The Great Deformation

by David Stockman

  At the next board meeting on February 4, 1997, Greenspan led a discussion on the possible need for a “preemptive move,” but his tone indicated that the Fed had already developed a paralyzing fear that the market might have a hissy fit if it tightened, and that this would spill over into the political arena: “If we raised rates and gave as the reason that we wanted to rein in the stock market, it would have provoked a political firestorm. We’d have been accused of hurting the little investor, sabotaging people’s retirement. I could imagine the grilling I would get in the next congressional oversight hearing.”

  Paul Volcker might have noted that getting grilled good and hard on Capitol Hill was near the top of the Fed chairman’s job description. Instead, Greenspan finished off the discussion with a pussy-footing game plan right out of the Arthur Burns’ playbook. With the FOMC’s consent, he would first publicly hint at a tightening move, deferring an actual increase in the Fed funds rate until the next meeting. As he explained to the committee, “What we are trying to avoid is bubbles that break.”

  Accordingly, at its next meeting on March 25 the FOMC approved a pinprick. It voted to raise the funds rate by just 25 basis points to 5.5 percent, thereby insuring that, indeed, no bubble would be broken. Greenspan leaves no doubt about his authorship of this half-hearted whiff. “I wrote the FOMC’s statement announcing the decision myself,” he noted, emphasizing that he had spoken purely in terms of “underlying economic forces that threatened to create inflation, and did not say a word about asset values or stocks.”

  This was now the bubble whose name could not be spoken. Yet, perhaps wondering momentarily whether the Fed was their friend after all, the punters on Wall Street caused the market to sell off by about 7 percent in response to the rate increase. After a few weeks, however, traders appeared to realize that the bubble word had not been spoken aloud because the Fed had no stomach for defusing the gambling frenzy under way on Wall Street.

  Accordingly, the bull came roaring back later in the spring, recouping the loss and pushing the market up by another 10 percent by mid-June 1997. And with that, Greenspan’s quixotic campaign against irrational exuberance came to an abrupt and permanent end.

  His parting thoughts on this matter, as outlined in his memoirs, are a stunning admission that in the pursuit of its foggy prosperity management agenda, the Fed had lost all sense of its core mission to maintain sound money and financial discipline. So doing, it had now become a wholly owned vassal of Wall Street. “In effect,” Greenspan concluded, “investors were teaching the Fed a lesson.”

  Yet a strange lesson it was. If there was any mantra among Wall Street traders at the time it was “Don’t fight the Fed.” So even as late as the spring of 1997, a stout move against the market’s bullish sentiment would have been a potent weapon, had the Fed really wished to quash speculative excesses.

  Unfortunately, Bob Rubin, the Goldman Sachs emissary on the third floor of the Treasury Building, had by now convinced Greenspan to unilaterally disarm. In the name of the free market, the nation’s central bank was to become the speculator’s best friend. Greenspan made this perfectly clear in his reprise of these events: “Bob Rubin was right: you can’t tell when a market is overvalued, and you can’t fight market forces.”

  Rubin had been a famous arbitrage trader, and getting the Greenspan Fed to roll over was his greatest arb job of all. By its silence the Fed would signal an intention to accommodate an unlimited run-up of the stock averages, giving Wall Street a wide birth to front run a rising market. Then, after the stock indices surged even higher, the Fed would turn a blind eye to the financial mania it was feeding, on the grounds that it couldn’t fight the very market it had bulled up.

  Greenspan 1.0 would have rejected such sophistry out of hand. Even recent history proved that a Fed committed to sound money should not hesitate to rebuke short-run market manias. Indeed, faced with a similar case of runaway speculation in the market for commodities and oil in October 1979, Volcker did not ask speculators if they would please to stand down in return for only a 25 basis point increase in their cost of carry. Instead, he raised the cost of speculation by 800 basis points and never looked back.

  Needless to say, the Greenspan Fed elected the very opposite course of action: “We looked for other ways to deal with the risk of a bubble,” Greenspan recalled, but after May 1997, “we did not raise rates any further and we never tried to rein in stock prices again.”

