The New Empire of Debt: The Rise and Fall of an Epic Financial Bubble (40 page)

TAKE IT AWAY, MAESTRO

In the spring of 2005, the American economy had been in “recovery” for over 37 months. It was an odd recovery. No one was quite sure what it was recovering from. There had been a recession in 2001 and 2002. But it was a curious recession. GDP growth went negative.Yet, consumer spending and credit continued to expand. If recessions were meant to correct the mistakes of the previous expansion, this one was a failure. Consumers should have spent less and increased savings. Then, after the recession was over, they should have had money to spend in the following expansion and a pent-up desire to buy what they had not bought during the recession.

The expansion was doomed from the beginning. Consumers had never stopped spending. So, when the economy turned around, they had saved no money. The only way they could continue spending was by borrowing more.The Fed helpfully dumped more alcohol in the bowl—lowering rates to make it easy for them. But by this time, the whole economy had become so woozy that the extra consumer spending had much less positive effect on the real economy than had been hoped. Americans borrowed and spent. But, in the new globalized economy, much of what they bought came from Asia—particularly China—which could turn out consumer goods at a lower cost than the United States.

What America really needed was not a consumer binge, but a capital spending boom. It needed to invest in new factories, new plants, and new jobs. The jobs would have given consumers real new income, with which to buy more goods and services and sustain the expansion. But gross investment—which had averaged 18.8 percent in the pre-Reagan years—had begun dropping the year Reagan entered the White House. By 2004, it had fallen to 1.6 percent—even dipping below zero periodically. People were spending, but on consumption, not future production.The gewgaws and gadgets bought from China merely put Americans further into debt. Neither jobs nor incomes improved. Typically, at this stage of a recovery (June 2005), 10 million more new jobs should have been created. Likewise, incomes went up $300 billion less than they should have, based on the pattern of previous recoveries.

Many economists—including Alan Greenspan—maintained that the lack of jobs was a sign of something good happening. “Productivity,” they said, “accounts for most job losses, not outsourcing.”

“Over the long sweep of American generations and waves of economic change,” explained the maestro, “we simply have not experienced a net drain of jobs to advancing technology or to other nations.”
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Could something be different this time? Could this be a kind of “new era” in American economic history? The answer we give is “yes” . . . but we will give it later. Here, our burden is more modest, and our proof comes more readily to hand. For here, we argue only that America’s leading economic and political policymakers are either rascals or numskulls.

Major tops in the credit cycle seem to correspond with major bottoms in economic thinking. From high offices all over the nation came the explanations, excuses, rationales, and obiter dicta; we don’t know whether they were corrupt or merely stupid. But when the guardians of the public financial mores began urging people to acts of recklessness, the country was in trouble. Buy more, said one Fed governor. Borrow more, said another. Don’t worry about debt, interest rates, or the loss of jobs, said the captain of them all. It was as though the National Council of Bishops had come out with a public statement urging wife swapping.The experience may not be unpleasant, but it is unseemly of them to say so.

“Go out and buy an SUV,” urged Fed governor Robert McTeer.
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Seventeen million people heeded his call each year, from 2001 to 2005.

On February 23, 2004, the Fed chief urged Americans to switch from fixed rate mortgages to ARMs—mortgages with adjustable rates, which left them much more exposed to interest rate increases, at the very moment when the Fed was increasing them.

If anyone could be held directly and immediately responsible for the record level of America’s foreign and domestic debts, it was Alan Greenspan. He had brought about a binge of borrowing by lowering interest rates down to Eisenhower-era levels. But spiking the punch was not enough; he was urging consumers to have another drink.

The Fed chairman had an uncanny way of arriving at ideas at a time when they would be of most benefit to his own career and of most danger to everyone else. To Greenspan, the conservative economist, the stock market looked “irrationally exuberant” in the mid-1990s, until a member of Congress pointed out to him that he would be better off keeping his mouth shut. A goldbug in the 1970s, Greenspan became the biggest purveyor of paper money the world has ever seen. Similarly, large federal deficits seemed at odds with his creed until it suited him to think otherwise. The new American empire needed easy money and almost unlimited credit: Alan Greenspan made sure it got them.

Markets make opinions, say old-time investors. Mr. Greenspan’s opinions neatly corresponded with the market for his services. As the debts and deficits mounted up, Greenspan underwent an intellectual metamorphosis. An article in the
New York Times
explained:

Many mainstream economists are worried about these trends, but Alan Greenspan, arguably the most powerful and influential economist in the land, is not as concerned:

In speeches and testimony, Mr. Greenspan, chairman of the Federal Reserve Board, is piecing together a theory about debt that departs from traditional views and even from fears he has himself expressed in the past.

In the 1990s, Mr. Greenspan implored President Bill Clinton to lower the budget deficit and tacitly condoned tax increases in doing so. Today, with the deficit heading toward a record of $500 billion, he warns more emphatically about the risks of raising taxes than about shortfalls over the next few years.

Mr. Greenspan’s thesis, which is not accepted by all traditional economists, is that increases in personal wealth and the growing sophistication of financial markets have allowed Americans—individually and as a nation—to borrow much more today than might have seemed manageable 20 years ago.

And here the article strikes gold:

This view is good news for President Bush’s reelection prospects. It increases the likelihood that the Federal Reserve will keep short-term interest rates low. And it could defuse Democratic criticism that the White House has added greatly to the nation’s record indebtedness.
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Out of convenience, rather than ideology, Mr. Greenspan came to see goodness in all manner of credit. Since he became head of the Federal Reserve system, debt levels rose from $28,892 for the average family in 1987 to $101,386 in 2005. Mortgage foreclosure rates, personal bankruptcies, and credit card delinquencies rose steadily. Mortgage debt rose $6.2 trillion during his tenure at the Fed. By January 2005, it had reached $8.5 trillion, or approximately $80,849 per household.
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But none of this seemed to bother the chief of America’s central bank nor its chief politicians.

