The Map and the Territory

by Alan Greenspan

  But at its core is creative destruction, a system of winners and losers. If we wish to achieve ever higher levels of productivity and standards of living, there is no alternative to displacing obsolescent low-productivity facilities with facilities embodying those technologies at the cutting edge. Arithmetic requires it. But there is the inevitable hardship imposed on significant segments of our workforce who lose their jobs and often their homes in that process of displacement.

  POLITICAL SCHISM

  The conflict of goals has manifested itself most visibly in recent battles over American federal budget priorities. These battles have exposed a schism in our national electorate that is unprecedented in our postwar experience. The political conflicts we are currently experiencing reflect the fiscal, monetary, and regulatory paths on which we find ourselves. The angst has had profound effects on long-term business investment confidence, as reflected in suppressed investment in assets with life expectancies over twenty years (see Chapter 7). Following its collapse, hopefully home building is on an important rebound. But at its latest reading (June 2013), single-family housing starts were still only a third of where they were at their peak of seven years ago.

  We need to lift the burden of massive new financial regulation that is becoming increasingly counterproductive (see Chapter 5). Overall business capital expenditures, as a share of cash flow, need to continue to rise from their lowest readings since the Great Depression of the 1930s. If we remove the pall of uncertainty on business and investors and merely return equity premiums to near normal, the rise in stock and other asset prices will do more to galvanize our recently moribund job market than any currently proffered government program (see Chapter 4). Moreover, we need to increase the level of bank lending currently suppressed by the lethargic demand for funds and the perceived need of banks to protect their equity capital (see Chapter 12).

  I recognize that such a reversal will put us back into a mode of elevated creative destruction and rejuvenated animal spirits. I see no alternatives, given human propensities that are prone to excess. I see no way of removing periodic irrational exuberances without at the same time significantly diminishing the average rate of economic growth and standards of living. There was no irrational exuberance in the Soviet Union and none in today’s North Korea. But there was, and is, a depressed standard of living. Rising standards of living require innovators who have unlimited expectation of success and perseverance no matter how many times they fail. Thomas Alva Edison in particular comes to mind. Exuberance (the propensity for optimism) is required—even if at times it runs to excess.

  Our fractional reserve financial structure is inevitably a source of instability. That can be readily addressed, however, by expanding the level of capital requirements of our banks and other financial intermediaries by more than currently contemplated. In doing so, we can remove many of the threats of an unstable financial system. Had large capital buffers been in place in 2005 and 2006, extensive losses would have nonetheless occurred, but they need not have toppled the financial system. With adequate capital, no contagious defaults could have arisen. For some banks, “adequate” equity capital requirements, however, may be too high to produce a competitive return on equity. They will have to shrink or liquidate. But high capital requirements, I strongly suspect, will also nudge the ratio of net income to assets higher in the process, leaving net income as a percent of capital in line with history’s remarkable period of stable returns to equity (see Chapter 5).

  THERE MUST BE A BETTER WAY

  Our highest priority going forward is to fix our broken political system. Short of that, there is no viable long-term solution to our badly warped economy. In America we are being pulled apart politically in ways unrivaled since the aftermath of the 1929 crash.

  Fortunately, modern societies have finally abandoned as unworkable the various economic models of socialism that were so popular a century or more ago. But we need to recognize that welfare states, unless contained, have proven similarly trouble prone. Even the long-vaunted welfare model of Sweden has felt the need for a significant overhaul.6

  Democratic societies such as ours require a broad and deep adherence to a set of principles that are not subject to compromise. As I noted in Chapter 10, for Americans it is our Bill of Rights. But if 300 million people are to live in relative peace and tranquillity, most every other legislative initiative must be subject to compromise. If every debate were on a matter of uncompromisable principle, we could never reach agreement on a functioning set of laws to which virtually the whole society could adhere. Such a condition happened once in this country and it led to wrenching internecine warfare. For the nation’s first nearly three quarters of a century, the festering inconsistency of adhering to the principle that “all men are created equal” yet condoning slavery finally exploded with, and was resolved by, a civil war. Our nation has since fought its way through two world wars, a Great Depression, a constitutional crisis leading to the resignation of a president, and most recently a Supreme Court ruling to determine the outcome of a presidential election.

  My first realization of a striking shift in our politics was brought to my attention by the staunch conservative three-term senator from Utah, Robert Bennett. He feared that despite his strong approval ratings, his 2010 reelection bid was by no means secure. In his 2004 reelection, Bennett won 69 percent of the vote. His problem, as he stated it, was unexpected contenders for his Senate seat from his political right. It was my first awareness of what later came to be known as the Tea Party, a political movement that emerged in 2009 and became a powerful force in the 2010 election.

  THE STAKES

  Both uncompromising sides of our ongoing debate on fiscal and other issues need to recognize that financial crisis lurks should we fail to resolve our deeply disruptive fiscal imbalance. And that imbalance is far greater than the official data portray (see Box 14.3). Differences even of the current magnitude are not new in this country, but as I noted in Chapter 10, we seem to have lost our legislative ability to reach across the aisle to find common ground for solutions. At risk is the status the American economy has held as the preeminent world economic power for more than a century.