  THE LTCM CRISIS OF SEPTEMBER 1998:

  WHEN FED PANDERING WENT ALL IN

  In fact, about eighteen months after the Fed abandoned its effort to prick the equity bubble, the market made its own sharp correction in response to the Russian and LTCM shocks. But even then, the Greenspan Fed could not see its way clear to stand aside and allow the market to do the dirty work. Instead, the Fed moved aggressively in the final quarter of 1998 to actually nullify the market’s own corrective adjustment.

  Thus, the policy of letting “market forces work their will” was now revealed to be operative only on the upside, not when flagging animal spirits took the stock averages for a tumble. The post-LTCM easing campaign confirmed that the Greenspan Put was now fully in place, thereby igniting the final, nearly hysterical blow-off phase of the stock market bubble.

  Indeed, the track record of the Fed’s policy actions during this interval is one of outright pandering to Wall Street speculators. After its abortive effort to prick the bubble in March 1997, the FOMC had kept the Fed funds rate constant at 5.5 percent through July 1998. Seeing that it had been given the “all clear” signal, the market took stock prices on a parabolic romp, with the S&P index rising from around 750 to nearly 1,200 in just fifteen months. By any conventional reckoning, this 60 percent gain on top of the prior huge market advance elevated the market to a perilous extreme.

  Not surprisingly, therefore, the market retreated swiftly after the Russian default and the LTCM fiasco became public in late August 1998. By the end of September, the S&P index was down by 12 percent, a modest pullback under the circumstances.

  Nevertheless, that was enough to spur the Fed into a full panic mode. It hurriedly cut the federal funds rate three times within fifty days, thereby stopping the market correction in its tracks. The wonder in hindsight, however, is why the Fed went into headlong bailout mode when the stock market index was still 40 percent higher than it had been in March 1997, the point at which the FOMC had first detected a bubble and had half-heartedly tried to prick it.

  Greenspan’s answer requires full citation because it is too damning to be fairly summarized. Staff studies at the time of the Russian default concluded that the Russian default would have negligible impact on the American economy. In Greenspan’s telling, “It was highly likely that the US economy would continue expanding at a healthy pace.”

  So why give financial speculators, who had become increasingly brazen, an unmistakable assurance that the Fed would send the pumper brigade to flood Wall Street with cash in response to the slightest economic hiccup? Greenspan’s answer was no more compelling than the case for buying crash insurance from an airport vending machine.

  Notwithstanding the solid outlook for the real economy, the Fed had opted to ease interest rates due to “a small but real risk that the default might disrupt global financial markets … we judged this unlikely but potentially greatly destabilizing event to be a greater threat to economic prosperity than the higher inflation that easier money might cause.”

  Obviously, the threat of higher inflation wasn’t the real issue and was, in fact, a red herring in a world in which the red factories of East China were expanding at breakneck speed. Likewise, during the fall of 1998 the considerable short-run momentum of the national economy was transparently evident in the Fed’s key high-frequency indicators on orders, shipments, consumption, and investment.

  Thus, during the fourth quarter real consumption increased at a 6.3 percent annual rate, fixed investment spending rose by 13 percent annually, and exports climbed at a
rate of 16 percent in real terms. That data is stunning proof that there was no economic emergency.

  The Main Street economy had not faltered one bit in the aftermath of the Russian and LTCM crises, and for good reason. Those events, like comparable financial panics in the decade ahead, were not economically “contagious” and largely played out in the gambling halls of New York, London, and Moscow.

  Indeed, the national economy’s bottom-line measure, real GDP, actually surged at a 7.1 percent rate during the final quarter of 1998. So while the macroeconomy plainly needed no help from the Fed, the clear and present danger actually facing the nation’s central bank was the risk of reigniting the raging stock market mania which the LTCM crisis had temporarily cooled.

