The Chastening

by Paul Blustein

  It was no laughing matter, however, that the United States was now seen by some observers as having behaved essentially the same as those Asian countries that Washington so often scolded for propping up insolvent financial institutions. At the Treasury staff meeting that morning, the discussion quickly turned serious about how to rebut the criticism that was already starting to pour in from abroad and at home. The key point, the meeting participants agreed, was that the Fed’s actions couldn’t be called a bailout, since no taxpayer money was being used, Just the central bank’s good offices. Moreover, Long-Term’s partners were losing 90 percent of their equity in the firm, so although they were in better shape than they would have been under a default scenario, they were not being made whole.

  Those arguments did not allay the moral-hazard concerns of experts like Burton Malkiel, an economics professor at Princeton, and J. P. Mei, a business professor at New York University, whose analysis in The Wall Street Journal on September 29, 1998, was particularly trenchant:If unsuccessful hedge funds are not allowed to fail, if brokerage firms believe they will somehow be protected from the effects of far too liberal margin requirements, if banks believe help will be forthcoming should loans go sour during unsettled market conditions, how will we discipline future decisions of investors and lenders? Will such intervention make our financial system even more fragile later?

  ... To be sure, the current intervention resembles a bankruptcy reorganization more than a true bailout. What distinguishes this rescue, however, is the active role played by an agency of the U.S. government. Anything that weakens the effect of market discipline and that lessens the punishment the market affords speculators when they have made incorrect decisions is likely in the long run to lead to more instability.

  Greenspan and McDonough faced unusually caustic questioning at a four-and-a-half-hour congressional hearing on October 1. “We hear a lot of speeches about free enterprise and the marketplace,” complained Rep. Bruce Vento, a Minnesota Democrat. “There seem to be two rules, a double standard: one for Main Street and another for Wall Street.” In a like vein, Rep. Spencer Bachus III, an Alabama Republican, said that since Washington had told welfare mothers and small business executives to fend for themselves, the same message “ought to also apply to rich Greenwich, Connecticut, investors who are multimillionaires.”

  But Greenspan, who held perhaps the greatest concerns among top U.S. officials about moral hazard, did not believe such criticism outweighed the Justification for intervening. He later told associates that he might have preferred if the meeting of the bank and brokerage firm executives had been held at one of the firms’ offices instead of the New York Fed. But since the Fed had done nothing more than help people draw conclusions about their own self-interest, he saw no great harm done and possibly much good. “Financial market participants were already unsettled by recent global events,” he said in his congressional testimony. “Had the failure of [Long-Term] triggered the seizing up of markets, substantial damage could have been inflicted on many market participants, including some not directly involved in the firm, and could have potentially impaired the economies of many nations, including our own.”

  Nobody can say whether that damage would have been as great as Fisher, McDonough, Greenspan, and the other policymakers feared. But they certainly perceived grave risks, and although their success in addressing those risks deserves credit, it is hardly comforting that those risks came so close to materializing.

  Alan Greenspan was never explicit in public about what the Federal Reserve intended to do about interest rates. But when he appeared before the Senate Budget Committee on September 23, 1998, the seventy-two-year-old Fed chairman was as plainspoken as he ever got in hinting that a rate cut was coming. “I think we know where we have to go,” he said. “I do not think we underestimate the severity of the problems with which we are dealing.” As markets cheered—the Dow closed up 257 points that day—Greenspan cited a litany of factors impelling the Fed toward an easier credit policy. “The more recent, more virulent phase of the crisis has infected our markets,” he said. “Flows of funds through financial markets have been disrupted, at least temporarily.... Issuance of equity, and of bonds by lower-rated corporations, has come virtually to a halt. Even investment-grade companies have cut back substantially on their borrowing in capital markets.” And although some corporations shut out of the bond markets were tapping banks for their cash needs, Greenspan was concerned about surveys of bankers showing that this source of funding might soon dry up as well. “Banks also are reportedly becoming more cautious and more expensive lenders to many companies,” he said. Accordingly, financial market stability must be restored “reasonably shortly to prevent the contagion from spilling over and creating difficulties for all of us.”

