The Alchemists: Three Central Bankers and a World on Fire

by Neil Irwin

  In Jackson Hole in 2005, it seemed as if the world’s economic problems had been more or less solved.

  • • •

  The Federal Reserve Bank in Kansas City, Missouri, one of the twelve regional outposts of the U.S. central bank, in 1978 began hosting an annual conference for scholars to gather and present their research. It was a low-profile affair at first, rotating among various cities and focusing on matters close to the hearts of those living in the Rocky Mountain region the bank served. “Western Water Resources: Coming Problems and the Policy Alternatives” and “Future Sources of Loanable Funds for Agricultural Banks” were two early topics. No one attending the first few conferences would have confused them with events of global significance.

  Roger Guffey, the Kansas City Fed president, and Tom Davis, its head of research, wanted to change that, to make the conference something special among economic policymakers. The first step was to shift the discussion from local concerns such as water and agriculture to broad issues of monetary policy. The next was to attract a top-tier crowd—which meant securing the attendance of Federal Reserve chairman Paul Volcker. Volcker was known to be a devotee of fly fishing, and Guffey and Davis surmised that if they could hold the event at a time and place with good opportunities to fish for trout, Volcker would come—and where Volcker went, the great economists and policymakers of the day would follow.

  Davis called up a contact in Colorado, where the event had been held in the recent past.

  We need a place for our symposium where people can fish for trout, he said.

  “What time of year are you going to hold it?” the contact asked, Davis later recalled. August was the answer.

  “Well, if you’re going to hold it in August, you can’t fish for trout in Colorado because it’s too warm . . . Can you go to Wyoming?”

  As we’ve seen, Volcker was under intense criticism for his high-interest-rate policies back in the muggy former swampland of Washington; the neighborhood where the Fed’s offices are located is called Foggy Bottom for a reason. Debt-loaded farmers surrounded Federal Reserve headquarters with tractors. Texas representative Henry B. Gonzalez even called for the chairman’s impeachment. Guffey and Davis’s 1982 invitation to fish and talk shop somewhere far away from the office couldn’t have been better timed.

  Volcker quickly became a regular in the crisp mountain air of Jackson Hole, one year staying out so long fishing that he showed up for the formal opening dinner still wearing his angling gear. Soon many of the world’s other central bankers started making the voyage to the tiny airstrip hard by the Rockies every August as well. Today, most tourists roaming the Jackson Lake Lodge’s RV-studded parking lot seem unaware that the people milling around near the lobby’s stuffed grizzly bear are among the world’s top economists and most powerful policymakers. They are invariably more impressed by the CNBC camera crew set up outside and the intense-looking, earpiece-wearing security guards than the central bankers themselves.

  The 110 attendees, including a handful of journalists, are chosen by the Kansas City Fed president, with the guest list constrained by the size of the Jackson Lake Lodge’s fur-trapper-modernist ballroom. This is surely the only conference of its type to which a Nobel laureate such as Berkeley economist George Akerlof would find himself invited only as the spouse of San Francisco Fed president Janet Yellen, not on his own account. Inevitably, small talk at the kickoff dinner devolves to analyzing who is and isn’t in attendance that year. New York Times columnist Paul Krugman, himself a Nobel laureate and once a regular attendee, concluded that he was blackballed from the conference for criticizing Greenspan too harshly.

  By 2005, Jackson Hole had its own traditions and even folklore. Don Kohn, who was a Greenspan adviser and vice chairman of the Fed until 2010, leads a Friday afternoon hike known as the Don Kohn Death March for its strenuousness; economists who are happy to chatter about monetary policy transmission mechanisms during the first mile tend to be too winded to do so by the last. The European attendees grumble about the American-style coffee, and one year—no one can quite remember which—European Central Bank president Jean-Claude Trichet gave from the podium a politically incorrect explanation of why the French trappers who first came across the nearby mountains called them “les Grand Tetons.” Then there’s the old saw, repeated with many permutations, about the central banker who entered the lodge’s gift shop and asked for a copy of the New York Times. “Do you want today’s or yesterday’s?” the possibly apocryphal clerk is said to have asked. “Today’s,” replied the perplexed banker. “Then come back tomorrow.”

