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

by Frederick Sheehan

  On December 19, 1991, GM announced that it would cut $1.1 billion from its previous 1992 capital spending plans. Coincidentally or not, Chairman Greenspan spoke on the same day. He declared that “the essential shortcomings of this economy is [sic] the lack of savings and investment… . Investment is the key to enhanced productivity and higher living standards.”26

  23 Investment Company Institute, “Mutual Fund Assets and Flows in 2000,” Perspective, February 2001.

  24 Levin, “General Motors to Cut 70,000 Jobs; 21 Plants to Shut.”

  25 U.S. Census Bureau, Current Population Reports, Consumer Income, p. 41, Table A-3.

  That depends on where you sit. “Shareholder value” was paying off. Corporate profits fell 21 percent during 1991, a year in which the S&P 500 rose 31 percent.27 The winnings were rising to the top. The CEOs of the largest 100 companies in America received an average of $2.63 million from grants and options in 1991 when their companies were losing money as if it was 1932.28 In 1976, a CEO had been paid 36 times the average worker’s salary. In 1993, average CEO pay was 131 times that of the average worker.29

  The Cock Crows: Greenspan Pricks the Bubble

  Alan Greenspan gave a clear warning that the carry trade was coming to an end. On January 31, 1994, before the Joint Economic Committee, he stated “Short-term interest rates are abnormally low in real terms”30 It was no secret that the borrow short and lend long strategy had refinanced the banking system. By early 1994, banks were liquid and lending.

  The Fed raised the funds rate from 3.0 percent to 3.25 percent on February 4. This was the first of several increases, the consequence of which was the most traumatic financial convulsion since the 1987 crash. Margin calls drove prices lower, prompting more margin calls and more selling. Longterm Treasury yields rose from 6.3 percent in January to 8.0 percent in December 1994.

  Greenspan may not have anticipated how derivatives had leveraged the financial system. Still, he could not have been completely surprised by the deleveraging. At the December 1993 FOMC meeting, Federal Reserve Governor Lawrence Lindsey warned: “[W]e all agree that the 3 percent [funds] rate is unsustainable. We all know we always act too late.”31 Lindsey talked about a rush into $1 million home mortgages since, at current interest rates and forthcoming tax rates, this was “like borrowing money free for 30 years.”32

  26 “Excerpts from the Fed Chief ’s Testimony,” New York Times, December 19, 1991.

  27Steve Lohr, “Recession Puts a Harsh Spotlight on Hefty Pay of Top Executives,” New York Times, January 20, 1992.

  28 Ibid.

  29 Joann S. Lublin and Scott Thurm, “Behind Soaring Executive Pay—Decades of Failed Restraints,” Wall Street Journal, October 12, 2006.

  30 Beckner, Back from the Brink, p. 348. Greenspan was testifying before the Joint Economic Committee, January 31, 1994.

  On a February 28, 1994, FOMC conference call, Chairman Greenspan declared: “I think we partially broke the back of an emerging speculation in equities. … We pricked that bubble [in the bond market] as well. … We also have created a degree of uncertainty; if we were looking at the emergence of speculative forces, which clearly were evident in very early stages, then I think we had a desirable effect.”33

  The Fed raised the funds rate from 3.25 percent to 3.5 percent on March 22. On an April 18 FOMC conference call, the chairman ventured: “[T]he sharp declines in stock and bond prices since our last meeting, I think, have defused a significant part of the bubble which had previously built up. We let a lot of air out of the tire, so to speak.”34 The Fed, Greenspan believed, could not stop here: “While we have defused a goodly part of the bubble, we have an awful lot left in there.”35 The need to defuse was so compelling that the FOMC decided to raise the funds rate from 3.50 percent to 3.75 percent during the call, rather than wait until the next meeting.

  At the May 17 FOMC meeting, the chairman decided to tighten again: “[W]e have taken a very significant amount of air out of the bubble. … I think there’s still a lot of bubble around; we have not completely eliminated it… . [T]he only way we’re going to pierce it is essentially to create a degree of uncertainty… . [W]e have the capability I would say at this stage to move more strongly than we usually do.”36 The FOMC voted to raise the funds rate from 3.75 percent to 4.25 percent.