  Still, Greenspan’s remarks left a major question for the markets to puzzle over: How much would the Fed cut rates? For a year and a half, the central bank had kept the federal funds rate—the key overnight lending rate for banks—at a steady 5.5 percent. Now speculation was mounting about what would happen to that rate at the following week’s meeting of the Federal Open Market Committee (FOMC) on September 29. Would the Fed lower the rate by 25 basis points (a quarter of a percentage point)? Fifty basis points? More? A lot was riding on the outcome. If the Fed cut rates only 0.25 percent, markets might draw the disheartening conclusion that Greenspan and his colleagues didn’t comprehend the extent to which the financial system was teetering. On the other hand, a bigger move might generate concerns that the Fed was aware of even worse problems in the system than were already known.

  At the New York Fed, Peter Fisher was contacting Wall Street bond traders and analysts to gauge the likely market reaction to each option. This sort of intelligence-gathering is an art form at which Fisher was well-practiced, and which he performed with the utmost care, because the traders were naturally cocking their ears for the slightest hint about which way the central bank was leaning. So as was his custom, Fisher asked his questions often and in a neutral way so as to avoid providing any information. Is the market now “pricing in” a Fed easing? (That is, have traders already factored the assumption of a lower federal funds rate into the price of securities?) If so, how much of a Fed easing has been priced in? Is the trading activity in various government securities—say, the one-year and two-year Treasury notes—reflecting the anticipation of a Fed move, or is some other factor involved?

  The dominant voice in the market was that the Fed had to do something—but it wasn’t clear whether that something ought to be a 25-basis-point rate cut or a larger one, Just so long as it was something.

  The group charged with making the final call, the FOMC, is one of Washington’s most peculiar decisionmaking bodies, deliberately designed to be insulated from short-term political pressure without being totally insensitive to the demands of the American people and their elected representatives. Among its twelve voting members are the seven governors of the Washington-based Reserve Board, who are appointed to fourteen-year terms by the president and confirmed by the Senate. (The chairman’s and vice chairman’s terms are four years, though they are legally entitled to serve their full terms as board members if they wish.) Another vote belongs to the president of the New York Fed, and the other four votes are apportioned on an annually rotating basis among the remaining eleven reservebank presidents (the heads of the Kansas City Fed, the San Francisco Fed, the Chicago Fed, and so forth).

  FOMC members—many of whom are economists, though others are bankers or banking experts—arrive at the eight meetings each year well briefed on business and financial conditions. Seated around a massive oval table, they spend hours in decorous debate, seeking to agree on a “directive” summarizing goals for money growth and the federal funds rate over the period before the next meeting. The directive, an abstruse document, guides the trading desk at the New York Fed as it buys and sells Treasury bills in an effort to achieve the panel’s targets.

  The chairman’s power w
ithin the FOMC is considerable. He controls the agenda and directs the Washington staff, which prepares the so-called blue book containing policy options for each meeting. But much of the chairman’s power flows from the loyalty that FOMC members, some of whom are former Fed staffers themselves, show their institution and its chief. Members who frequently dissent or repeat dogmatic arguments tend to become isolated and lose influence.

  Greenspan, whose Fed chairmanship began in August 1987, derived much of his clout from his expertise as an economic forecaster. Except for a two-year stint as chairman of the Council of Economic Advisers under President Ford, his career prior to the Fed was spent running an economic consulting firm, where he earned a national reputation and a lucrative client list based on meticulous scrutiny of statistics concerning manufacturing, labor markets, credit conditions, and other indicators suggesting when and how the economy was likely to grow, slow, or contract. Greenspan treated his Fed colleagues with deference, using his wry sense of humor to soften disagreements. But those who challenged him had a high burden of proof, for Greenspan steeped himself in the economy’s minutiae, constantly mining the central bank’s unrivaled data-gathering capabilities and probing its staff of over 200 economists for insights on linkages, trends, and statistical quirks. (An example: What are the implications, he once queried a group of staffers, of the Mortgage Bankers Association’s mortgage-refinancing index in weeks with a holiday?)

