by Matt Taibbi
“The one way you can have a particularly disastrous bubble is if it’s fueled by the central bank,” says Fleckenstein. “And that’s what Greenspan did.”
A person can easily go crazy trying to understand everything the Fed does,* so in the interests of sanity it’s probably best to skip the long version and focus on its magical money-creating powers, the key to the whole bubble scam. The bank has a great many functions—among other things, it enforces banking regulations and maintains and standardizes the currency—but its most obvious and important job has to do with regulating the money supply.
The basic idea behind the Fed’s regulation of the money supply is to keep the economy as healthy as possible by limiting inflation on the one hand and preventing recession on the other. It achieves this by continually expanding and contracting the amount of money in the economy, theoretically tightening when there is too much buying and inflation and loosening when credit goes slack and the lack of lending and business stimulation threatens recession.
The Fed gets its pseudo-religious aura from its magical ability to create money out of nothing, or to contract the money supply as it sees fit. As a former Boston Fed chief named Richard Syron has pointed out, the bank has even fashioned its personnel structure to resemble that of the Catholic Church, with a pope (the chairman), cardinals (the regional governors), and a curia (the senior staff).
One way that money is created is through new issuance of private credit; when private banks issue new loans, they essentially create money out of thin air. The Fed supervises this process and theoretically monitors the amount of new loans issued by the banks. It can raise or lower the amount of new loans by raising or lowering margin requirements, i.e., the number of hard dollars each bank has to keep on hand every time it makes a loan. If the margin requirement is 10 percent, banks have to keep one dollar parked in reserve at the Fed for every ten they lend out. If the Fed feels like increasing the amount of money in circulation, it can lower the margin rate to, say, 9 percent, allowing banks to lend out about eleven dollars for every one kept in reserve at the Fed.
The bank can also inject money into the system directly, mainly through two avenues. One is by lending money directly to banks at a thing called the discount window, which allows commercial banks to borrow from the Fed at relatively low rates to cover short-term financing problems.
The other avenue is for the Fed to buy Treasury bills or bonds from banks or brokers. It works like this: The government, i.e., the Treasury, decides to borrow money. One of a small group of private banks called primary dealers is contracted to raise that money for the Treasury by selling T-bills or bonds or notes on the open market. Those primary dealers (as of this writing there are eighteen of them, all major institutions, including Goldman Sachs, Morgan Stanley, and Deutsche Bank) on occasion sell those T-bills to the Fed, which simply credits that dealer’s account when it buys the securities. Through this circular process the government prints money to lend to itself, adding to the overall money supply in the process.
In recent times, thanks to an utterly insane program spearheaded by Greenspan’s successor, Ben Bernanke, called quantitative easing, the Fed has gotten into the habit of buying more than just T-bills and is printing billions of dollars every week to buy private assets like mortgages. In practice, however, the Fed’s main tool for regulating the money supply during the Greenspan years wasn’t its purchase of securities or control over margin requirements, but its manipulation of interest rates.
Here’s how this works: When a bank falls short of the cash it needs to meet its reserve requirement, it can borrow cash either from the Fed or from the reserve accounts of other banks. The interest rate that bank has to pay to borrow that money is called the federal funds rate, and the Fed can manipulate it. When rates go up, borrowers are discouraged from taking out loans, and banks end up rolling back their lending. But when the Fed cuts the funds rate, banks are suddenly easily able to borrow the cash they need to meet their reserve requirements, which in turn dramatically impacts the amount of new loans they can issue, vastly increasing the money in the system.
The upshot of all of this is that the Fed has enormous power to create money both by injecting it directly into the system and by allowing private banks to create their own new loans. If you have a productive economy and an efficient financial services industry that rapidly marries money to solid, job-creating business opportunities, that stimulative power of a central bank can be a great thing. But if the national economy is a casino and the financial services industry is turning one market after another into a Ponzi scheme, then frantically pumping new money into such a destructive system is madness, no different from lending money to wild-eyed gambling addicts on the Vegas strip—and that’s exactly what Alan Greenspan did, over and over again.
