The Great Deformation

by David Stockman

  In these instances, of course, one of the adults involved didn’t wish to consent. Yet here was the New York Fed issuing marching orders for counterparty trades to be cleared anyway, thereby institutionalizing a kind of paternalistic busybody role which became more blatant with each subsequent financial panic.

  It also sowed incalculable moral hazard. Since the Fed manhandled all disputed payments to completion, none failed and no one got fired for unsafe counterparty arrangements. These lax practices were simply allowed to gestate further until the next crisis.

  Unaccountably, Alan Greenspan saw no contradiction between his free market philosophy and this kind of capricious meddling. In his memoirs he described Corrigan as “the hero of this effort” and that it was “his job as head of the New York Fed to convince … Wall Street to keep lending and trading—to stay in the game.”

  Stay in the game! Eighteen years later, Chuck Prince, the hapless lawyer put in charge of the Citibank train wreck, said the same thing; that is, that he would keep his traders and bankers dancing until the music stopped.

  In the cold light of day, it is evident that Greenspan had already fallen into splitting hairs after less than three months on the job. While acknowledging that “ordering a bank to make a loan … would be an abuse of government power,” he also approvingly recited Corrigan’s standard speech. He purported to instruct hardened Wall Street financiers on the rudiments of customer relations: “We’re not telling you to lend … just remember people have long memories, and if you shut off credit to a customer … he’s going to remember that.”

  You think? Indeed, why this kind of patronizing Business 101 reeducation message should have led Corrigan to “bite off a few earlobes,” according to Greenspan’s description of Corrigan’s technique, is not exactly clear. But the real issue was not whether the New York Fed was “urging” as opposed to “ordering” bankers to accept unwelcome counterparty risks. The question was, why did Wall Street need a governmental nanny to help assess risks and clear trades, even in the heat of a sell-off?

  WHEN GREENSPAN WHIFFED:

  THE END OF FREE MARKET FINANCE

  The implication was that free markets don’t work when they are most needed, and that the financial system was already broken, dangerously unstable, and not to be trusted in a crisis. And this was at a time in October 1987 before credit default swaps, collateralized debt obligations (CDOs), and many of the other “financial weapons of mass destruction,” as Warren Buffet would later call them, had even been invented.

  In fact, Greenspan whiffed on his first time at bat, and in so doing he began to eviscerate the market’s capacity for self-correction. This breakdown, in turn, ensured that “free money” liquidity–pumping campaigns would be needed repeatedly to offset future panics in the free market. The Fed was already on the slippery slope.

  An even more damaging nanny state intervention occurred the day after the crash. On Tuesday, October 20, the market staged an initial dead-cat bounce rally but by midday hit an air pocket as buy orders dried up for even the big-cap names of the day. During a frenzied two-hour interval around midday, the New York Stock Exchange came within minutes of closing, and the Merc actually did halt trading for thirty-five minutes because the markets were bidless and in free-fall.

  Then suddenly around 12:30 P.M. the market reignited. It was almost as if the ghost of J. P. Morgan had sent his emissary to the US Steel post and placed a buy order, as he did when he single-handedly stopped the Panic of 1907.

  But it was no ghost that placed a flood of buy orders during the post-Tuesday-morning rebound, nor was it even Adam Smith’s invisible hand of the market looking for a bargain price. Instead, it was the visible hand of Washington that had begged, browbeaten, and bullied corporate CEOs to rush into the stock market in unison to buy back their own shares.

  Apologists might be inclined to excuse this assault on the free market as representing the overwrought emotions of bunkered-down officialdom. Arguably, even the scholarly Greenspan may not have known about Teddy Roosevelt’s superb example from the 1907 Wall Street turmoil, when he stayed in the swamps of Louisiana on his bear hunt rather than trouble himself with the commotion at the New York Stock Exchange.

