Maestro

by Bob Woodward

  Treasury Secretary Jim Baker had flown back to the United States on the Concorde. He too thought the one-sentence statement was brilliant. They were lucky to have Greenspan at the Fed. Baker wasn’t sure that Volcker would have been so quick to act.

  Corrigan never figured the whole thing out, and part of him didn’t want to know. If it was a major miracle rescue of American capitalism, several people or firms might have operated in concert to manipulate the market. That was technically a scheme, and possibly illegal. And if someone in the government or the Fed had given tacit approval, encouragement or even just a wink, that would make it worse. Corrigan decided that he didn’t want to pursue the matter.

  For all Greenspan knew, it might have been a handful of individuals who made the move. There was no telling whether the transactions were made out of knowledge or desperation, skillful calculation or serendipity. Was it possible that American capitalism was given a reprieve by the strategic—or accidental—investment of several million dollars? It was possible, of course. Or perhaps the bottom had been reached and the market had pulled out naturally. Whatever the answer, Greenspan’s largest realization was they hadn’t known what to do. They could set up a crisis committee, confer, send messages to the financial markets, seek intelligence, talk tough or smart, look at the data until they were blue in the face and try to project, but they were all novices given the problem they faced.

  That wonderful, nebulous space between the free markets of capitalism and regulations of government was the land of the unknown. It was Greenspan’s first major lesson at the Fed, and he had been chairman only 72 days.

  • • •

  Greenspan set up a crisis command post in his office. He, Johnson and some of the others stayed round the clock for the next several days. They were eating crummy sandwiches and keeping in constant contact with Corrigan in New York, the other bank presidents and market people from around the world.

  On Thursday, October 22, the president of the Chicago Fed called with a new crisis. First Options, a subsidiary of Continental Illinois, a giant bank, was broke and could no longer provide loans to the options market.

  The Fed, as the regulator of banks, had insisted that Continental keep a firewall between its depositors’ money and its subsidiaries, such as First Options. The firewall was there to protect the bank from being drained while supporting a failing subsidiary and to protect depositors from losing their money. Continental now wanted relief from the firewall in order to keep First Options afloat.

  William Taylor, head of the Fed’s bank supervision enforcement division, rushed into Greenspan’s office as the chairman and Johnson were sitting at a small oval coffee table.

  “We have to shut them down,” Taylor said. They had to follow their own regulations and protect Continental Bank and its depositors. They could not let First Options bleed the bank.

  Taylor didn’t have the big picture, Johnson knew. The failure of First Options would send the options market into paralysis and perhaps trigger another stock plunge. He looked at Greenspan, who seemed to signal agreement.

  “Let them do it,” Johnson said to Taylor. “Don’t block it. Let the money go. We’ll clean this up later.”

  Greenspan just nodded.

  Things weren’t fixed, he realized again. There was no mathematical way to figure out what was happening, let alone what had already happened, no way to remove the many elements of uncertainty. It was more sobering than ever.

  2

  * * *

  “PASSING A TEST: Fed’s New Chairman Wins a Lot of Praise on Handling the Crash,” read the headline in the Wall Street Journal five weeks after the stock market crisis. Federal Reserve Bank presidents, Wall Street analysts and staffers gave Greenspan credit for a cool and quick reaction.

  For his part, Greenspan felt he had dodged a bullet that was still flying through the air. He continued his analysis of what precisely had happened on Wall Street and why. In January 1988, a government commission headed by Nicholas F. Brady, chairman of the old-line Wall Street firm Dillon, Read & Co., released its 340-page report on the crash. Brady, who had served briefly as a Republican senator from New Jersey, criticized Wall Street’s computer-driven trading practices that automatically dump large blocks of stock when prices drop significantly, amplifying declines. The commission recommended so-called circuit breakers to halt price movements automatically. The report also recommended one overarching regulatory structure, because stocks and the ancillary futures and options exchanges were in reality one market.

  “The financial system came close to gridlock,” the report said, adding that “the experience illustrates how a relatively few, aggressive, professional market participants can produce dramatic swings in market prices.” Continuing, it said, “Monday, October 19, was perhaps the worst day in the history of U.S. equity markets,” noting that the next day—the so-called Terrible Tuesday of October 20—was equally unnerving, when trading was halted in 175 stocks, including some of the biggest names.

  Some banks that borrowed extensively from the Fed at the discount rate during the crash were now perceived to be in precarious financial shape because they had needed so much money. In general, the Fed expected banks to borrow at the discount rate—usually a below-market rate—only after all other sources of funds had been exhausted. The Fed monitored who borrowed at the discount rate and chastised those who came too frequently, which usually kept that borrowing at a minimum. In the wake of the crash, discount rate borrowing became even less popular and less important as banks didn’t want to appear to be weak. So the fed funds rate became increasingly important, giving the FOMC and their decisions more significance than ever before. The FOMC had eased the fed funds rate very slightly since the crash, and in January the rate stood at 63/4 percent. At the committee meeting on February 10, after hearing lengthy presentations about the economy, Greenspan turned to interest rate policy.