  In the formal sessions, a series of economists stand and present academic papers on which the rest of the participants then comment, sometimes scathingly. The major economic journals may be considered more desirable venues for works of high-grade macroeconomic theory, but Jackson Hole is where papers on the practical questions of how to manage a modern economy are delivered and discussed. Here the focus is on the concrete decisions facing policymakers. Were interest rates kept too low in major industrial economies in the early years of the 2000s? At Jackson Hole, two top academic economists, John Taylor of Stanford and Alan Blinder of Princeton, might offer contrasting views, both in response to a paper by Charles Bean, the number two official at the Bank of England charged with actually making interest rate decisions for a nation of sixty-two million people.

  But the informal sessions might be a greater attraction for many central bankers, some of whom travel from the other side of the earth to attend. Besides fishing trips and hikes, there are between-session coffee breaks, western-style buffet meals on Friday and Saturday nights, and, for a persistent few, late-night talks at the Blue Heron Lounge over a bottle of Snake River Pale Ale or glasses of whiskey. A few smoke cigars.

  It was over these cigars and meals and coffees and hikes that the “Jackson Hole Consensus” was formed. Bean coined the term in a paper presented at the conference in 2010, referring to the mutually agreed-upon “ingredients of a successful policy framework” for central banking. But the Jackson Hole Consensus was more than just the collective wisdom of the world’s leading central bankers; it was viewed as almost a recipe for how to keep the Great Moderation going. Among the ingredients:

  Monetary policy is the best means of economic stabilization. The messy realities of politics mean that fiscal policy—taxing and spending—isn’t a very good tool for dealing with the routine ups and downs of the economy. Let central bankers handle those by adjusting how much money to push into or suck out of the banking system.

  Central bankers are at their best when insulated from politics. Let us make our own decisions about what is best in the long term, without you politicians hassling us.

  Stable prices are the goal. The best thing we central bankers can do for an economy is make sure that prices change gradually and predictably over time.

  Markets work. The prices of assets—tech stocks, say, or houses in Florida—are determined in markets that are pretty darn efficient. Sure, there might be the occasional bout of irrational exuberance, but it’s better for us to clean up the mess afterward than to try to deal with those bubbles proactively.

  Financial crises are history. An advanced nation, with skilled central bankers and modern financial markets, could never have the kind of catastrophic financial crisis that drags down an entire economy for a generation. We know too much about how to prevent it.

  These ideas weren’t outlandish given what the world was experiencing. Consider the events in the United States just a few years before. The stock market had ascended to too-good-to-be-true heights throughout the late 1990s, rising more than 20 percent each year from 1995 to 1999. Investors had convinced themselves of the emergence of a “New Economy” promising both perpetual prosperity and astonishing returns on even the most ill-planned ventures that happened to have “.com” in their names. Just as that bubble was bursting and reality was setting in, in Septem
ber 2001 the United States suffered a devastating terrorist attack that created a wave of fear and panic across the land, instigated years of war, and even destroyed some of the physical infrastructure of the U.S. financial system by rendering much of lower Manhattan inaccessible.

  And amid all that, what happened? The Federal Reserve began lowering its target for short-term interest rates in January 2001, just as the stock market decline began to pinch the broader economy, and it cut rates eleven times that year—once just six days after the September 11 attacks—so the tumbling stock market was counteracted by cheaper money, which created greater financial incentive for consumers to buy cars and houses and for businesses to borrow money to buy new equipment. The morning of the attacks, the Fed—Greenspan was in transit back from Basel, so Vice Chairman Roger Ferguson was in charge—issued a statement: “The Federal Reserve System is open and operating. The discount window is available to meet liquidity needs.” Translation: The Fed is ready and willing to flood the banking system with dollars to avoid a situation in which Americans show up at their ATMs to withdraw cash but can’t because their bank is out of money. Within a few days, the Fed was swapping dollars with the European Central Bank, the Bank of England, and the Bank of Canada to try to prevent the global banking system from shutting down.