  BOX 14.3: CONTINGENT LIABILITIES

  Throughout most of American history, a private bank or firm under stress was expected to either save itself or file for bankruptcy. Government bailouts were almost never on the table. That ethos remained largely intact into the twenty-first century. Even Fannie Mae and Freddie Mac were “officially” not too big to fail as late as 2006. The bailout premise cracked in 2007 and was eviscerated in 2008. The general current expectation in most markets is that large financial institutions and some iconic nonfinancial firms, in trouble, would be rescued by the government. Virtually overnight the liabilities of much, if not most, of finance, along with some nonfinancial debt, became de facto contingent liabilities of the U.S. government (including the Federal Reserve).

  For decades, American sovereign debt has always been a potential, but rare, source of support for private financial intermediaries (Continental Illinois) and nonfinancial firms (Lockheed). But the recent bailout of General Motors and Chrysler has underscored a future willingness on the part of government, as an almost routine policy initiative, to backstop private business far more generously. Central banks in developed countries, more generally, have also made it clear by their actions in 2008 and since that in the event of a future pending default of the private financial system, they will step in and provide as much credit as is required to prevent such defaults and their associated contagion. For finance, such guarantees ultimately lead to a collapsing and consolidating of much of the banking system into the central bank. This has in fact already occurred to the banking systems of the southern Eurozone. Moreover, expansions in a central bank’s assets and monetary base have always created increases in money supply (transaction balances) (see Chapter 12) that, with a long lag, almost invariably ignite the general price level.

  POLITICAL W
ASHINGTON

  My introduction to “political Washington” came in the 1960s when I was first invited to the dinners that were hosted by the Washington Post’s Katharine Graham, pundit Joseph Alsop, and others. To my recollection, the invitees to these dinners were ritualistically half Democrats and half Republicans. Today, attendance at similar dinners is predominantly a 95 to 5 percent split, with either Democrats or Republicans in the majority.

  A NECESSARY IMPERATIVE

  The bias toward unconstrained deficit spending is our top domestic economic problem. During the 1920s and earlier, budget deficits were avoided because there was a fear that they would immediately engender financial distress and inflation. That view, of course, was uninformed and soon was set aside as deficits arose and the sky did not fall.7 But the fact remains that the only way to get permanently lower tax rates is to lower spending. We are fooling ourselves if we believe otherwise. I acknowledge the possibility, or even probability, that we may not be able to solve the social benefits dilemma without some form of crisis that would reset the political incentives toward restraint. But wise heads may preempt such an outcome. I miss the likes of Senators Howard Baker, Bob Dole, Daniel Patrick Moynihan, and Lloyd Bentsen, whose wisdom is sorely needed in today’s halls of Congress.

  So long as the pall of economic uncertainty that created the severe retrenchment of long-lived investments persists (see Chapter 7) and fiscal policy remains in stalemate, inflation is most likely to remain contained. But as economic uncertainty eventually lifts, driven by our propensity for optimism, so will business activity, inflation, and interest rates. But as our experience in the second half of 1979 demonstrated, change can happen unexpectedly and rapidly.8 If late 1979 is any criterion, inflationary crises will engender seminal changes in fiscal policy and politics.

  Contemplating a return to years of balanced government budgets does currently seem a bit of a stretch. Moreover, even if we can retain America’s century-long gross domestic private savings rate that ranged mostly between 15 percent and 20 percent of GDP, we still need to address how those savings will be invested in the future.

  Despite its temporary breakdown in 2008, the U.S. financial system is still clearly in the forefront of global finance, as it has been since the end of World War I. Viable competitors to replace the U.S. dollar as the world’s reserve currency are nowhere in sight. Russia’s financial system has advanced from its Soviet legacy, but its capitalism is more “crony” than it is Adam Smith. China may someday develop highly advanced finance, but that will take many years of cumulative progress on its financial infrastructure and processes. Admittedly, however, our international status is not what it was.

  But before I despair of the future, I need to remind myself that we have been here before. Consider the national psyche of the United States in 1940. We had just been through a near decade of economic stagnation. The future appeared bleak. America’s greatness was in our past. Less than a decade later, the American economy was humming on all cylinders.

  ACKNOWLEDGMENTS

  This book would have barely gotten off the ground, and certainly would never have reached completion, were it not for the dedication of my three key assistants—Noah Hall, Jeffrey Young, and Katie Byers Broom. Noah deciphered and edited my illegible script through the many iterations of the book and contributed significantly to the research behind it as well, both quantitative and qualitative. Jeff conducted the majority of the countless statistical analyses that supported the narrative of the book and controlled the more than sixty exhibits displayed throughout. Katie researched many historical topics and accordingly compiled data series that allowed me to extend much of the book’s pivotal investigations well into our past.

  I am indebted to the large number of my former Federal Reserve Board colleagues who were most helpful in recollecting our shared experiences over my eighteen-year tenure. David Stockton in particular, since retired from the Board, was of immeasurable assistance in the early months of researching and writing this book until previous commitments to the Bank of England called him away. Pat Parkinson, also formerly of the Fed, has kept me abreast on the latest innovations of the derivatives markets. Peter Wallison and Brian Brooks enhanced my understanding of the legal intricacies of mortgage markets.

