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

by Frederick Sheehan

  21

  The Fed’s Prescription for Economic Depletion

  1994–2002

  Why care? I think there is a longterm social cost we are going to pay from all this… . consumption has expanded more quickly than the income of the great majority of American households.1

  —Federal Reserve Governor Lawrence Lindsey to the FOMC, 1996

  It is time to part with the stock market and to address mortgages—or, more to the point, debt. The increasing burden of consumer debt had been an FOMC topic since the early 1990s. Federal Reserve Governor Larry Lindsey expressed fears about the overindebted American. His lectures occasionally animated another FOMC member (or, more often, a Fed staffer) to respond, but the Federal Reserve spent far more time talking about its “symmetrical” or “asymmetrical” communiqués.

  The first half of this chapter steps back to FOMC meetings between 1994 and 1996. Larry Lindsey spoke while the committee sat. Lindsey was not ahead of his time. The danger was present. He was not only ignored but also listened as other FOMC members explained that Americans were not spending enough.

  1 FOMC meeting transcript, July 2–3, 1996, p. 33.

  251

  The second half of the chapter reviews FOMC meetings in 2002. Greenspan and others dedicated a good part of their time to monitoring the latest data on rising house prices, home-equity withdrawals, and how much Americans contributed to GDP growth by spending their cashouts.

  Across the bridge between the earlier and later FOMC meetings, there are two trends worth remembering:

  1. U.S. households borrowed $336 billion in 1996; they borrowed $1.1 trillion in 2006.

  2. U.S. consumers held $5.2 trillion of debt in 1996; this had risen to $12.9 trillion in 2006.2

  The Lindsey Lectures

  Between 1994 and 1996, Federal Reserve Governor Lawrence Lindsey gave several presentations to the FOMC on a single theme. The middle class was not recovering from the recession of the early 1990s, but it continued to spend. Americans were relying on more credit and gains from financial markets. Cash earnings from work were slipping. At the February 1994 FOMC meeting, Lindsey explained that among the “bottom 99 percent . . . what we’re seeing is a big change in the functional distribution of income away from wages.”3 He compared the period from 1983 to 1988, when “56 percent of all the increase in personal income was paid in the form of wages.”4 In 1992 and 1993 that fell to 47 percent, and “during 1993 that fell to 38 percent.”5 [Lindsey’s second reference to 1993 seems to mean the fourth quarter—author’s note.]

  In Lindsey’s conclusion, “the non-rich, non-old live paycheck to paycheck, quite literally. That’s where all their income comes from. Remember, virtually none of the capital income or business income goes to them. They have to live on their wages and that wage share is also declining… . [T]he middle-class, middle-aged people who are borrowing are really getting their income squeezed.”6 At another point in the meeting, Fed staffer Michael Prell noted a developing trend: “[W]e’ve already gotten to a period of high-level housing activity.”7

  2 Federal Reserve Flow-of-Funds Accounts, Z-1

  3 FOMC meeting transcript, February 3–4, 1994; “the bottom 99 percent,” p. 20; rest of quote, p. 21.

  4 Ibid., p. 22.

  5 Ibid.

  At the May 1995 FOMC meeting, Lindsey again pestered the committee, warning, “[T]here has been a lot of easing of credit terms. At some point this is going to stop.”8 Lindsey made one of his few errors in prophecy: “This is certainly not the kind of environment that is sustainable.”9 Lindsey warned that the Fed’s own forecasts for 1996 assumed a decline in the saving rate from 1995.

  To an economist, a declining savings rate is a good thing; a rising savings rate is bad. Janet Yellen, an academic economist by training, expressed the standard interpretation taught in college classrooms. Her worry was the opposite of Lindsey’s: she was “concerned about the possibility” of the savings rate remaining too high. It had averaged 4.1 percent in 1993 and 1994 and had risen to “5.1 or 5.2 percent” in the first quarter of 1995.10

  1994: Installment Debt Financed Personal Consumption

  Lindsey took the opposing view: that 44 percent of the growth in personal consumption expenditures (PCE) during 1994 “was financed through installment debt, and this can’t go on forever.”11 Yellen feared that if the Fed’s prediction of a 4.4 percent or 4.5 percent savings rate in 1996 was correct, this could have “significant repercussions for the forecast,”12 meaning that GDP growth would slow down significantly. If individuals saved too much (even though 4 percent or 5 percent was a very low rate by historical standards), a recession might follow.