  31 FOMC meeting transcript, December 21, 1993, p. 28.

  32 Ibid., p. 27.

  33 FOMC meeting transcript, February 28, 1994, p. 3.

  34 FOMC meeting transcript, April 18, 1994, p. 7.

  35 Ibid., p. 9.

  36 FOMC meeting transcript, May 17, 1994, p. 32.

  At the August 16 meeting, Greenspan expressed satisfaction: “I think we clearly demonstrated that the bubble for all practical purposes has been defused.”37 The FOMC raised the funds rate another 0.50 percent at this meeting, to 4.75 percent. (It would follow with two more rate increases, to 6.0 percent, by February 1, 1995.)

  Greenspan was also forthright in public. On May 27, 1994, he told Congress that depositors had shifted their money out of banks and from money market funds into stocks and bonds, “and some of those buying the funds perhaps did not fully appreciate the exposure of their new investments to the usual fluctuations in bond and stock prices.”38 The Federal Reserve chairman was obviously well versed in the novice investor’s exposure to unfamiliar territory.

  Derivative Lessons

  Greenspan witnessed derivative mayhem when he raised the funds rate from 3.00 percent to 3.25 percent. Askin Capital Management was a $600 million hedge fund that lost all of its money by April 7, 1994.39 The Piper Jaffrey Institutional Government Income Portfolio lost 28 percent of its principal.40 It happened that 93 percent of the Piper Jaffrey fund was invested in mortgage derivatives called collateralized mortgage obligations (CMOs). The mortgages were all rated AAA because the government backed them.41 This would not be the last time derivative strategists and their models sank the ship by misestimating the risks of AAA rated mortgage securities.

  Companies groping for shareholder value included Air Products and Chemicals (which lost $113 million) and Dell Computer (which lost $35 million).42 Securities and funds sold by NationsBank, Fidelity Investments, the Vanguard Group, Fleet Financial, and United Services Advisors suffered unexpected losses.43

  37 FOMC meeting transcript, August 16, 1994, p. 32.

  38 Beckner, Back from the Brink, p. 365.

  39 Frank Partnoy, Infectious Greed: How Deceit and Risk Corrupted the Financial Markets (New York: Henry Holt, 2003), p. 128.

  40 Ibid., p. 130.

  41 Ibid., p. 122.

  42 Ibid., pp. 114, 136.

  Financial derivatives were born to serve a need—to hedge the currency and interest-rate risks of companies. As the market grew, they served desires. Instead of hedging, companies often speculated. Banks were willing to help. Derivative sales were very profitable. Between 1990 and 1993, Merrill Lynch earned more than $3.1 billion, topping the total profits of its previous 18 years as a public company. Over $100 million of its 1993 earnings were from derivative sales to a single client: Orange County, California, which lost $1.7 billion on the trades and filed for bankruptcy.44

  Congress Trusts Greenspan, Ignores Soros

  Congress held hearings on the derivatives maelstrom in April 1994. George Soros appeared before the House Banking Committee on April 13. Soros was the one hedge fund manager who was famous, and would have been known to Congress. He told the legislators: “There are so many [new financial instruments], and some of them are so esoteric, that the risks involved may not be understood even by the most sophisticated investors.”45

  After the congressional study was completed, Alan Greenspan dismissed it as unnecessary. He described the risk of derivatives as “negligible.”46 Congress chose to believe Greenspan and ignore Soros.

  Worse than misapprehending the derivative menace, Greenspan, Congress, and probably most economists did not contemplate the possibility that such an unbalanced economy would ev
entually not respond to Federal Reserve money stimulus.

  At the October 6, 1992, FOMC meeting, Federal Reserve Governor Wayne Angell addressed the attenuating influence of finance on an economy. “Since we have watched the Fed funds rate come down from 9.9% to 3.0%—that’s 690 basis points—and it has had less than the intended effect upon credit and upon spending, then it seems very appropriate for us to look again at this model.”47

  43 Ibid., pp. 131–132.

  44 Ibid., p. 117.

  45 Ibid., p. 114.

  46 Hubert B. Herring, “Business Diary,” New York Times, May 29, 1994.

  In early 2009, the Federal Reserve and Treasury attempted to rouse the economy by extending trillions of dollars to banks and industries. It is want of imagination to fill the patient with ever larger doses of the same medicine. Yet, this remains the Federal Reserve’s modus operandi.

