Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession (25 page)

The Greenspan Hypothesis

The Fed chairman presented his proposal as a coherent whole at the December 19, 1995, FOMC meeting. He raised “a broad hypothesis about where the economy is going over the longer term and what the underlying forces are.”
¹⁰
Greenspan was puzzled: “One would certainly assume that we could see [the acceleration of technological change] in the productivity data, but it is difficult to find it there. In my judgment there are several reasons, the most important of which is that the data are lousy. . . . [W]e are not capitalizing various types of activities properly. . . . That creates economic value in the stock-market sense, and we are not measuring it properly.”
¹¹
He had been looking at business cycles since the late 1940s, and “there was just nothing like this earlier.”
¹²

⁶
FOMC meeting transcript, November 15, 1995, p. 16.
⁷
Ibid., p. 18.
⁸
Daniel E. Sichel,
The Computer Revolution
(Washington DC: Brookings Institution, 1997).
⁹
Greg Ip and Jacob Schlesinger, “Did Greenspan Push US HighTech Optimism Too Far?”
Wall Street Journal
, December 28, 2001.

The Federal Reserve chairman might control the debate, but he did not control the government numbers. It would be best if the productivity figures supported his hypothesis. The reclassification of software as a capital expenditure in 1999 helped.

The gestation of his productivity brainstorm approximated the period in which he was cutting the fed funds rate during his 1995–1996 reelection campaign. Greenspan broached his productivity rationalization at the August 1995 meeting and turned it into a hypothesis at the December 1995 meeting. The Federal Reserve cut the funds rate by 0.25 percent on July 6, 1995, December 19, 1995, and January 31, 1996.

Irrational Exuberance

Alan Greenspan’s speeches will not tax the editors of
Bartlett’s
, but one phrase has stuck: his warning of “irrational exuberance” on December 5, 1996. That it struck such a nerve is more important than the phrase itself. He could not have raised the possibility in a more tentative fashion. (“But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade?”
¹³
) There was no mention of manias or crashes. He used the word
bubble
only to imply that he was not anxious: “We as central bankers need not be concerned if a collapsing financial asset bubble does not threaten to impair the real economy, its production, jobs, and price stability.”

¹⁰
FOMC meeting transcript, December 19, 1995, p. 35.
¹¹
Ibid., p. 37.
¹²
Ibid.
¹³
Speech available at http://www.federalreserve.gov/boarddocs/speeches/1996/
19961205.htm.

He was speaking in the midst of a stock market bubble, and almost everyone feared it or knew it, including the Federal Reserve. On November 25, 1996, the
Wall Street Journal
had reported: “Federal Reserve Board Chairman Greenspan isn’t talking about the stock market these days. In fact, the word among Fed officials is: don’t use the words ‘stock’ and ‘market’ in the same sentence. No one wants the blame for the crash.”
¹⁴
Two days later, the Bank for International Settlements (the central bankers’ central bank) warned about the “prevailing euphoria” in global credit markets.
¹⁵

At the September 24, 1996, FOMC meeting, Greenspan said: “I recognize that there is a stock market bubble problem at this point. . . . We do have the possibility of raising major concerns by increasing margin requirements. I guarantee that if you want to get rid of the bubble, whatever it is, that will do it. My concern is that I am not sure what else it will do.”
¹⁶
Of course he couldn’t know what else it would do, but he had identified a stock market bubble and that he could burst it. He would later deny that he could do either.

Splicing his statements from the September 24, 1996, meeting to the December 5, 1996, speech, the drama of how the Fed would respond to a bubble was over. At the September FOMC meeting, the chairman would not act, since he was “not sure what else it will do.” On December 5, Greenspan stated that the Fed would only act if “a collapsing financial asset bubble does not threaten to impair the real economy.” Since any popped asset bubble will not only threaten but also to some degree impair the real economy, his dilemma could never be resolved. He spent the next 10 years talking.