  “One thing about this meeting, which I think is pretty important,” Greenspan said, “is that we have to find the mechanism by which we are perceived to be in a general consensus.” Reagan was in his last year as president, and the administration was winding down, he noted. “There are elections coming up and we are turning out to be the only people who are minding the store.” Everyone else was playing politics with the economy—at a time when the stock market was still relatively high and the economic situation highly unstable. In Greenspan’s view, it was an important time for the Fed to speak with a single voice, even if no one was totally comfortable with the final decision. The markets were still healing from the stock market crash, and any rash move by the committee might cause further damage. “If we were to indicate that we were tightening,” Greenspan added starkly, “the shock to the markets I think would break the stock market.”

  The others expressed a wide range of views, and Corrigan could see that Greenspan had been clairvoyant in anticipating disagreement and asking for consensus preemptively. The committee engaged in a prolonged, torturous technical discussion but seemed to agree that, in delicate conditions of economic uncertainty, the chairman needed a great deal of flexibility to make interest rate changes between the scheduled FOMC meetings every six weeks.

  After listening, Greenspan presented a plan that would give him authority to make, on his own, minor adjustments to the fed funds rate between meetings. The FOMC would take no official action, but Greenspan would have the flexibility to ease rates down slightly. Technically, this was called an asymmetric directive toward easing. Since Greenspan’s unilateral action would not be publicly announced, there would be no immediate public impact. Fed watchers would know what had happened, but the impact of the rate move would seep into the markets largely unnoted by the general public. The vote in favor was unanimous.

  “My congratulations to you, Mr. Chairman,” Ed Boehne said, referring to the unanimity. “You have performed a miracle.”

  “I don’t know where it came from,” Greenspan replied, and the meeting ended.

 
The answer, in part, was fear. With the stock market crash just four months earlier, the country had been about as close to financial disaster as it dared ever come.

  • • •

  Earlier in the year, one of Treasury Secretary Baker’s assistants had sent a letter to the Fed arguing that the economy would weaken and interest rates should be lowered. Greenspan told the FOMC that he resented the pressure and promised to “use a sledgehammer” to stop it.

  The letter eventually became public, and on February 24, Greenspan told the Senate Banking Committee that he had raised his sharp objections with Baker. If such pressure to cut rates continued, Greenspan said, “we will feel the necessity to do the opposite.”

  The next day’s headline in The Washington Post read: “Greenspan Tells Administration to Stop Pressure.”

  • • •

  Nonetheless, Manuel Johnson thought Greenspan was too passive. The aggressive, ambitious board vice chairman thought Greenspan ran his own office and the Fed too much like an academic department. The new chairman was obviously the best numbers man around, but he seemed an expert in being obtuse, too frequently declaring at their committee meetings that the situation was murky. In the interest of prudence, Greenspan would often argue that he wanted the future data to direct their next action. Most often, that meant the committee would vote for asymmetric directives, which let the chairman make changes between meetings. What Johnson seemed to miss was that Greenspan’s apparent passivity meant he had the power to determine the timing of interest rate changes. It was exactly what he had done at the February meeting. The FOMC was basically ceding operational control to Greenspan. Throughout the spring, the committee continued to give the chairman the power to raise rates through an asymmetric directive.

  Greenspan feared an outburst of inflation. Lower interest rates for an ailing economy could soon become the disease. As the economy grew, businesses would raise prices and workers would receive higher wages. This chain of events would spark dangerous, even debilitating, inflation. As he often said, inflation destroyed the purchasing power of the dollar and eventually led to lower economic growth and lost jobs. He wanted to keep focused on the law, which said the Fed was to maintain stable prices—no, or low, inflation—and economic growth that could be sustained year after year. It was tricky.

  Inflation was now hovering around or above 4 percent, higher than Greenspan wanted. By June, he had raised the fed funds rate to 71/2 percent.

  Though Johnson had been appointed as part of Jim Baker’s effort to put Reaganauts who favored lower rates on the board, by the late summer of 1988 he saw the need to raise interest rates even more. The evidence showed that the economy was overheating and pressures from workers for potentially inflationary wage increases were growing.

  At the June 30 FOMC meeting, Corrigan spoke with some passion about his fear of skyrocketing inflation. “If the inflation rate, however measured,” Corrigan said, “were to get in the area of 5 percent or more, just getting it back to 4 percent—much less price stability, whatever that means—is going to involve enormous costs to the economy.” The obvious cost would be a Fed-induced recession to drive inflation down, achieved by large rate increases to slow the economy.

  Greenspan argued for no immediate rate hike but for continuing the asymmetric directive. He won by a vote of 8 to 3, but the district bank presidents were pushing for higher rates. By July, the next month, 9 out of 12 of the bank presidents had submitted requests for a discount rate increase because of their fears of inflation.

  Greenspan and Johnson devised a subtle strategy. They would attempt to persuade the board to grant the less important but publicly visible discount rate increase, hoping that the public announcement impact would reduce pressure from the bank presidents for FOMC action to increase the key fed funds rate.

  Greenspan had some missionary work to do to persuade the reluctant board members.