  Scrutinizing the data, in Greenspan’s view, was essential because monetary policy works with a lag; that is, a change in interest rates usually takes nine months or even more before it produces an impact on output, Jobs, and pricing decisions. Accordingly, as Greenspan once put it, “We need to be forward-looking.... There is no alternative to basing actions on forecasts.” His prognostications sometimes missed the mark, notably in 1991 when he overestimated the strength of the economy and kept interest rates high, contributing to a brief recession. But his 1991 mistake faded into memory as the Fed kept the economy humming with stable prices well into the second half of the 1990s. By mid-1998, his image as a peerless economic helmsman had reached an all-time high thanks to his apparent success in orchestrating a “Goldilocks economy”—not too hot, not too cold, but Just right.

  But the FOMC meeting on September 29, 1998, was concerned with something different from the usual questions about how a rate change might affect homebuying and business capital spending and other aspects of the “real” economy. The concern was the much more immediate and intangible problem of how to restore confidence in the financial markets. The staff presented a forecast showing a considerable slowing in the economy in months ahead, even though almost no data had emerged showing that consumers or businesses were reducing spending; the forecast was based mainly on expectations about how the market upheaval would affect consumer and business behavior.

  Debate at the meeting revolved around this issue: Since the Fed had kept the funds rate unchanged for so long, was it sufficient for the central bank to move in the direction the markets were so desperate to see, even if only by a quarter of a point? Or did the Fed have to move further, to send a clearer signal of its intentions to take whatever steps were required to alleviate the markets’ stress? The preponderance of views, including Greenspan’s, favored the 25-basis-point option. The panel’s hawks argued that although the risk of rising inflation may be receding, it was not eliminated, so a larger easing would be unwise. Others warned that a half-point rate cut might spook the markets by conveying an exaggerated sense of the Fed’s worries. Greenspan himself felt the Fed ought to keep as much of its powder dry as possible; the central bank would likely have to cut rates again soon, depending on what happened in the markets, so it should move incrementally at first.

  Following Greenspan’s lead, the committee unanimously approved the 25-basis-point cut. Rivlin favored a 50-basis-point move but didn’t argue particularly strongly for it; as she admitted later, “It was a close question.” One reassuring consideration was that the Fed could change the rate again, if it chose, before the next FOMC meeting, although it had not taken such action between meetings since 1994. Indeed, the committee, despite misgivings among some of the hawks, adopted an “asymmetric directive,” implying a bias in favor of another easing move. In classic Fedspeak, the directive stated: “A slightly higher federal funds rate might or a somewhat lower federal funds rate would be acceptable in the intermeeting period.” (The tipoff: “would” is a stronger word than “might.”)

  In the early afternoon of September 29, the Fed announced the committee’s decision to cut the funds rate by 25 basis points, citing “recent changes in the global economy and adjustments in U.S. financial markets,” but it said nothing about the bias in favor of ease. The markets first yawned with disappointment—then all hell broke loose.

  The Dow fell 28 points the day of the announcement, then 237 points the next day, and 210 the next. More distressing, from Fed officials’ points of view, was the continued dash for safety in the bond markets. On September 30, the yield on the thirty-year Treasury bond fell below 5 percent for the first time since the administration of Lyndon Johnson, and the following day the yield fell to 4.88 percent—down nearly a quarter of a percentage point in two days, an astonishingly rapid move for such a supposedly stable government security. Although the decline in Treasury yields might sound like good news, it meant that the market’s faith was continuing to erode in any bond lacking Uncle Sam’s imprimatur. Foreign stock markets also took a drubbing on September 30, with Brazil down 9.6 percent, Frankfurt off 7.6 percent, and Paris shedding 5 percent. “The message [of the 25-basis-point cut in the funds rate] was supposed to be, ‘We’re on the case, and if the situation demands, we’ll do more,’” said Fed Governor Laurence Meyer. “That latter part of the message didn’t get across.”