Greenspan Raises the Funds Rate—Once

Greenspan raised rates in 1997 once: from 5.25 percent to 5.50 percent in March. It would have been far better if he had not raised rates the Fed Funds rate at all. At the March 1995 meeting, Federal Reserve Governor Lindsey reminded the FOMC of its tentative communiqués in the spring of 1993. (That was when the Fed held the funds rate at 3 percent, funding the carry-trade recapitalization of the banking industry). Lindsey had said, “I have to conclude that doing that, if anything, cemented the market’s view that we were stuck at a particular rate. It only built the market’s confidence that they could borrow at 3 percent and lend at 6 percent, which is literally what they were doing.” Lindsey warned the FOMC not to sound tough (in the form of an “asymmetric” public statement, asymmetric being any meaningful change in language from the Fed’s previous statements) if it did not have the courage to stick to its convictions (in which case it should release a “symmetric” statement, indicating no change in the Fed’s outlook): “[I]f what we fear is a bubble, we should not in my view go asymmetric unless we really expect to raise rates. . . . [Meaning—once the Fed started raising rates, and indicated publicly that it intended to pursue an objective, it should keep raising rates until the stock market’s speculative atmosphere disappeared.—author’s note] Given what we did in 1993 . . . I am afraid we would only strengthen the conviction of the market and maybe actually exacerbate the bubble.”
¹⁷

¹⁴
“The Outlook: Worried Fed Watches Markets Climb,”
Wall Street Journal
, November 25, 1996, p. A1.
¹⁵
Grant’s Interest Rate Observer
, December 5, 1996, p. 1.
¹⁶
FOMC meeting transcript, September 24, 1996, pp. 30–31.

Lindsey resigned in early 1997. The FOMC made the one-time hike in 1997 without the benefit of Cassandra’s wisdom. As in the Greek myth, Lindsey was right. After the FOMC it tightened once in 1997 and then backed off, speculators had no fear. The market never looked back. The statements by Greenspan at the early 1994 FOMC meetings show he knew that one-time rate hikes were not enough. What had changed by 1997?

The politicians may have frightened Greenspan. In January 1997, he told the Senate Committee on the Budget that “the stock market continued to climb at a breathtaking rate.”
¹⁸
Before the Senate Banking Committee on February 26, 1997, Greenspan did warn, in his fashion, that the stock market was overpriced: “[R]egrettably, history is strewn with
visions of such ‘new eras’ that, in the end, have proven to be a mirage. In short, history counsels caution. Such caution seems especially warranted with regard to the sharp rise in equity prices during the past two years.”
¹⁹
Responding to a senator’s question, he repeated his most famous phrase, making a distinction that a three-year-old would understand: “It’s not markets that are irrational. It’s people who become irrationally exuberant.”
²⁰
That he thought it was worth mentioning signifies his timidity.

¹⁷
FOMC meeting transcript, March 28, 1995, p. 48.
¹⁸
Senate Committee on the Budget, “Performance of the U.S. Economy,” January 21, 1997.

Senator Phil Gramm from Texas disagreed with the errant forecaster: “I think people hear what you are saying and conclude that you believe equities are overvalued. I would guess that equity values are not only
not
overvalued but may still be undervalued.”
²¹
On March 4, Greenspan spoke before the House Committee on the Budget.
²²
Congressman Jim Bunning from Kentucky told Greenspan that the chairman’s stock market forecast was “misguided.”
²³
This may seem like a topic that was beyond the congressman’s brief, but he was vectoring toward the most destabilizing influence of Greenspan’s freelance opinions: his inflammation of the stock market. “ ‘My question to you,’” Bunning said, “ ‘is why have you, on two occasions, taken to jawboning the U.S. stock market and the U.S. bond market with your comments to affect a free and open market as head of the Federal Reserve Board, which is in charge of setting monetary policy?’”
²⁴

Chairman Greenspan replied that markets have a direct influence on monetary policy.
²⁵
This is true. Greenspan would deny this link— and the Federal Reserve’s responsibility—as the bubble grew fearsome. While stocks rose, there was no one person who was more responsible for the stock market mania. The chairman disowned his personal influence when he responded to Bunning: “ ‘Nobody can affect [markets] in a fundamental way.’” This may be true, but Bunning questioned Greenspan because the chairman’s influence was anything but fundamental. It was—take your pick—emotional, abstract, spiritual, or absurd, but not fundamental. Richard W. Stevenson, a reporter at the
New York Times
, wrote the next day that Bunning was “clearly not satisfied with Mr. Greenspan’s protestations of innocence and impotence.”
²⁶
This is a remarkable summation of Greenspan’s road to success. Congressman Bunning, a former major league pitcher, winner of 224 games and member of baseball’s Hall of Fame, achieved that success by preying on hitters’ weaknesses. Greenspan’s self-effacing innocence and impotence was obvious to the hurler, who hit more batters than all but 10 pitchers in the history of baseball.