  47 FOMC meeting transcript, October 6, 1992, p. 21.

  11

  Cutting Rates and Running for Another Term as Chairman

  1995–1996

  I think the downside risks are basically coming from the possibility of significant increases in stock and bond prices. … Ironically, the real danger is that things may get too good. When things get too good, human beings behave awfully.1

  —Alan Greenspan, March 1995

  The back half of the 1990s looked gloomier than the first half. In early January 1995, the Wall Street Journal, New York Times, and Barron’s published annual reviews and forecasts, all of which agreed that Wall Street and Main Street were in a funk. Top brokerage firm analysts were interviewed. One was David Shulman, chief equity strategist at Salomon Brothers, who confirmed that “cash is in a bull market right now.” Most of the experts expressed caution; about half of those interviewed expected the stock market to fall in 1995.2

  1 FOMC meeting transcript, March 28, 1995, pp. 42–43.

  2 David Kansas, “Analysts Figure Either Stocks or Bonds Must Give Ground to the Other This Year,” Wall Street Journal, January 3, 1995, p. R3.

  133

  The New York Times special section “Outlook 1995” captured the consensus: “Rarely since World War II have … citizens [of the world’s most powerful economies] been so worried that the good times are about to end before they get their share of the bounty.” The Times observed that the United States had suffered 20 years of job stagnation, and “workers [are] convinced that economic upturns benefit everyone but them.”3

  The gloominess may have been overdone. The refinancing of corporate balance sheets was rewarded—corporate earnings more than doubled between 1992 and 1997.4 From 1989 to 1994, business debts grew by just 5.6 percent ($204 billion). On the other hand, the combination of downsizing and offshoring was grinding down the middle class. Consumer debts grew by 36 percent over the 1989 to 1994 period ($1.2 trillion)—six times the growth of business debts.5

  Constraining Money Growth and

  Boosting Credit

  What tided over the indebted was the rise in available credit. The Federal Reserve has a direct hand in the size of the monetary base. Through the mid-1990s, the Fed was slowing down this contribution to the economy. (The monetary base rose by 10.2 percent in 1993, by 8.1 percent in 1994, and by 3.9 percent in 1995, and would increase 4.0 percent in 1996.6) This showed discipline, but the Fed was ceding control over the monetary aggregates that are more responsive to commercial bank lending policies. It had reduced reserve requirements (mentioned in Chapter 10) and permitted banks to “sweep” assets from retail checking accounts. This latter practice reduced bank reserve requirements by about $4.5 billion (around 8 percent) in 1995.7

  3 David E. Sanger, “Global Prospects Brighten for Most,” New York Times, January 3, 1995, p. C1.

  4 Jim Rogers, “For Whom the Closing Bell Tolls,” welling@weeden, http://www.welling. weedenco.com, August 8, 2003. The 15 largest mergers in 1994 were stock or cash transactions. The LBO was dead. From: Greg Steinmetz, “Mergers and Acquisitions Set Records but Lacked that ’80s Pizazz,” Wall Street Journal, January 3, 1995, p.R8.

  5 Richebächer Letter, July 2003, p. 4.

  6Federal Reserve Statistics and Historical Data, H.3, Table 1: “Aggregate Reserves of Depository Institutions and the Monetary Base (Adjusted for Changes in Reserve Requirements—SA and NSA)”; http://www.federalreserve.gov/releases/h3/hist/.

  A much broader measure of growth—one that is more attuned to credit than to money—is M3. The rate of credit creation within the limits of M3 rose 2.6 percent in 1994, 6.2 percent in 1995, 9.9 percent in 1997, and 10.4 percent in 1998.8 The Fed interest rate increases through 1994 and early 1995 were for naught, since banks’ lower reserves permitted them to lend more. To an extent, borrowed funds went into the stock market and other speculative activities.

  This was the period when Alan Greenspan became a household term (term, since “Alan Greenspan” seemed as much a thing as a person). It was also the period when credit decisions beyond bank lending—such as securitizing subprime assets—further reduced the influence of the Fed (should it wish to restrain the economy).

  Bailing Out Mexico—With an Eye to Greenspan’s 1996 Reelection

  The bailout of a foreign country is a political decision made by Congress and the executive branch of the government, which is not a topic for this book. However, Alan Greenspan’s insertion of the Federal Reserve requires an abbreviated peso detour.