WHAT HATH ALAN WROUGHT?

For years, we have been working on Greenspan’s obituary. As far as we know, the man is still in excellent health. We do not look forward to the event; we just don’t want to be caught off guard. Maybe we could even rush out a quickie biography, explaining to the masses the meaning of Mr. Greenspan’s life and work.

We see something in Alan Greenspan’s career—his comportment, his betrayal of his old ideas, his pact with the Devil in Washington, and his attempt to hold off nature’s revenge at least until he leaves the Fed—that is both entertaining and educational. It smacks of Greek tragedy without the boring monologues or bloody intrigues. Even the language used is Greek to most people.Though the Fed chairman speaks English, his words often needed translation and historical annotation. Rarely did the maestro make a statement that was comprehensible to the ordinary mortal. So much the better, we guess. If the average fellow really knew what was being said, he would be alarmed. And we have no illusions.Whoever attempts to explain it to him will get no thanks; he might as well tell his teenage daughter what is in her hot dog.

Alan Greenspan was the most famous bureaucrat since Pontius Pilate. Like Pilate, he hesitated, but ultimately gave the mob what it wanted. Not blood, but bubbles. Greenspan’s role in the empire was more than that of a Consul or a Proconsul. He was the Prefect. He was the quartermaster who made sure the empire had the financial resources it needed to ruin itself.

We don’t know how heaven will judge him. According to the central bankers’ code, Greenspan has committed neither sin nor crime. He is seen as a paragon of virtue, not vice. Yet, as Talleyrand once remarked to Napoleon, “Sire, worse than a crime, you have committed an error.”

When the winds of imperial debt-finance blew, Mr.Volcker planted his feet and stuck out his jaw. His successor, Mr. Greenspan, tumbled over.The Fed chairman’s error was to offer more credit on easier terms to people who already had too much. During Greenspan’s reign at the Fed, more new money and credit was created than under all the rest of the Fed chiefs combined. Consumer debt rose to its highest level in history, the ratio of debt to income also rose higher than it has ever been. The effect was to inspire bubbles all over the world and to transform the United States from the world’s largest creditor to its biggest debtor.

What the Greenspan Fed had accomplished was to put off a natural, cyclical correction and transmogrify an entire economy into a monstrous
economic
bubble. A bubble in stock prices may do little real economic damage. Eventually, the bubble pops and the phony money people thought they had disappears like a puff of marijuana smoke. There are winners and losers. But in the end, the economy is about where it began—unharmed and unhelped. The households are still there and still spending money as they did before. Only those who leveraged themselves too highly in the bubble years are in any trouble.

But in Greenspan’s bubble economy, something awful happened. Householders were lured to take out the equity in their homes.They believed that the bubble in real estate prices created wealth that they could spend. Many did not hesitate. Mortgage debt ballooned in the early years of the twenty-first century—from about $6 trillion in 1999 to $12 trillion at the end of 2008—increasing the average household’s debt by $60,000. Americans still lived in more or less the same houses. But they owed far more on them.

We had given up all hope of ever getting an honest word out of the Fed chairman on this subject when, in early February 2005, the maestro slipped up. He gave the aforementioned speech in Scotland entitled “Current Account.” Jet-lagged, his defenses down, the poor man seems to have committed truth.

“The growth of home mortgage debt has been the major contributor to the decline in the personal saving rate in the United States from almost 6 percent in 1993 to its current level of 1 percent,” he admitted. Thus, did he bring up the subject. Then, he began a confession: The rapid growth in home mortgage debt over the past five years has been “driven largely by equity extraction,”
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said the man most responsible for it. By this time, listeners were beginning to take notes. And pretty soon, even the dullest economist in the room was adding two plus two. Mr. Greenspan lowered lending rates far below where a free market in credit would have put them. With little to be gained by putting money in savings accounts and a lot to be gained by borrowing, households did what you would expect; they ceased saving and began borrowing.What did they borrow against? The rising value of their homes—“extracting equity,” to use Mr. Greenspan’s jargon.The Fed chairman had misled them into believing that the increases in house prices were the same as new, disposable wealth.

But the world’s most famous and most revered economist didn’t stop there. He must have had the audience on the edge of its chairs. He confessed not only to having done the thing but also to having his wits about him when he did it. This was no accident. No negligence. This was intentional.

“Approximately half of equity extraction shows up in additional household expenditures, reducing savings commensurately and thereby presumably contributing to the current account deficit ....The fall in U.S. interest rates since the early 1980s has supported home price increases,” continued America’s answer to Adam Smith.
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“Lacking in job creation and real wage growth,” explained Stephen Roach, “private sector real wage and salary disbursements have increased a mere 4 percent over the first 37 months of this recovery—fully ten percentage points short of the average gains of more than 14 percent that occurred over the five preceding cyclical upturns.Yet consumers didn’t flinch in the face of what in the past would have been a major impediment to spending. Spurred on by home equity extraction and Bush administration tax cuts, income-short households pushed the consumption share of U.S. GDP up to a record 71.1 percent in early 2003—an unprecedented breakout from the 67 percent norm that had prevailed over the 1975 to 2000 period . . . .”
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Since the fall of the Berlin Wall, nearly everyone seems to agree that central planning is bad for an economy. The central planners, as any Economics 101 student can tell you, do a poorer job of delivering the goods than the “invisible hand” of Mr. Market.

Joseph Schumpeter sharpened the point: “Our analysis leads us to believe that recovery is only sound if it does come from itself. For any revival which is merely due to artificial stimulus leaves part of the work of depression undone and adds, to an undigested remnant of maladjustments, new maladjustments of its own.”