¹⁹
Senate Committee on Banking, Housing, and Urban Affairs, “The Federal Reserve’s Semiannual Monetary Policy Report,” February 26, 1997.
²⁰
Floyd Norris, “A Warning Investors Have Ignored Before,”
New York Times
, February 27, 1997, p. D1.
²¹
Jerome Tuccille,
Alan Shrugged: The Life and Times of Alan Greenspan, the World’s Most Powerful Banker
(Hoboken, N.J.: Wiley, 2002), p. 226. Tuccille also gives comments from Jim Bunning, writing as if Bunning were a senator and speaking at the same meeting as Gramm. Bunning was a congressman at the time.
²²
House Committee on the Budget, “Bias in the Consumer Price Index,” March 4, 1997.
²³
Tuccille,
Alan Shrugged
, p. 226.
²⁴
Richard W. Stevenson, “Terse Congressman Questions Greenspan’s Market Motives,”
New York Times
, March 5, 1997.
²⁵
Ibid.

The day after the chairman’s February 26, 1997, testimony before the Senate, he was in the headlines of the
New York Times
: “Greenspan Warns Again that Stocks May Be Too High.” If that didn’t upset the markets, there was another headline in the same newspaper “Greenspan Speaks and Stocks Plunge.” The
Times
published seven articles that mentioned Greenspan on February 27.
²⁷
The following day, it published seven more, including an editorial: “Wise Warnings to Giddy Investors.”
²⁸

Whether it was fear of politicians or not, Greenspan did not raise the funds rate again. He worked on his productivity hypothesis instead.

The Subprime Warning

Other markets were running amok. Asset-backed derivatives had spread beyond the homely mortgage and credit card receivables. The market was buying untested securities such as future receipts of Pakistan Telecommunication Corporation, credit card transactions in Mexico, airline-ticket payments for TACA International (an El Salvadorian airline), automobile installment payments in Thailand, and David Bowie’s future album receipts (a rock star who had peaked in the 1970s).
²⁹
Closer to home, the fastest growing subprime lenders were filing for bankruptcy (e.g., Jayhawk Acceptance), suffering downgrades (e.g., Olympic Financial), and disclosing fraud. (In February, Mercury Finance Company, “the Mercedes-Benz of the subprime auto lending industry,” disclosed that 50 percent of its 1996 net income never existed.
³⁰
)

²⁶
Ibid.
²⁷
Source for
New York Times
articles: proquest.bpl.org.
²⁸
The seven articles include “If Groundhogs Were Boastful: ‘I Hate to Say I Told You So.’”

Over the coming months, this cycle of subprime lending unwound. Nonpayment on mobile-home loans produced default charts that looked like hockey sticks. These loans would never have been offered if the financier had not been able to sell them to an investment bank. The investment bank acted as a veteran second baseman in a double play—it bought the mortgage (from the financier) and sold it (in an asset-backed security) as quickly as possible to an investor. A pension fund or mutual fund investor now owned the trailer (through the purchase by its yield-and bonus-chasing money manager). Each of the participants along the assembly line profited. Bankers earned fees and pension plans earned interest until the defaults swelled. The pension plan bore all the losses. (The evicted trailer owner was none the better, either.)

“Bulldog,” a 325-pound automobile repo man and “credit adjuster” from Dallas, explained the inevitable consequence of lending in the subprime loan market: “Aw, it’s just a bunch of Wall Street intellectuals showing how dumb they are. How are you going to make money off people that don’t have any money? I don’t think these Wall Street folks have any idea what they are dealing with.”
³¹
Nor did the Fed.

At the time Bulldog shared his sound banking philosophy, subprime home lenders were sprouting wings. Ameriquest Mortgage, New Century Financial Corporation, and Countrywide Credit Industries Inc., were busy selling subprime mortgages to Wall Street firms. It was not a coincidence that they were based in or around Irvine, California, home to Lincoln Savings and Loan and other detritus of the previous decade’s savings and loan fraud.