  Through the 1980s and early ’90s, Mexico had been spending too much. The peso was pegged to the dollar. In late December 1994, the Mexican government devalued and let the peso float. It fell 42 percent in a matter of days. The possibility of political upheaval and a drop in trade (the United States ran a trade surplus with Mexico in 1994) served as an incentive to bail out the Mexican government.9

  7 In 1990, the Fed eliminated the 3 percent requirement on nonpersonal time deposits and net eurocurrency liabilities. In 1992, the Fed lowered the required reserve ratio transaction deposits from 12 percent to 10 percent. See Joshua N. Feinman, “Reserve Requirements: History, Current Practice, and Potential Reform,” Federal Reserve Bulletin, June 1993, pp. 569–589. In 1995, banks took more advantage of “sweeping” depositors’ checking account balances into money-market deposit accounts that earn interest. Since no reserves are required to be held against the deposit account, the bank can then lend against the sweep. This reduced bank reserve requirements by about $4.5 billion in 1995. New York Federal Reserve Annual Report 1995, pp. 13–30; www.newyorkfed.org/aboutthefed/annual/annual95/omkt.pdf.

  8 St. Louis Federal Reserve, Economic Data, Monetary Aggregates, M-3 and Components.

  Treasury Secretary Robert Rubin led the bailout effort. Congress rebelled. President Clinton diverted funds for the bailout. Rubin took his case to the legislators. He had only recently been installed as treasury secretary. Alan Greenspan carried more political weight on Capitol Hill. Greenspan accompanied Rubin to the Senate and House office buildings “testifying and lobbying in support of the package.”10

  This was quite a compromise by the Federal Reserve chairman. Federal Reserve Governor John LaWare put it bluntly: “ ‘It politicized the Fed to the extent that we were asked to endorse a political settlement or agreement. … It was a compromise of Federal Reserve independence and something that we have obviously jealously guarded for a long, long time.’ ’’11 But LaWare understood that Greenspan was playing a more important political game. Greenspan needed to be “ ‘a friend of the guy who has the power to keep him in power.’”12 Keeping him in power probably refers to Greenspan’s reappointment in 1996. FOMC decisions in 1995 may have been influenced by Greenspan’s reelection campaign.

  1995: A Midyear About-Face To many, 1995 was the year when the financial system inflated beyond redemption.

  In February, the Fed raised the funds rate to 6 percent.13 Then, in July, the Federal Reserve cut the rate to 5 ¾ percent. Such a quick turnabout is unusual. The Fed runs the risk of looking like a chicken with its head cut off. The FOMC was
motivated to loosen money by slowing retail sales and car sales, rising unemployment claims, and a lower purchasing managers’ index.14 At the July meeting, Greenspan told the committee: “[T]he data of the last few weeks clearly are moving in the direction that … we at least seem to have reached the maximum risk potential and probably are now somewhat on the other side”15 (meaning that recessionary risks had abated). He recommended a 25 basis point cut even while stating: “[S]ince the risks are beginning to ease slightly, there is no urgency here.”16

  9 Steven K. Beckner, Back from the Brink: The Greenspan Years (New York: John Wiley & Sons, 1996), p. 379.

  10 Ibid., p. 382.

  11 Ibid.

  12 Ibid.

  13 Ibid., p. 389.

  14 Ibid., pp. 396–401.

  The decision was Greenspan’s. FOMC members had plenty of time to air their views (71 pages of transcript), but a clue to Greenspan’s grasp on the committee arises from a plaintive question after the decision had been made. An unidentified speaker asks, “Is there a press release?” Greenspan responded, “I am sorry. The draft reads as follows: ‘Chairman Alan Greenspan announced today that the Federal Open Market Committee decided.’”17 Greenspan had brought the committee’s communiqué to the meeting.

  “The Greenspan Fed” Was Exactly That When Volcker ruled, the board was not a rubber stamp. There was no such unruliness under Greenspan. There was rarely an interesting discussion.

  Alan Blinder was appointed to the vacant post of vice chairman of the Federal Reserve in 1994. A Princeton undergraduate, he earned his Ph.D. at MIT, where his dissertation was supervised by Robert Solow (also one of Ben S. Bernanke’s thesis sponsors).18 Blinder served on the Council of Economic Advisers in the first Clinton administration (where his greatest contribution may have been as algebra homework consultant to Chelsea Clinton).19 Blinder was filling the home stretch of a 14-year term vacated by David Mullins. Clinton wanted to reappoint Blinder to a full 14-year term in 1996, but Blinder declined. Instead, he returned to Princeton. Blinder did not speak publicly about his decision, but when Felix Rohatyn, investment banker from Lazard Frères and “Evening Hours” companion of Alan Greenspan, decided to pursue the opening, Blinder asked: “Why are you doing it? I’m leaving because I can’t stand it.”20