish his own reputation.

Volcker was physically intimidating at six feet seven inches and famously opaque in his utterances. Greenspan was not physically imposing. “How did my Jewish uncle get to be the most powerful man in the world?” Clinton’s labor secretary, Robert Reich, quipped. But he could be intellectually intimidating, just as opaque as Volcker if not more so, and far better at disarming or disabling his opponents inside and outside the Fed. Best of all, he came through his first early test with flying colors.

Only two months after Greenspan took over from Volcker, in October
1987, the stock market crashed. Thanks in part to the Fed’s quick reaction, and some good luck, the crash didn’t produce even a mild recession. Thus was born Greenspan’s reputation as a wise man. Bernanke, who was still fighting off a financial crisis a year and a half after it began, would later complain good-naturedly that Greenspan had it easy.

Greenspan cemented his status as a guru with unique foresight in the mid-1990s with an intellectually courageous call that the Internet-based New Economy was so fundamentally changing the U.S. economy that the Fed could permit the economy to grow faster than most inflation-fearing economists thought prudent. The result was lower unemployment without higher inflation — and a technology stock market bubble for which Greenspan got substantial blame. But even after that bubble burst, and a recession ensued, the Greenspan Fed managed to get the economy going again by aggressively cutting interest rates — and the United States avoided the misery that followed the bursting of a real estate and stock market bubble in Japan.

Bush was right. Greenspan
was
a rock star — at least at that moment. He had steered the U.S. economy around the Asian financial crisis in 1998, two wars with Iraq, and the September 11 attacks. To economists, bond traders, and businessmen, he was a hero. “No one has yet credited Alan Greenspan with the fall of the Soviet Union or the rise of the Boston Red Sox, although both may come in time as the legend grows,” Princeton’s Alan Blinder, a former Fed vice chairman, and Ricardo Reis wrote in a 2005 evaluation of Greenspan that pronounced him “amazingly successful.” Volcker had been far from anonymous, but the proliferation of business cable TV channels and the arrival of the Internet turned Greenspan into a celebrity of far larger dimensions than the chief justice of the Supreme Court and the leaders of Congress — and with a far longer tenure and more credibility than the president himself.

After he retired as chairman of the Fed, Greenspan kept laughing — all the way to the bank. With the help of Washington’s superagent (and lawyer) Robert Barnett, Greenspan landed a reported $8.5 million advance for his memoirs. The book,
The Age of Turbulence
, hit the bookstores in the fall of 2007, a year and a half after he retired, just as the Great Panic was getting
under way. The title was apt for a book that looked back to the 1987 crash, the 1989 fall of the Berlin Wall, two U.S. wars with Iraq, the September 11 attacks, and the emergence of China and India as economic powers.

But Greenspan had no idea how much more turbulence lurked just over the horizon, nor how his then sterling reputation would suffer — fairly and unfairly — in the aftermath.

The causes of the Great Panic are many, the list of culprits long. Ultimately, every check on the system failed to restrain the excess and greed or to correct for the myopia and delusional optimism. Blame the well-paid executives and directors of the nation’s financial institutions who gambled with their own companies and the U.S. economy. Blame the bankers’ much-ballyhooed approach to “risk management” that disguised rather than illuminated their risks. Blame the credit rating agencies that stamped “AAA” on securities that didn’t warrant that excellent status. Blame the chain of subprime mortgage makers — from unregulated mortgage brokers on the front lines to securitizers on Wall Street — who were driven by fat fees to make loans that were unwise for borrower and lender alike. Blame the supposedly sophisticated investors who bought risky, complex mortgage-linked securities they didn’t understand. Blame the home buyers with house lust that exceeded their paychecks. Blame the politicians who spent crucial years on the sidelines, swayed either by moneyed interests or excessive trust in markets. Blame the regulators who couldn’t or wouldn’t keep pace with the evolution of finance. Blame the reporters who failed to press questions or take cranky Cassandras seriously. Blame the Federal Reserve, which was, after all, created to head off financial panics. And, yes, blame Alan Greenspan, who during his nineteen years at the helm had created the Fed in his image.