Alan Greenspan met with major challenges almost immediately after taking office in August 1987. The first was the stock market correction of October of that year, and the next was the recession of the early 1990s, brought about by the collapse of the S&L industry.
Both disasters were caused by phenomena Greenspan had a long track record of misunderstanding. The 1987 crash was among other things caused by portfolio insurance derivatives (Greenspan was still fighting against regulation of these instruments five or six derivative-based disasters later, in 1998, after Long-Term Capital Management imploded and nearly dragged down the entire world economy), while Greenspan’s gaffes with regard to S&Ls like Charles Keating’s Lincoln Savings have already been described. His response to both disasters was characteristic: he slashed the federal funds rate and flooded the economy with money.
Greenspan’s response to the 1990s recession was particularly dramatic. When he started cutting rates in May 1989, the federal funds rate was 9 percent. By July 1991 he had cut rates 36 percent, to 5.75 percent. From there he cut rates another 44 percent, reaching a low of 3 percent in September 1992—and then he held rates at that historically low rate for fifteen more months. He showered Wall Street with money year after year. When he raised rates again in February 1994, it was the first time he had done so in five years.
Here we have to pause briefly to explain something about these rate cuts. When the Fed cuts the funds rate, it affects interest rates across the board. So when Greenspan cut rates for five consecutive years, it caused rates for bank savings, CDs, commercial bonds, and T-bills to drop as well.
Now all of a sudden you have a massive number of baby boomers approaching retirement age, and they see that all the billions they have tied up in CDs, money market funds, and other nest-egg investments are losing yields. Meanwhile Wall Street was taking that five consecutive years of easy money and investing it in stocks to lay the foundation for Greenspan’s first bubble, the stock market mania of the nineties.
Baby boomers and institutional investors like pension funds and unions were presented with a simple choice: get into the rising yields of the stock market or stick with the declining yields of safer investments and get hammered. As economist Brian Wesbury puts it, it was as if Greenspan was holding up a green light, inviting people to rush into the equity markets.
“When you come to a green light in your car, how many of you have ever stopped your car, gotten out, gone around, and made sure that it’s okay to go through?” says Wesbury.
Greenspan himself was fully aware that his rate cuts were pushing people into the stock markets. In testimony before the Senate on May 27, 1994, he said:
Lured by consistently high returns in capital markets, people exhibited increasing willingness to take on market risk by extending the maturity of their investments … In 1993 alone, $281 billion moved into [stock and bond mutual funds], representing the lion’s share of net investment in the U.S. bond and stock markets. A significant portion of the investments in longer-term mutual funds undoubtedly was diverted from deposits, money market funds, and other short-term lower-yielding, but less speculative investments.
So Greenspan was aware that his policies were luring ordinary peo
ple into the riskier investments of the stock market, which by 1994 was already becoming overvalued, exhibiting some characteristics of a bubble. But he was reluctant to slow the bubble by raising rates or increasing margin requirements, because … why? If you actually listen to his explanations at the time, Greenspan seems to say he didn’t raise rates because he didn’t want to be a bummer. In that same Senate testimony, he admits to seeing that investors were chasing a false dream:
Because we at the Federal Reserve were concerned about sharp reactions in the markets that had grown accustomed to an unsustainable combination of high returns and low volatility [emphasis mine], we chose a cautious approach … We recognized … that our shift could impart uncertainty to markets, and many of us were concerned that a large immediate move in rates could create too big a dose of uncertainty, which could destabilize the financial system.
Translation: everybody was used to making unrealistic returns, and we didn’t want to spoil the party by instituting a big rate hike. (Cue Claude Rains in Casablanca after the Nazis shut down Rick’s roulette game: “But everybody’s having such a good time!”) Instead, Greenspan’s response to the growing bubble in the summer of 1994 was a very modest hike of one-half of one percentage point.