  GREENSPAN’S CONTENT-FREE RATIONALIZATION FOR THE POST-LTCM EASING PANIC

  When the Fed cut interest rates on September 28th, the stock market was still at a breathtaking high and could have fallen another 25 percent before it retraced even its March 1997 level. Greenspan’s reasoning as to why the stock index could not be allowed to fall to at least a level which only months earlier he had viewed as manifesting “irrational exuberance” was content free. As during the BlackBerry Panic of 2008, a lurid metaphor was held to be dispositive: “Panic in a market is like liquid nitrogen—it can quickly cause a devastating freeze.”

  It can be well and truly said that with such lame arguments from friends, the free market needed no enemies. The S&P 500 index was mildly correcting at a level which was triple where it had been a decade earlier. So the Fed’s easing action under that circumstance was unaccountable; it boiled down to the implicit proposition that the stock market had become a doomsday machine and that if left on its own it would plunge straight into the abyss.

  If this was Greenspan’s reason for easing, then Wall Street had already passed the point of “too big to fail.” A financial system that couldn’t absorb the collapse of the Moscow stock market—a backwater den where thieves gathered to fence their stolen property—or the liquidation of a modest-sized betting pool like LTCM, in fact, was implicitly too dangerous to exist.

  Greenspan’s proposition was not remotely true, however. There was no economic calamity in letting the stock market come to its senses the hard way, as was evident two years later after the S&P 500 had plunged by 50 percent from its mid-2000 peak. Notwithstanding this purported destabilizing shock, the truth was that the Main Street economy barely faltered and the 2001–2002 downturn proved to be so shallow as to barely qualify as recession.

  So the truth was that the Fed had turned its monetary fire hose on the stock market in September and October 1998 for no good reason. These misguided “emergency rate cuts” had caused the S&P 500 index to soar from 1,000 to nearly 1,500 by June 2000. This amounted to a 50 percent flare-up in less than twenty months, and one which was destined to come plunging back to earth.

  During this final flameout, the maestro’s blindness to the speculative mania that the Fed itself was fostering became palpable. In the middle of the final parabolic run of the market in 1999, Greenspan told a congressional committee that the Fed would not “second guess hundreds of thousands of informed investors.”

  Yes, Wall Street investors were “informed,” but what they were informed about was the eagerness of the nation’s central bank to put an absolute floor under the stock market and thereby make even rank speculation a “can’t lose” proposition. In his congressional testimony, the chairman of the Federal Reserve actually put speculators on public notice that the Fed would continue to eschew any and all efforts to impose financial discipline.

  Henceforth, if a financial bubble should break, the Fed would clean up the mess after the fact. Needless to say, that utterance guaranteed that the stock bubble would keep on inflating because now there was no fear whatsoever that the Fed would rediscover Martin’s punch bowl and take it away. Even when the Fed did begin raising interest rates in mid-1999, it was in baby step increments of 25 basis points and well telegraphed to the market.

  Through it all, Greenspan was apparently operating on a truly misbegotten assumption; namely, that financial bubbles are an ordinary-course market upwelling that need not trouble policy makers overly much. “While bubbles that burst are scarcely benign,” Greenspan opined, “the consequences need not be catastrophic for the economy.”

  Thus reassured, the financial markets partied on. Yet here was the essence of the giant error that would lead to irreversible financial deformations in the years ahead. The Fed chairman was disingenuously attributing the rampant financial mania all around him to the verdict of the free market rather than the monetary jet fuel the Fed was pouring into it.

  FREE MARKET CATECHISM AND THE ELEPHANT IN THE ROOM

  So free market catechism, ironically, became an ideological cover for what amounted to reckless negligence by the central bank. Even long after the fact, when it was evident that capital markets had been turned into dangerous casinos, Greenspan did not hesitate to exonerate the Fed’s failure to rein in the very stock market bubble it had fostered: “I’d come to realize we’d never be able to identify irrational exuberance with certainty, much less act on it, until after the fact. The politicians to whom I explained this did not mind; on the contrary, they were relieved that the Fed was disinclined to try to end the party.”