  Most assuredly, however, Greenspan and the other officials did not begin to appreciate how booby-trapped the capital markets were with leveraged gambling schemes and speculative computerized trading programs. In fact, by not allowing the market to burn itself out on October 20 and the days that followed, the Fed was actually catalyzing another even more dangerous phase of the speculative bubble.

  The market needed an aloof disciplinarian at that historical inflection point. What it got instead was a hand-wringing central bank nanny giving the “all clear” sign when none was warranted.

  In truth, the October 1987 crash would have done no lasting damage to the American economy. As in the case of the BlackBerry Panic of 2008, the archives of the Fed and Treasury do not hold even a hastily scribbled analysis of the transmission process by which pricking an immense, artificial bubble in the stock market would have driven the Main Street economy into the drink. As shown in the next chapter, there was no such prospect.

  Nor did the Fed even consider the long-run gains foregone due to its market-propping interventions. Portfolio insurance had been an exercise in sheer stupidity, enabled by the cowboys in the S&P pits who were speculating with 5 percent down payments. Mr. Market’s vengeful punishment, therefore, was not an irrational outbreak of “animal spirits” as the Fed implicitly held, but simply a necessary and unavoidable purge of the speculative excesses that had been fostered by the central bank itself. The true meaning of Black Monday was that the monetary system was fundamentally broken and that the cronies of capitalism had been steadily booby-trapping the marketplace with dangerous and unstable financial instruments.

  THE MOST THUNDEROUS WAKE-UP CALL IN FINANCIAL HISTORY—IGNORED

  The 23 percent stock index drop on Black Monday had been double the 13 percent drop during the worst day of the 1929 crash. The $500 billion in paper losses approximated the GDP of France. Could the nation’s central bank have gotten a more urgent warning that the US financial system was already drastically out of kilter?

  But the Greenspan Fed misunderstood the most thunderous wake-up call in financial history. Had it not been so attentive to the wails and moans from the trading pits in both New York and Chicago, it might have seen that the post–Camp David régime of printing-press money was also an incubator for speculation and leveraged trading schemes of magnitudes and riskiness that had been theretofore unimaginable.

  Greenspan, Angell, and most of the rest of the Fed were perhaps too smitten with the wonders of the free market. Somehow they totally ignored the corrupting influence of the freely printed money they were dispensing.

  It’s notable that writing about the traumatic events that greeted his first months in office more than twenty years later, Greenspan offered not a single clue as to why the rabid market animal which had bared its teeth on Black Monday had appeared out of the blue. Certainly the Fed had never asked whether the crash had anything to do with its own conduct of monetary policy under the new floating money régime and the now vast marketplace of hedging machinery that had arisen to cope with it.

  Instead, the financial futures market was given a clean bill of health, which under the circumstances was preposterous. Leading a whole posse of Wall Street notables gathered to assess the crash, Nick Brady, head of Dillon Read and therefore the managerial heir of the great Douglas Dillon, did not live up to his pedigree. The S&P 500 futures pits had become a raging financial cyclone, dropping by 29 percent in a single day, yet the Dillon Commission did not find much wrong except the need for ameliorative gimmicks like circuit breakers.

  So no lessons were learned and seat-of-the-pants monetary policy went on its merry way, functioning increasingly as a central economic planning scheme. For several more years Greenspan remained the incessant data hound, alert to every mo
vement of scrap iron prices, containerboard shipments, and any sign of incipient goods and services inflation. Ironically, however, he largely ignored the growing menace in the financial markets.

  So the age of the Greenspan Put began, even if that was the furthest thing from the chairman’s intention. Rather than permit the market to purge the first great speculative bubble which had emerged from the Friedmanite régime of floating central bank money, the Fed had charged forward in just the opposite direction.

  When the bond market turmoil came in 1994, followed by the peso crisis shortly thereafter and then by the Asian, Russian, and Long-Term Capital Management crisis as the decade unfolded, the patented fire brigade response of October 1987 was repeated with increasing intensity. Eventually the market’s capacity for self-correction was eviscerated entirely, setting the stage for the toxic deformation known as “too big to fail.”