  On Friday evening, August 5, Johnson attended a ceremony and parade at the Marine Barracks in Washington, D.C., honoring Jim Baker, an ex–marine officer. Baker was resigning from Treasury to take over the management of the presidential campaign of his longtime friend Vice President George Bush. Though Bush was assured the Republican nomination after his primary victories, his campaign seemed to be in trouble. Much attention was focused on the Republican National Convention later that month.

  Johnson approached one of Baker’s deputies to say they were having some tense moments at the Fed. It’s not clear how it’s going to come out, Johnson hedged, but the outcome could be a discount rate increase.

  Oh my God, the deputy replied, what are we going to do? How do we deal with that?

  On the morning of Sunday, August 7, Baker appeared on NBC television’s Meet the Press and said he did not think the Fed was sending signals that a rate hike was coming soon.

  On Tuesday, August 9, about 7:30 a.m., Greenspan dropped by the office of board member Martha R. Seger, a Reagan appointee from Michigan who generally opposed rate hikes. She had felt neglected and pushed around during the Volcker era, and she was keenly aware of the devastation to manufacturing in her home state caused by previous recessions.

  Greenspan argued that they had to worry that inflation would not just rise but come roaring back, making it impossible to extinguish without significant rate hikes in the future. In addition, they had to demonstrate their public commitment to inflation fighting. Such a demonstration with a discount rate hike would diminish inflation expectations and help keep price increases down. He badly wanted a consensus.

  Seger finally agreed.

  Several hours later, at a special early morning meeting, the Board of Governors voted to raise the discount rate 1/2 percent. The vote was 6 to 0.

  Greenspan knew Jim Baker was not going to be pleased. Bush was behind 7 points in the polls, and the economy was a growing issue in the campaign. Greenspan and Baker had been friends for 12 years, and Greenspan owed Baker a lot—in some respects, no less than the Fed chairmanship. Greenspan also respected and admired Baker for his political and social skills. He often said that if he were ever in serious legal trouble, he would hire Baker as his attorney in a heartbeat.

  Greenspan believed that Baker deserved to be told about the rate increase. He decided to go over to see Baker to break the news before it was announced.

  At Treasury that Tuesday afternoon, Greenspan tried to come straight to the point.

  I’m sure you’re not going to be happy, he said, looking Baker in the eye, but we’ve decided that it was necessary and we’re announcing a rate increase within the hour.

  “You know,” the treasury secretary said, “you just hit me right here.” He indicated his stomach.

  “I’m sorry, Jim,” Greenspan said.

  Baker flew off the handle and began screaming bloody murder.

  Greenspan thought it was a simulation of anger, not genuine, a display of Baker’s showmanship. He felt he could see through Baker. The treasury secretary would perhaps need to be able to tell Bush, their political associates or the media that he had blown his top and taken Greenspan to the woodshed. Greenspan had long since dissected Baker’s well-honed verbal style. He knew that a word delivered with a certain spin or manner could change the whole meaning.

  Baker’s rant lasted only about 20 seconds. “What shall I say?” he then inquired. He asked for specific advice on what the proper public response should be.

  The rate increase, Greenspan said, was essential for the long-term stability of the economic system, and they could not have avoided doing it. A discount rate increase was the best way to send a public message that they were vigilant about inflation.

  Years earlier, Greenspan had learned a rule of institutional survival: Bring the bad news yourself. He didn’t believe anyone else could convey such delicate messages the way he wanted them conveyed. It was important to look people in the eye, to lay out the facts that would soon emerge and to be as direct as possible. The chairman had found that there was no alternative if h
e wanted to have future relationships with those like Baker. But it wasn’t just a matter of survival. Bringing the news personally gave him power—he was the one who had and would share the still-secret decision—and further cemented his relationship.

  At 9:45 a.m. the Fed announced the increase.

  “You goddamn traitor!” Baker was soon screaming at Manuel Johnson, launching a brief, vehement attack. He was joking, but worried, too.

  “Now give me a chance to explain,” Johnson said. This is in the interest of the economy and ultimately in your interest and that of Bush. It would keep inflation under control.

  “You’re probably right,” Baker said, “but your timing sucks.” He calmed down. “I know you guys have a job to do, but this is ridiculous.”

  “There is no good time to do this,” Johnson replied, noting it was much better now than, say, in late October right before the presidential election.

  Later that day, Treasury and the White House issued statements voicing disappointment in the rate hike but overall approval of the Fed and Greenspan. White House spokesman Marlin Fitzwater said there was “a sound reason” for the hike, and the Fed was “doing a good job” keeping inflation low and under control.

  That week, Fed Governor Kelley’s wife of 34 years, Ellen, died. His longtime Houston friend Jim Baker, who had him appointed to the Fed, invited him over to dinner.

  Baker and his wife, Susan, were sympathetic and warm as they ate, but Baker couldn’t avoid bringing up the discount rate hike. Now in full swing as the Bush campaign manager, Baker said that it was killing them. He didn’t see how it was necessary. While he wouldn’t ask for any special favors for the administration or for Republicans, he sure as hell didn’t think it was right to kick either the Republicans or the Democrats in the teeth. And the Fed had kicked them in the teeth, Baker added, in his pleasant but grinding, insistent drawl. He just couldn’t imagine how they could do that.