  It goes without saying that the occupational calling of politicians is enabling the party, not ending it. Yet by 1999, even Washington didn’t need a central banker to explain the science of bubble detection—it was plainly evident that the Wall Street party had now succumbed to the madness of the crowd. The parabolic path of the NASDAQ index during that final period left nothing to the imagination.

  In January 1997, when the Fed had been in the middle of its cogitation about irrational exuberance, the NASDAQ index had stood at 1,200. After it completed its post-LTCM panic-easing cycle in late 1998, the index had doubled to 2,400. And then it doubled again, reaching 5,000 just over a year later in early March of 2000.

  In all, the punters on the NASDAQ had bid up the index by an insane magnitude: to wit, by 320 percent in just thirty-nine months. The legendary story of Japanese herd behavior on the eve of its own spectacular crash had now become operative on this side of the Pacific. “If we all cross the street together when the light is red,” the saying went, “how can we meet any harm?”

  The catastrophic aftermath of the Japanese equity bubble was plainly evident by the final years of the 1990s, and the harm wasn’t merely semi-benign, as the Fed’s “wait till it crashes” stance implied. Instead, it was deeply injurious and debilitating, as demonstrated by Japan’s post-crash economic stupor.

  Japan had been viewed as the world’s unstoppable engine of growth at the time Greenspan became chairman in August 1987, but when the Nikkei index plunged from a peak of 50,000 in 1989 to below 10,000 a few years later, the Japanese economy fractured. It recorded virtually zero GDP gain for the entire decade of the 1990s and its financial system collapsed into a smoldering heap of busted assets and unrepayable debts.

  This lamentable breakdown did not happen because Japan’s fabled “salary men” got tired of working, or because Japanese factories suddenly lost their competitive edge, or because Japan’s total dependence on imported raw materials and energy became too burdensome. These were long-standing structural realities and nothing about them changed after 1989.

  The Nikkei crash simply did not arise from the real economy. Rather, the Japanese fiasco was the handiwork of Japan’s central bank and its reckless attempt to engineer prosperity by flooding the economy with bank credit, especially after the 1985 Plaza Accord.

  So, with the Japanese example squarely on its viewing screen, it was nothing short of astounding that the Greenspan Fed fostered a retracement of nearly the exact bubble path trod by the Bank of Japan. And it did so with about a ten-year lag, meaning it already knew how the movie was going to end.

  Indeed, in what amounted to a replay of the Japanese banking bubble, the US banks a
nd the various shadow banking institutions grew by leaps and bounds during the Fed’s long money-printing campaign through the eve of the dot-com crash. When this campaign began at the time of the black Monday crash in October 1987, total bank loans and investments along with assets held by money market funds, GSE securities, commercial paper, and repo amounted to about $4.5 trillion.

  By the time the NASDAQ began its violent descent in March 2000, however, this total had grown to $17 trillion. And the responsibility for this breakneck rate of expansion in financial assets, almost 11 percent annually over nearly a decade and a half, belonged squarely on the doorstep of the Fed.

  In fact, it was self-evident that the $17 trillion in liabilities needed to fund these swollen asset footings had not been generated by a sudden surge in the propensity of households and businesses to save out of current income. The national savings rate had actually plummeted from about 10 percent to 4 percent during this thirteen-year period, meaning that households were putting less into savings accounts, not more.

  Instead, the Fed’s constant injection of high-powered reserves into the banking system, coupled with the ever increasing visibility and credibility of the Greenspan Put, had fostered a financial chain reaction: newly minted central bank money stimulated rapid private debt extensions, which was used to bid-up asset prices, which elicited more collateralized credit, which drove asset prices still higher.

  HONEST SAVINGS VS. CONJURED CREDIT

  The Austrian economist Ludwig von Mises had explained this type of credit boom cycle way back in 1911, but by the 1990s the hubris of monetary central planners superseded the plaintive monetary wisdom of an earlier age. In those benighted times, economists and legislators alike knew the difference between the honest savings of the people and bank credit made out of thin air.