Now here comes the crazy part. At around the same time that Greenspan was testifying before the Senate that a cautious approach was fine, that no drastic action was needed, and there was no danger out there of a bubble, he was saying virtually the exact opposite at a meeting of the Federal Open Market Committee (FOMC), the humorously secretive and Politburo-esque body charged with making rate adjustments. Here is Greenspan on May 17, 1994:
I think there’s still a lot of bubble around; we have not completely eliminated it. Nonetheless, we have the capability, I would say at this stage, to move more strongly than we usually do without cracking the system.
This testimony is amazing in retrospect because about eight years later, after the crash of the tech bubble, Greenspan would openly argue that bubbles are impossible to see until they pop. It is, he would say in 2002, “very difficult to definitively identify a bubble until after the fact—that is, when its bursting confirmed its existence.”
A few months after Greenspan warned the FOMC that there was still some “bubble around,” he suddenly announced that the bubble had been popped. At an FOMC meeting in August 1994, he said that the May rate hike of one-half a percentage point had solved the problem. “With the May move,” he said, “I think we demonstrated that the bubble for all practical purposes had been defused.”
About a half year later, in February 1995, Greenspan would raise rates for the last time for many years. “One can say that while the stock market is not low, it clearly is not anywhere close to being as elevated as it was a year or so ago,” he said.
Within a few months after that, by July 1995, Greenspan was back to cutting rates, slashing the funds rate from 6 percent to 5.75 percent, flooding the economy with money at a time when the stock market was exploding. With easy credit everywhere and returns on savings and CDs at rock bottom, everyone and his brother rushed ass first into the tech-fueled stock market. “That’s the beginning of the biggest stock market bubble in U.S. history,” says Fleckenstein.
But Greenspan’s biggest contribution to the bubble economy was psychological. As Fed chief he had enormous influence over the direction of the economy and could have dramatically altered history simply by stating out loud that the stock market was overvalued.
And in fact, Greenspan in somewhat hesitating fashion tried this—with his famous December 1996 warning that perhaps “irrational exuberance” had overinflated asset values. This was spoken in the full heat of the tech bubble and is a rare example of Greenspan speaking, out loud, the impolitic truth.
It’s worth noting, however, that even as he warned that the stock market was overheated, he was promising to not do a thing about it. On the same day that he spoke about “irrational exuberance,” Greenspan said that the Fed would only act if “a collapsing financial asset bubble does not threaten to impair the real economy.” Since popping a bubble always impairs the real economy, Greenspan was promising never to do anything about anything.
Despite Greenspan’s rather explicit promise to sit on his liver-spotted hands during the bubble, Wall Street reacted with unbridled horror at Greenspan’s “irrational exuberance” quote, which made sense: the Internet stock party was just getting going and nobody wanted to see it end. A mini-panic ensued as the Street brutally responded to Greenspan’s rhetoric, with the NYSE plunging 140 points in the first hour of trading the day after his comments. The New York Times even ran a front-page story with the headline “Stocks Worldwide Dive as Greenspan Questions Euphoria.”
For a man who hated to be disliked on Wall Street, the reaction was a nightmare. “Greenspan was freaked out by the response,” says one newspaper reporter who covered Greenspan on a daily basis at the time. “That [irrational exuberance business] was the one time he said something in a way that was clear enough and quotable enough to make the newspapers, and all hell broke loose.”
And so, true to his psychological pattern, Greenspan spent much of the next four years recoiling from his own warning, turning himself all the way around to become head cheerleader to the madness.
In fact, far from expressing concern about “irrational” stock values, Greenspan subsequently twisted himself into knots finding new ways to make sense of the insane share prices of the wave of Worthless.com stocks that were flooding the market at the end of that decade. The same man who as early as 1994 was warning the FOMC about “a lot of bubble around” took to arguing that there was no bubble.