  CHAPTER 15

  GREENSPAN 2.0

  WITHIN A FEW YEARS, THE CARNAGE OF BLACK MONDAY WAS merely a historical footnote. It had not left a trace of damage on Main Street, meaning that the Fed had panicked for no good reason. Indeed, it had been a “neutron crash” from which the national economy emerged not only standing but actually expanding. Given that the quarter began with a stock market wipeout of immense violence, the robust 7.1 percent GDP growth rate recorded during the final quarter of 1987 was almost freakish.

  Yet it would be a drastic mistake to view Black Monday as merely Wall Street sound and fury signifying nothing. The S&P 500 index had stood at nearly 340 as recently as mid-August before suddenly plunging to 225 on October 19. Other than during the 1930s, there had never been anything close to a one-third drop in the stock market in just sixty days.

  BLACK MONDAY: WASTED CRISIS

  Black Monday constituted a warning, therefore, but the danger it foretold was actually about the risks and instabilities accumulating within the financial system itself. Already by the late 1980s, Professor Friedman’s floating money contraption had resulted in a substantial loosening of the capital and money markets from their historical moorings in the real economy.

  Accordingly, what happened on Wall Street would increasingly reflect the machinations of the nation’s central bank, not the economic outlook for Main Street. The stock market was no longer a mechanism for discounting corporate earnings; it was becoming a monetary slot machine for placing wagers on the actions of the nation’s central bankers.

  As seen previously, the Black Monday crash had been fueled and accelerated by the new tools of computerized speculation, and most especially program trading in the S&P futures pits. But the initial catalyst for the selling panic had been a mistaken reaction in the equity markets to the new Fed chairman’s tightening moves within weeks of taking office in August 1987. Wall Street appeared to believe that it was dealing with another Volcker; that is, with a successor who was reputed to be an economic conservative and who had even been tutored on the virtues of the gold standard by Ayn Rand.

  Greenspan’s weak-kneed response to the stock market plunge readily dispelled that misimpression. It also forfeited a golden opportunity to put financial discipline and sobriety front and center at the nation’s central bank. The new Fed chairman only needed to pronounce that the American economy was healthy and to then repair to the sound money posture that Carter Glass had sketched out seventy-five years earlier. In so doing, he would have reminded Wall Street that the Fed had no dog in the equity market hunt and was therefore indifferent to fluctuations in the stock averages. Under free market capitalism, it was the job of investors, traders, and speculators, not the central bank, to determine how the stock market would value prospective corporate earnings.

  By putting the stock market on life support following Black Monday, however, the Greenspan Fed crossed another monetary Rubicon. For the first time in its history, the Fed embraced the stock averages as a target of monetary policy and affirmed that the path to economic prosperity wended through the canyons of Wall Street.

  This fateful decision set up the unelected branch of the state to be mugged and captured by crony capitalists as it became more deeply ensnared in the machinations of Wall Street speculators. Black Monday, therefore, constitutes another key inflection point in the long cycle of financial deformations that were triggered by the Camp David repudiation of America’s external debts and domestic financial discipline.

  NO TIN CUP FOR WALL STREET

  The transmission mechanism between the central bank and Wall Street is a small circle of authorized, or “primary,” bond dealers who execute the Fed’s open market purchase and sale of government debt. After the demise of Bretton Woods, the Fed became a chronic and massive purchaser of Treasury securities and only an infrequent seller.

  This asymmetry was financially corrosive in its own right, since the Fed buys government bonds by depositing newly created cash in dealer bank accounts. In turn, the heavy flow of new cash into the banking system meant the Fed was fostering far too much cheap credit—funds which fueled speculation in commodities during the 1970s and stocks and bonds in the late 1980s and 1990s.