  There was a postboom recession in 2001, all right. But the interventions by the Greenspan Fed were so successful at arresting the economy’s decline that it was the mildest recession of the modern era. By the time the world’s central bankers gathered to honor Greenspan in Jackson Hole, the unemployment rate was back down to 4.9 percent, lower than it had been during even a single month in the 1980s.

  Yet for all the global prosperity that the Jackson Hole Consensus had brought by that August, there were already hints that something was off. In the United States, home prices were reaching untold new highs. By 2006, the average U.S. home cost 5.2 times as much as the median American income. From 1985 to 2000, it’d cost only about three times as much. The increase was even more dramatic in certain parts of the nation, particularly Sun Belt cities like Miami, Phoenix, and Las Vegas, where the real estate market bore more than a few resemblances to the Internet stock boom of a few years earlier. “South Florida is working off a totally new economic model than any of us have ever experienced in the past,” a Miami real estate broker told the New York Times in 2005.

  Lenders made their terms easier, competing for business by offering a proliferation of home loans that bankers never would have considered in a different era: zero-money-down loans, in which a person could buy a house without putting up any cash; stated-income loans—or, as they quickly became known, “liar loans”—in which people declared how much money they made rather than proving it; negative-amortization loans, in which the payments the consumer made each month weren’t even enough to cover the interest due, meaning the amount they owed rose over time rather than fell. It was a new era in which speculation in real estate seemed like a riskless path to fantastic wealth.

  The United States wasn’t the only place where housing prices were climbing to heretofore unknown levels. On the sunny Mediterranean coast of Spain, retirees from Britain and Germany were buying up houses so fiercely that prices rose 145 percent from 1997 to 2005. In Britain, a nation in the midst of the best fifteen years of economic growth in a century, home prices increased 154 percent during the same period. In Ireland, thanks to a favorable business climate and rapid job creation, prices rose 192 percent. Across the planet, people were rapidly concluding that four walls and a roof were more valuable relative to earnings than they had ever been before. The Economist tallied the value of all housing in the developed world as having risen to $70 trillion in 2005, from $30 trillion just five years earlier.

  But the run-up in home prices was an effect, rather than a cause, of some fundamental problems in the world economy. And indeed, the nations where home prices soared were the same ones where household debt levels also rose to previously unknown levels. In 1980, total American household debt—mortgages, credit cards, auto loans, and everything else—amounted to 52 percent of economic output. By 2005, Americans had run up enough debt to put that number at 97 percent, meaning it would take just about one year of the nation’s entire economic production to pay it off.

  Over that quarter century, and particularly from 2000 to 2005, the ability to borrow money easily became a salve for all manner of economic hurts. Jobs may have been scarce at times—both the 1991 and 2001 recessions were followed by slow, “jobless” recoveries—but consumers were able to keep buying things because they could always put them on a credit card or take out a second mortgage when times were tough. The result: Americans in 2005 had $41,000 in household debt for every man, woman, and child in the country, up from $6,400 in 1980. If debt levels had grown only as fast as the overall economy, consumers would have owed less than half as much.

  The details were different in other countries where home prices rose, but the basic trend wasn’t: In Spain, for example, mortgage debt rose at an average rate of 20 percent a year from 2000 to 2004, a period in which home prices rose 16 percent a year. It’s almost impossible for real estate prices to go through that kind of rapid price increase without borrowed money making it possible, which raises a question: Just who was doing all that lending—and why? To answer that, you have to go back a little bit.