  The Fed’s image as a crisis-fighter suffered as well, even among the general public. A few days after the meeting, Edward Boehne, president of the Philadelphia Fed, checked into a hotel in a small Pennsylvania town, where the clerk looked at his title and declared: “You didn’t do enough.”

  Before the era of antiglobalization protests, the annual meetings of the IMF and World Bank were renowned for glittery social gatherings, and the conclave held the first week of October 1998 was no different, notwithstanding the dismal state of global economic affairs. Limousines clogged Washington’s downtown streets as they always had during these meetings, which attracted several thousand financiers from all over the world eager to rub elbows with top economic policymakers and potential business partners. Guests feasted on pea pancakes topped with caviar, oysters on the half shell, bowls of shrimp, and platters of lamb at a reception hosted by the National Commercial Bank of Saudi Arabia at the National Air and Space Museum. Merrill Lynch held a party at a Georgetown estate once owned by descendants of Martha Washington’s family, where attendants wearing colonial costumes played musical instruments and announced guests as they arrived. At the Turkish Bankers Association’s reception, plates of sumptuous Turkish specialties were piled high. The Phillips Gallery, with its famous collection of Impressionist paintings, was the site of J. P. Morgan & Co.’s soiree, and Goldman, Sachs chose the Corcoran Gallery as its party locale.

  Yet as the liquor flowed, the tuxedo-clad waiters hovered, and the string quartets serenaded, the mood among the partygoers was bleak, sometimes shockingly so. Vernon Jordan, the high-powered attorney and Clinton golfing buddy, held a dinner party at his northwest Washington home, and asked five or six of his most prominent guests, including Larry Summers and Jim Wolfensohn, to say something after dinner about where the global economy was going. Their assessments “all had the same world-is-coming-to-an-end theme,” recalled James Harmon, then president of the U.S. Export-Import Bank, whose wife remarked to him as they were leaving the party: “My God, we’re all going to be buying canned goods!”

  The pessimism was not uniform. Europeans came to the meetings far less alarmed than the Americans, and they were taken aba
ck by the dire tone of their U.S.-based counterparts, in both the public and private sectors. The Europeans had seen little if any evidence in their markets of banks and bondholders refusing to extend credit, so “it was striking to see these American financial figures panicking,” said one British official. At a breakfast organized by a major New York-based commercial bank, top European central bankers listened agape as the bank’s CEO warned them to brace themselves for the fallout that would soon ensue when his bank withdrew its credit lines from every hedge fund it had ever financed.

  Partly as a result of these differences in perception, sharp clashes marred the weeklong meetings. To U.S. and IMF officials, the Europeans were hopelessly inward-looking, obsessed with the forthcoming launch of the euro and clueless regarding the likely impact of the crisis on their countries’ economies. As far as the Europeans were concerned, American officials were overreacting to the Long-Term problem and seemed excessively eager to take bold action—perhaps, the Europeans suspected, because of Clinton’s desire to look presidential and bury the Monica Lewinsky scandal.

  Fueling the antagonism was Clinton’s announcement on October 2, Just as the meetings were getting under way, of a proposal for a change in the IMF’s strategy that was aimed at enabling the Fund to act earlier in heading off crises before they started. The president unveiled the proposal during remarks on the South Lawn of the White House only hours before the House Judiciary Committee was scheduled to release voluminous grand Jury testimony and other documents concerning the Lewinsky case—no coincidence, as far as the Europeans were concerned. “We have got a vested interest in averting a global financial slowdown by taking initiatives and doing it now,” Clinton declared. “We know we are going into an unprecedented time. This country has got to lead.”