  Yet there was an even more insidious aspect. The Fed’s post–Camp David license to perpetually monetize government debt caused a dangerous transformation of its bond dealer network. These banking houses had long been a Wall Street backwater populated by a handful of undercapitalized bond brokers who traded government securities by appointment.

  During the Greenspan era, however, it became a phalanx of balance sheet powerhouses aggressively engaged in the Treasury debt moving and storage business. In practical terms, the bond dealers became a potent lobby for easy money, and for obvious reasons: falling interest rates generated windfall gains on the bond inventories carried by the primary dealers and also lowered the cost of carry on their heavily leveraged balance sheets.

  Accordingly, the Wall Street pressure to monetize government debt reached toxic dimensions in the years after Black Monday. At length, the first Greenspan stock market bubble was born. Between 1987 and 1998, for example, the Fed doubled its holdings of government debt, thereby pumping freshly minted deposits into the bank accounts of Wall Street primary dealers at a 7.5 percent annual rate. This was a money-printing spree that topped even the record Arthur Burns had set during the inflationary 1970s.

  What Wall Street wanted in the years after 1987, however, was the opposite of what the American economy actually needed. Given the great East Asian wage deflation then under way, the US economy needed not easy money and high living, but a regimen of frugality, including steadfastly higher interests rates to slacken household consumption, coax out greater domestic savings and investment, and encourage the sustained deflation of internal prices and costs.

  The years after Black Monday thus constituted a splendid opportunity for the Fed to begin disgorging the massive $220 billion hoard of government debt it had imprudently accumulated during the Great Inflation and the Reagan deficit breakout. Selling down its government debt holdings would have forced interest rates higher—probably much higher, but a market clearing price for debt is exactly what the nation’s economy required.

  By that point in time, however, the primary dealers were not much interested in buying notes and bills from the Fed because that drained cash from Wall Street. Figuratively it amounted to passing a tin cup that functioned to dry-up liquidity, shrink private credit, and heighten the risks faced by speculative traders.

  By forcing interest rates higher, demonetization of the public debt and shrinkage of the Fed’s balance sheet would also tend to reduce the mark-to-market value of dealer bond inventories, causing lower profits and reduced bonuses. In short, there was nothing about the pathway to financial discipline and sound money that appealed to the Wall Street dealers. As they saw it, the Fed’s job was just the opposite; namely, to function as their financial concierge, supplying cash and liquidity to the markets even if it involved monetizing more and more of the federal debt.

  THE REPUDIATION OF GREENSPAN 1.0


  Unfortunately, the steely resolve needed to drain the Fed’s balance sheet of its huge post-1971 build-up of government debt was not in Greenspan’s playbook. The sound of accolades for the tech boom proved more compelling. Accordingly, the Fed continued to rapidly accumulate government debt, and thereby provide the monetary fuel for excessive private credit issuance by the banking system, even after the stock bubble moved toward parabolic extremes after May 1997.

  That the Greenspan-led central bank elected to pander to Wall Street, rather than suppress the growing speculative momentum, was surprising. This type of Wall Street coddling had been tried before, in the late 1920s, to disastrous effect, and had been famously denounced by none other than Alan Greenspan himself.

  In a notable 1966 essay in defense of the gold standard, Greenspan 1.0 had insisted that the source of the 1929 crash and the Great Depression which followed was that the Fed had “pumped excessive paper reserves into American banks” between 1924 and 1928. This mistaken policy had resulted in excessive growth of private credit, which “spilled over into the stock market, triggering a fantastic speculative boom.”

  If there was any illusion that the late-1920s stock mania had been benign, Greenspan’s indictment of the Fed’s drastic error and belated attempt to reverse course dispelled all doubt. By 1929, he had noted: “It was too late … the speculative imbalances had become so overwhelming that the attempt [to tighten] precipitated a sharp retrenching and a consequent demoralizing of business confidence … the American economy collapsed … the world economies plunged into the Great Depression of the 1930s.”