  Lindsey predicted that the high percentage of personal consumption expenditure financed from installment debt would slow because banks were lending recklessly.13 He might have added—although there was no reason to do so, since even the FOMC presumably understood—that the longer it went on, the worse the carnage would be. Since it went on for another 12 years, the bankruptcy of both parties—the lenders and the borrowers—was complete.

  6 Ibid. Lindsey explains each step of his study on p. 21. Lindsey also discusses what he discovered within each income group in much greater detail than can be covered in this book.

  7 Ibid., p. 13.

  8 FOMC meeting transcript, May 23, 1995, p. 25.

  9 Ibid.

  10 Ibid., p. 27.

  11 Ibid., p. 25.

  12 Ibid., p. 27.

  Greenspan also talked about installment debt. Of Governor Lindsey’s concern, “I would only respond by suggesting that part of the problem with this big increase in installment credit, which really is outsized,” is a product of the mortgage market. “[L]arge realized capital gains . . . have been financed in the mortgage market. [Gains from selling houses at a profit.] Those funds are going disproportionately into the financing of consumer durables.”14

  1995—Greenspan’s Concern: Mortgage Market Slowing Down

  Greenspan seemed concerned the mortgage market was slowing. Consumers had switched to credit cards and the like to continue spending at a fast clip, since home equity was apparently receding. It might not be a coincidence that at the FOMC meetings in July 1995, December 1995, and January 1996, the Fed cut the funds rate from 6.00 percent to 5.25 percent. Greenspan wanted to be reappointed Federal Reserve chairman in 1996. Lower mortgage rates would aid his cause.

  At the July 1995 meeting, Greenspan expanded on how important mortgages were to the economy: “The home builders data clearly indicate that things are moving. This is important not only because of the importance of the residential construction sector, but also because history suggests that motor vehicle sales and some parts of the residential building industry move together. If there is firmness in the home building area it has to exert, if history is any guide, some upward movement in the motor vehicle area, which would be very useful.”15 It would be especially useful to a civil servant whose popularity is measured by GDP growth.

  13 Another possibility: “all these backward-looking assumptions our examiners make about the quality of the balance sheet begin to go in reverse.”

  14 FOMC meeting transcript, May 23, 1995, p. 32.

  Lindsey continued his lecture series, whether it interested the FOMC or not. If one can judge by formality of composition, Lindsey was less interested in Federal Reserve decorum than his compatriots were. For instance, after warning about “asset re-diversification” in 1993, he raised the Boston Chicken IPO as a sign of speculation, then suggested the Fed cook up its own fast-food IPO, asking: “What do you think, Al?”16 Nobody at the FOMC ever called Greenspan “Al” and very rarely “Alan.” He was “Mr. Chairman.”

  In January 1996, Lindsey was “more pessimistic than the staff about the state of the household sector.”17 He thought the debate of rich versus poor was the wrong question. The normal separation of income brackets missed a larger problem. He was not concerned so much with income distribution as he was with the indebtedne
ss of American households, rich, poor, and in-between. All of the income brackets—from rich to poor—received interest income, but it was “highly skewed.” In the $50,000–$100,000 income bracket, the top 8.4 percent of taxpayers received 70 percent of all interest income in that class.18 Lindsey calculated that more than half of the “well-to-do” range had more non-mortgage debt than financial assets.19 “In other words, far more than half of upper income households, not to mention lower income households, do not now have financial assets that exceed their debt.”20 This was in 1996, when Americans were relatively unburdened with debt (in comparison to the present).

  Lindsey’s Warnings

  In July 1996, Lindsey grasped the problem of indifferent lenders: “[T]he new computerized underwriting procedures continue to extend ever more credit even as debt levels grow. The traditional warning flags simply are not present for the great majority of people who are taking on new debt.”21

  16 FOMC meeting transcript, December 21, 1993, p. 27.

  17 FOMC meeting transcript, January 30–31, 1996, p. 10.

  18Ibid., p. 11. Lindsey also discusses the $20,000–$30,000 income class: “[T]he top 4.7 percent got 60 percent and the top 13 percent got 79 percent of the interest income received by that class.”