  For the second time in seven years, Scott Moyers of Penguin Press shepherded me through the joys and agonies of book writing. His clarity of thought helped me structure the arguments of this effort. His colleague at Penguin Press Mally Anderson acted as the liaison between my team and all of the departments at Penguin that had a hand in turning our initial draft of the manuscript into, I trust, a polished, shelf-ready book. She also offered her own valuable editorial insights, particularly in the selection of in-text exhibits.

  Finally, I owe my deepest gratitude to my wife Andrea, whose support and encouragement through pressured periods of writing was indispensable to my effort.

  As I warned in The Age of Turbulence, there are errors in this book. If I knew where they were, I would have fixed them. But of the ninety thousand words, my probabilistic mind tells me some are wrong.

  APPENDICES

  NOTES

  INTRODUCTION

  1. 13 (3) was subsequently altered by Dodd-Frank.

  2. Wolfowitz, incidentally, was the father of Paul, who became president of the World Bank. I was deeply moved when Paul asked me to write a note to his children about the grandfather they never knew.

  3. As I note in Chapter 4, I believe asset price causation is underrepresented in most models.

  4. Effective management that marries human labor and engineering, for example, does require insights into how people interact in the hierarchy of all business organizations, but it is a minor part of nonfinancial decision making.

  5. IMF, World Economic Outlook, April 2007, p. xii.

  6. I mumbled, “I can’t believe we could have a once-in-a-century type of financial crisis without a significant effect on the real economy globally.”

  7. Christina Romer and Jared Bernstein, “The Job Impact of the American Recovery and Reinvestment Plan”; January 9, 2009.

  8. John M. Keynes, The General Theory of Employment Interest and Money (Whitefish, MT: Kessinger Publishers, 1936/2010), pp. 161–62.

  9. Fortune, March 1959. It was not my finest hour. Stocks continued to rise for years.

  10. Undaunted, almost four decades later, I opined that on rare occasions, “fear, whether irrational or otherwise, grips participants and they unthinkingly disengage from risky assets in favor of those providing safety and liquidity. The subtle distinctions that investors make, so critical to the effective operation of financial markets, are abandoned.” (Statement before the Committee on Banking and Financial Services, U.S. House of Representatives, October 1, 1998)

  11. Regression analysis per se measures only the association between variables and the probability that that association is other than by chance. Economic judgment must be applied to indicate causation.

  CHAPTER 1: ANIMAL SPIRITS

  1. An economic model based on the “economic,” that is, rational, man is surely a first approximation. Even Adam Smith, the founder of modern economics, in Wealth of Nations (1776) recognized that reality does not quite fully fit his great insights of the way markets function and self-interest creates wealth.

  2. I have always been intrigued by where such epiphanies originate. I know introspectively that if I accumulate a large amount of seemingly unrelated information, in time, new ideas will pop into my head that organize and draw conclusions from that store of information. I have no awareness of the internal process that, apparently, percolated in the frontal lobe of my brain in a process that reminds me of the workings of an impenetrable black box from which ideas flow without antecedents.

  3. Daniel Kahneman, Thinking, Fast and Slow (New York: Farrar, Straus and Giroux, 2011) p. 4.

  4. Colin Camerer (Cal Tech) and George Loewenstein (Carnegie Mellon), Behavioral Economics: Past, Present, Future (October 2002
), pp.1–2.

  5. Sidney Homer and Richard Sylla, A History of Interest Rates, 3rd ed. (New Brunswick, NJ: Rutgers University Press, 1991).

  6. The choice offered to the children was either to eat one marshmallow immediately or abstain in return for two, fifteen minutes later.

  7. Thorstein Veblen, The Theory of the Leisure Class: An Economic Study of Institutions (1899).

  8. Ori Heffetz of Cornell University conducted an imaginative test of Veblen’s thesis when he separated consumption of goods and services on the basis of their visibility to others. His analysis notes that “income elasticity is . . . higher if a good is visible and lower if it is not.” In passing, Heffetz underscores the historical stability of the propensity in quoting from Plato: “Since . . . appearance tyrannizes over truth and is lord of happiness, to appearance I must devote myself.” Ori Heffetz, “A Test of Conspicuous Consumption: Visibility and Income Elasticities,” The Review of Economics and Statistics 93, no. 4 (November 2011).

  9. Dorothy S. Brady and Rose D. Friedman, “Savings and the Income Distribution,” Studies in Income and Wealth, NBER (1947), pp. 247–65.

  10. Sample surveys of U.S. consumer income and outlay have been published periodically by the U.S. Department of Labor and its predecessors since 1888. I collected data from twenty-one surveys from 1888 to 2012. The raw survey data appeared to have no consistent pattern until I exhibited each income bracket’s ratio of spending to income against each particular year’s average family income. Then, like Brady and Friedman, for all twenty-one surveys, the ratio of spending to income for those households with a third of the nation’s average income concentrate around 1.3 (that is, spending exceeds income by 30 percent). The spending/income ratio then falls eventually to about 0.8 at double the average income level.