What did Greenspan and his Fed know, and when did they know it? What did they do — or fail to do — about it? What did the Fed miss? What could the Fed have done differently to prevent the Great Panic or, at least, to minimize the damage the panic did to the global economy? The answers fall into four categories.

In the wake of the bursting tech-stock bubble and a weakening economy, the Fed began cutting interest rates aggressively in January 2001. The Fed’s target for the federal funds rate — its key interest rate, the one at which banks borrow from one another overnight — plunged from 6.5 percent at the beginning of 2001 to 3.5 percent at the time of the September 11 attacks. After the attacks, the Fed kept cutting the rate, ending 2001 at 1.75 percent. As the economy sagged and fears of Japanese-style deflation grew, the Fed later dropped the rate to a forty-five-year low of 1 percent and kept it there until June 2004.

When the Greenspan Fed finally turned to raising interest rates, it did so at what it described as a “measured pace” — very slowly. Taking its foot off the monetary gas pedal ever so cautiously, the Fed raised the fed funds rate by only one-quarter of a percentage point every six weeks or so. The rate didn’t cross 3 percent until May 2005. Greenspan took it to 4.5 percent on his last day on the job.

When interest rates are so low, credit is usually cheap and plentiful, and the prices of stocks, houses, and other assets tend to rise. It’s cheaper to borrow to buy assets, and the alternative — putting money in the bank or in bonds — is less attractive because returns are so low. The
Wall Street Journal
tracked this phenomenon in a 2005 front-page series called “Awash in Cash” that illustrated how in a world of cheap and plentiful credit people will pay just about anything for anything — and this was before the worst of the subprime mortgage loan craze.

Among the examples:

• A week after Hurricane Katrina, a defaulted loan backed by aging tugboats and barges in coastal Alabama came up for sale. A firm called Mooring Financial Corporation, a firm that buys troubled loans at a discount, was interested but couldn’t determine how well the boats had survived the hurricane, or even whether their cash-starved owner had kept up the insurance. So Mooring
  bid fifty to fifty-five cents on the dollar, and it considered that generous. The winning bidder offered about ten cents more on the dollar.
  

• Australia’s biggest homegrown investment bank, Macquarie Bank, leased Chicago’s Skyway toll road for ninety-nine years for $1.8 billion, hundreds of millions of dollars more than some Chicago officials thought it would fetch.
  

• An investment partnership run by Grantham, Mayo, Van Otterloo & C
  O.
  , a Boston money manager with a taste for timber, bought more than 5 percent of the land in the state of Maine.
  

To be sure, Fed policy during this first part of the decade kept the economy chugging along, but there is a potential downside to sustained very low interest rates — a downside that goes far beyond overpaying for assets. As economic historian Charles Calomiris of Columbia University observed, “The most severe financial crises typically arise when rapid growth in untested financial innovations” — such as complicated securities invented to invest in mortgages — “coincided with … an abundance of the supply of credit.”

This is exactly what happened during the last years of the Greenspan Fed. With interest rates low, investors took greater and greater risks to get higher returns. This risky investing is called “reaching for yield” — and in the mid-2000s, there was a lot of reaching. The difference between the interest rates that investors demanded on risky securities and those on the safest U.S. Treasury securities — the “spreads” or “risk premiums” — narrowed. After years of sunny economic weather, investors acted as if it would never rain again.

Greenspan himself saw some danger. In an August 2005 speech, he cautioned, “History has not dealt kindly with the aftermath of protracted periods of low-risk premiums.” (Translation: You’re paying too much for those stocks, risky bonds, and mortgage-backed securities.) He warned, in his opaque style, that the likely scenario was that an “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.” (Translation: a crash.) But the words weren’t chosen to enter the popular
culture the way his December 1996 warning about “irrational exuberance” in the stock market did, nor did he draw any link between these “low-risk premiums” and the abundance of credit. Rather, with some justification, he described the investor optimism as “the apparent consequence of a long period of economic stability.” (Translation: The Fed was doing such a good job that people thought the good times would last forever.)