  19 Ibid. Lindsey had “thrown out the very poor and the very rich income classes because there are problems in interpreting both of those.”

  20 Ibid.

  Lindsey went on to teach a lesson that made little impression on the Federal Reserve chairman. “[F]rom my experience at Neighborhood Reinvestment22 and from the studies done here at the Board, it is clear that high LTV [loan-to-value] loans are a big risk for future delinquency… .[W]hen economic distress occurs, individuals with no equity in their homes have less incentive to stay than those who have such equity. Our experience shows these high LTV loans can be successfully and profitably made, but they require enormous amounts of handholding and follow-through with the borrower… .Why care? I think there is a longterm social cost we are going to pay from all this. . . . Consumption has expanded more quickly than the income of the great majority of American households”23 [author’s italics]. His recollection of Neighborhood Reinvestment illuminates the nonsense of mass, subprime, and HUD 3 percent down payment lending. It cannot be done.

  Lindsey wasn’t through. He again admitted that he had been wrong about the endurance of the borrowing madness, then warned: “[T]he price we are paying is the increasing fragility of the underlying financial structure of the household sector”24 [author’s italics].

  Mr. Lindsey and Mr. Coffee Lindsey was nearing the end of his Federal Reserve governorship at the September 1996 FOMC meeting:

  MR. LINDSEY. [O]ur luck is about to run out in the financial markets because of what I would consider a gambler’s curse: We have won this long, let us keep the money on the table… . But the longterm costs of a bubble to the economy and society are potentially great. They include a reduction in the longterm saving rate, a seemingly random redistribution of wealth, and the diversion of scarce financial human capital into the acquisition of wealth… . I think it is far better that we [burst the stock market bubble] while the bubble still resembles surface froth and before the bubble carries the economy to stratospheric heights. Whenever we do it, it is going to be painful however… . [I]f the optimists are wrong, then indeed not only our luck but that of the markets and of the economy has run out. Thank you.25

  22 In 1978, Congress established the Neighborhood Reinvestment Corporation. The act defined Neighborhood Reinvestment’s mission as “revitalizing older urban neighborhoods by mobilizing public, private and community resources at the neighborhood level.”

  23 FOMC meeting transcript, July 2–3, 1996, p. 33.

  CHAIRMAN GREENSPAN. On that note, we all can go for coffee.

  Mr. Coffee escaped once again.26

  Lindsey had summed up our future. His only error was timing. He did not—but who did?—predict that the stock market bubble would grow for 3½ more years. The stock market bubble forestalled a reckoning. That bubble concealed much that was wrong with a misaligned economy— specifically, the amount of borrowing required to boost the GDP.

  The gambler’s curse did not strike for another 10 years. First, the stock market cured all that plagued the “real” economy. After that failed, Greenspan seeded a national housing carry trade.

  “[T]he non-rich, non-old liv[ing] paycheck to paycheck”27 would live off the profits and collateral as the Dow rose from 5,000 to 11,000. This collateral, whether physical, conceptual, or psychological, “carried the economy to stratospheric heights.”28 When the stock market ceased to deliver, houses collateralized spending. In 2009, “not only our luck but that of the markets and of the economy has run out.”29

  Interlude—1999: Greenspan Dissembles

  Federal Reserve Chairman Alan Greenspan, before the Committee on Ways and Means, U.S. House of Representatives, January 20, 1999, “State of the Economy”:

  [D]iscussions of consumer spending often continue to emphasize current income from labor and capital as the prime sources of funds, during the 1990s, capital gains, which reflect the valuation of expected future incomes, have taken on a more prominent role in driving our economy. The steep uptrend in asset values of recent years has had important effects on virtually all areas of our economy, but perhaps most significantly on household behavior. It can be seen most clearly in the measured personal saving rate, which has declined from almost six percent in 1992 to effectively zero today. . . . In fact, the net worth of the average household has increased by nearly 50 percent since the end of 1992… . Households have been accumulating resources for retirement or for a rainy day, despite very low measured saving rates. The resolution of this seeming dilemma illustrates the growing role of rising asset values in supporting personal consumption expenditures in recent years. It also illustrates the importance when interpreting our official statistics of taking account of how they deal with changes in asset values.