Greenspan’s eventual explanation for the growing gap between stock prices and actual productivity was that, fortuitously, the laws of nature had changed—humanity had reached a happy stage of history where bullshit could be used as rocket fuel. In January 2000 Greenspan unveiled a theory, which he would repeat over and over again, that the economy had entered a new era, one in which all the rules were being rewritten:
When we look back at the 1990s, from the perspective of say 2010, the nature of the forces currently in train will have presumably become clearer. We may conceivably conclude from that vantage point that, at the turn of the millennium, the American economy was experiencing a once-in-a-century acceleration of innovation, which propelled forward productivity … at a pace not seen in generations, if ever.
In a horrifyingly literal sense, Greenspan put his money where his mouth was, voting for the mania with the Fed’s money. An example: On November 13, 1998, a company called theglobe.com went public, opening at $9 and quickly jumping to $63.50 at the close of the first day’s trading. At one point during that day, the stock market briefly valued the shares in theglobe.com at over $5 billion—this despite the fact that the company’s total earnings for the first three quarters of that year were less than $2.7 million.
Four days after that record-shattering IPO, which clearly demonstrated the rabid insanity of the tech-stock tulipomania, Alan Greenspan again doused the market with lighter fluid, chopping rates once more, to 4.75 percent. This was characteristic of his behavior throughout the boom. In fact, from February 1996 through October 1999, Greenspan expanded the money supply by about $1.6 trillion, or roughly 20 percent of GDP.
Even now, with the memory of the housing bubble so fresh, it’s hard to put in perspective the craziness of the late-nineties stock market. Fleckenstein points out that tech stocks were routinely leaping by 100 percent of their value or more on the first day of their IPOs, and cites Cobalt Networks (482 percent), Foundry Networks (525 percent), and Akamai Technologies (458 percent) as examples. All three of those companies traded at one hundred times sales—meaning that if you bought the entire business and the sales generated incurred no expenses, it would have taken you one hundred years to get your money back.
According to Greenspan, however, these companies were not necessarily valued incorrectly. All that was needed to
make this make sense was to rethink one’s conception of “value.” As he put it during the boom:
[There is] an ever increasing conceptualization of our Gross Domestic Product—the substitution, in effect, of ideas for physical value.
What Greenspan was saying, in other words, was that there was absolutely nothing wrong with bidding up to $100 million in share value some hot-air Internet stock, because the lack of that company’s “physical value” (i.e., the actual money those three employees weren’t earning) could be overcome by the inherent value of their “ideas.”
To say that this was a radical reinterpretation of the entire science of economics is an understatement—economists had never dared measure “value” except in terms of actual concrete production. It was equivalent to a chemist saying that concrete becomes gold when you paint it yellow. It was lunacy.
Greenspan’s endorsement of the “new era” paradigm encouraged all the economic craziness of the tech bubble. This was a pattern he fell into repeatedly. When a snooty hedge fund full of self-proclaimed geniuses called Long-Term Capital Management exploded in 1998, thanks to its managers’ wildly irresponsible decision to leverage themselves one hundred or two hundred times over or more to gamble on risky derivative bets, Greenspan responded by orchestrating a bailout, citing “systemic risk” if the fund was allowed to fail. The notion that the Fed would intervene to save a high-risk gambling scheme like LTCM was revolutionary. “Here, you’re basically bailing out a hedge fund,” says Dr. John Makin, a former Treasury and Congressional Budget Office official. “This was a bad message to send. It basically said to people, take more risk. Nobody is going to stop you.”
When the Russian ruble collapsed around the same time, causing massive losses in emerging markets where investors had foolishly committed giant sums to fledgling economies that were years from real productivity, Greenspan was spooked enough that he announced a surprise rate cut, again bailing out dumb investors by letting them borrow their way out of their mistakes. “That’s what capitalism is supposed to be about—creative destruction,” says Fleckenstein. “People who take too much risk are supposed to fail sometimes.” But instead of letting nature take its course, Greenspan came to the rescue every time some juiced-up band of Wall Street greedheads drove their portfolios into a tree.