  • • •

  In the late 1990s, a string of emerging nations experienced deep financial crises. Investors lost confidence in what had been rapidly growing economies in, among other nations, Thailand, Indonesia, and South Korea and pulled their money out. The countries’ currencies and stock markets collapsed, and millions found themselves newly unemployed. Governments around the world—not just the ones directly affected by that crisis—took a lesson away from the experience: What global investors give—an influx of investment dollars—they can also take away. And they’ll probably take it away at the worst possible time.

  If you’re a head of state in a fast-growing economy, that tells you one big thing: You’d better have a lot of savings in the bank. You need reserves large enough to allow your country to weather a withdrawal by speculators. So you’d better buy some of the safest investments on earth. If you’re an extremely wealthy individual in the developing world—a manufacturing company owner in China, say, or an oil potentate in the Middle East or a well-connected businessman in a former Soviet republic—your thinking is much the same. Why worry about the risk that your government could fall, or that you could lose favor or otherwise lose the great privilege to which you’ve become accustomed?

  The best way to protect against those hazards would be to own a bunch of ultrasafe investments in a country that’s politically stable. For various other idiosyncratic reasons, some cultural, some legal, even people in many advanced countries were similarly eager for safe investments during the early 2000s. Germany, with its saving-oriented populace, had so much money filling its banks that they had to find other places to put their money. With the baby boomers in the world’s advanced economies in their peak earning years, pension funds were desperate for places to park cash, too.

  In 2005, Ben Bernanke, then a Federal Reserve governor, called all of this extra cash the “global savings glut.” Because there was so much of it, there were more people looking for safe, secure places to put money than there were safe, secure places to put it. Capitalism is a powerful force for creating that which is in demand—even something as intangible and elusive as a safe investment. To try to meet the demand for reliable places to park cash—and to make a great deal of money for itself along the way—the finance industry more or less conjured them out of thin air.

  Any one mortgage can be quite risky as an investment. The borrower might lose his or her job and be unable to repay it, or prices in the home’s neighborhood might go down instead of up. But if you put a whole bunch of mortgages together into a single pool that people can buy or sell in financial mar
kets, you get rid of some of that risk. And to turn all those risky mortgages into an ultrasafe investment, you can create tiers: Instead of just one bundled-mortgage bond, there can be several.

  At the bottom is a security for people who want to take on some risk and get a greater return. The first time somebody doesn’t pay back his or her mortgage, those investors lose money—that’s the price they pay for getting a higher return on their investment. At the top is a security for more cautious investors, people who don’t give up a dime until the losses hit, say, 40 percent of what was loaned out. Those investors get paid a much lower return for their investment. But they also have almost no risk of losing their money. After all, what are the odds that so many people will be unable to repay their mortgages? Or that housing prices will have fallen so far that 40 percent of what was loaned out is lost? Low, indeed—or at least it seemed so.

  As if by magic, the financial industry transformed all those risky loans to individual borrowers into that which global investors most coveted—a supersafe investment the firms that rate the safety of bonds would call AAA. The basic idea had been around since the 1980s, but it took off in a previously unseen way in the 2000s. In the United States alone, $901 billion of these privately issued mortgage-backed securities were issued in 2005, up from $36 billion a decade earlier.

  And the trick wasn’t just applied to mortgages; the big financial firms did the same thing with almost any type of loan you could imagine: credit cards, student loans, corporate loans. In the United States, there were $8.1 trillion worth of such securities in existence in 2005, up from $2.6 trillion in 2000. When that number peaked, in 2007, it had reached almost $11 trillion. Each one of those eleven trillion dollars was simultaneously an asset to one party (perhaps a German bank, or South Korea’s government investment fund, or a wealthy Indian) and a debt of someone else (perhaps a family in Florida who bought the three-bedroom house with a pool that they’d long dreamed of using borrowed money, or a family in Kansas who paid for a trip to Disneyland with their credit card, or a real estate developer in New York who bought an office tower at an unprecedentedly high price).