The Greenspan Fed’s policy of sustained low interest rates reflected an almost exclusive focus on keeping the economy growing and avoiding falling prices for goods and services, not on restraining the prices of houses or stocks. That was what Greenspan believed central banks should do. Throughout 2003, Bernanke was a strong ally of Greenspan’s in making the case that the Fed should keep interest rates low and should say so publicly. In June 2003, transcripts released in 2009 reveal, he suggested to colleagues that it might “make sense tactically to say publicly that we are willing to lower the federal funds rate to zero if necessary,” and argued for using the end-of-meeting statement “to signal our willingness to keep policy easy so long as there is a risk of further disinflation and continuing economic weakness.” It wasn’t clear at the time that the strategy was wrong, a point easily overlooked by those who criticize it now. The fact is, the U.S. economy did keep growing, and deflation didn’t arrive. Indeed, one reason investors were willing to pay so much for risky securities was that they believed — or acted as if they believed — that the Fed and other central banks had found a way to keep economies growing with little inflation and with recessions that were mild and infrequent.

But Nassim Nicholas Taleb, an options trader who made his reputation by describing unanticipated but unusually important events that he called “black swans,” criticizes Greenspan — and Bernanke — for failing to see that the calm was masking a building of hidden risks. “It was like someone sitting on dynamite and saying, ‘It’s okay, we’re safe because nothing has happened.’”

Despite its apparent successes, the Greenspan Fed had some well-respected contemporary critics. One of the most prominent was Bill White, a veteran of the British and Canadian central banks, who between 1994 and 2008 was a top economist at the Bank for International Settlements, an international organization in Switzerland for central bankers. From that perch, White cautioned the Fed and like-minded central bankers against
looking only at conventional measures of inflation. In a 2006 paper, for instance, he warned that easy money might not lead to “overt inflation” of the sort measured by the Consumer Price Index, but rather to an investment boom that would be followed by a painful bust, “an eventual crisis whose magnitude would reflect the size of the real imbalances that preceded it,” he wrote. “Mistakes … take a long time to work off.”

At that time and since, Greenspan countered that the Fed was impotent: global flows of money were so great they overwhelmed the Fed’s ability to make credit scarce or costlier by moving up short-term rates. Even when the Fed raised short-term rates, he said, the longer-term rates on which mortgages depend didn’t rise as much. “We tried in 2004 to move long-term rates higher in order to get mortgage interest rates up and take some of the fizz out of the housing market, but we failed,” Greenspan said just as the Great Panic was beginning. He publicly labeled this “the conundrum,” the fact that the Fed was — albeit slowly — raising short-term interest rates, and long-term rates were not following. Bernanke provided intellectual cover on this front by talking about “a global savings glut,” a torrent of savings from China and the rest of Asia that flooded global markets and especially the United States and was overwhelming the Fed’s ability to tighten credit. Greenspan concurred. The arrival of billions of Chinese, Indian, and Eastern European workers into the global economy created such an antiinflationary force that long-term interest rates simply wouldn’t rise no matter what the Fed did, he asserted.

Not all the members of Greenspan’s FOMC were enthusiastic about pledging to keep rates low for, as the Fed put it at the time, “a considerable period.” The debate over including the phrase in the end-of-meeting statement at the August 12, 2003, meeting was so vigorous that Greenspan had to ask for a show of hands to see whether the advocates — including Bernanke and Kohn — were outnumbered. “I will stipulate that, unless we get a significant vote in favor of putting it in, I would recommend that we drop it and bring it up for discussion … next time,” he said, according to transcripts released in May 2009. Seven of the eighteen members of the FOMC present objected, an extraordinary protest by FOMC standards. “Right on the margin,” Greenspan said, ruling that the unusual vow would be included in the statement. But many of those at the Fed who embraced the low interest rates of the early
2000s — or favored even lower rates, such as Bob Parry, former president of the San Francisco Fed — would later contend that the Fed should not have kept rates so low for so long. And, in retrospect, they were correct. Among outsiders, that view became conventional wisdom: the
Wall Street Journal
asked fifty-five economists in March 2008 if they agreed with this statement: “With the benefit of hindsight, the Fed was too slow to raise the federal funds rate after taking the target to 1 percent in 2003?” Some 84 percent said yes. “Bernanke is paying for Greenspan’s sins,” said one. “I suppose, with hindsight, we are gods,” another quipped. Indeed, what was clear later was not obvious at the time.