  25 FOMC meeting transcript, September 24, 1996, pp. 24–25.

  26 One could interpolate Greenspan’s statement later in the meeting, “I recognize there is a stock market bubble at this point” (p. 29), as being inspired by Lindsey, but Greenspan’s train of thought in FOMC meetings was rarely methodical.

  27 Lawrence Lindsey, FOMC meeting transcript, February 3–4 1996, p. 21.

  28 Lawrence Lindsey, FOMC meeting transcript, September 24, 1996, p. 25.

  The Federal Reserve chairman spent the nineties reinterpreting— really reinventing—productivity. Now he was off to the races redefining household wealth.

  2002: The Federal Impoverishment Committee

  The FOMC was preoccupieal with the Stock Market through 2001. In 2002, houses drew greater interest, when members were of two minds.30 Some committee members worried that the funds rate was too low. They thought current policy was inflationary and speculative. (The Fed had cut the funds rate 11 times in 2001, from 6.5 percent to 1.75 percent.) Some worried that the economy was too weak—current policy was not stimulative. Under Greenspan, such a tussle would always favor the stimulators. In the end, the former group was routed: the funds rate would be cut from 1.75 percent to 1.25 percent in November.

  30 FOMC Transcripts are released five years after the meetings. This book addresses transcripts through December 2002. The 2003 transcripts were recently released.

  Even on the day the FOMC cut the funds rate, Anthony Santomero, president of the Fed’s Philadelphia branch, warned about increased borrowing and leveraging: “Real estate lending has continued to rise, and some banks indicate that the pace of refinancings has accelerated.”31 At the next meeting, a Federal Reserve staffer noted: “[T]his productivity growth really reflects higher productivity in the mortgage banking business. . . . that’s real productivity.”32 The economy was operating upside down. It was the speed of financing—of which Lindsey had warned in the previous decade—that operated at a post-human rate and caused a co
nfederacy of mischief.

  The case for a higher funds rate was frequently voiced by FOMC members, especially early in the year. They argued that zero or negative real interest rates—when borrowing rates are below the rate of inflation—encourage senseless borrowing. Greenspan recognized their concern. At the March 2002 meeting, he thought “one could argue in retrospect that we may have moved too fast on the downside.”33 In other words, the fed funds cut from 6.5 percent to 1.75 percent during 2001 was too much, too fast. Nevertheless, Greenspan had a greater concern: “[I]f the mortgage rate goes up, we will get some restraining effects on personal consumption expenditures because a goodly part of PCE [the personal consumption rate] has been financed by equity extraction from the appreciation in housing values.”34

  Greenspan’s reasoning follows: if the Fed were to reintroduce a positive real rate of interest—when borrowing rates are above the inflation rate—consumers might not borrow as much against the equity they had accrued on their houses. He had long believed that consumers needed to spend their equity extraction to buoy the economy.

  This had colored Greenspan’s view at the mid-1990s FOMC meetings and his 1999 Ways and Means testimony. To a central planner, the urgency was greater by 2002, since very little else was expanding. At the November 6 meeting, Edward Gramlich’s opinion catalogued the FOMC’s struggle to identify the source of recovery: “What is going to drive the economy? In the late 1990s it was investment; more recently it has been consumption and housing. What’s next? I can’t find much.”35 Other FOMC members were also at a loss. That was the meeting at which the committee cut the funds rate from 1.75 percent to 1.25 percent. Mortgage finance carried the economy for the next four years.

  31 FOMC meeting transcript, November 6, 2002, p. 43.

  32 FOMC meeting transcript, December 10, 2002, p. 16.

  33 FOMC meeting transcript, March 19, 2002, p. 88.

  34 Ibid., p. 89.

  Greenspan’s speeches and testimony extolled America’s rising “wealth.” This was a charade. House prices were the major portion of household wealth. (This is a number released on the quarterly Federal Reserve flowof-funds statement.) As house prices rose, dwellers could borrow more against this imaginary wealth. This home-equity extraction kept the GDP growing. This rising tide was an illusion, since what it did not change was the debt owed.