We know what happened next: Over the ensuing years, the role of the Fed crept significantly, from that of inflation fighter to market therapist, and ultimately to the guarantor of asset prices.
After the 1987 crash, Wall Streeters were relieved. Instead, they should have been concerned. They had unknowingly made a deal with the devil, one that would prove quite costly down the road. The supposedly unique Federal Reserve intervention after the 1987 crash was hardly a one-off—it became the Fed’s modus operandi which continues to this day.
The 1987 crash laid bare many of the structural flaws of the market. During trading of the highest-ever volume on Black Monday, the market’s internal plumbing had failed. Orders were not executed for hours, quotes did not update, and specialists were overwhelmed at their posts. At brokerage firms, phones rang and rang unanswered.
The mechanical functioning of the NYSE was not the result of any intelligent design. The conventions for executing equity orders had evolved on an ad hoc basis. It took the stresses of the crash to reveal the market’s warts.
The President’s Working Group on Financial Markets
In 1988, President Ronald Reagan issued Executive Order 12631 establishing the President’s Working Group (PWG) on Financial Markets. The goal of the PWG was to “enhance the integrity, efficiency, orderliness, and competitiveness of our Nation’s financial markets while maintaining investor confidence.” (Once again with the psychology.)
Twenty years later, it remains a secretive organization, one whose formalized meetings keep no minutes and whose functions are poorly understood. There is surprisingly little academic publishing on this body. Due to its secretive nature, the PWG’s workings are often described in market folklore as “they,” as in “They won’t let the market drop, they were in buying today.”
It wasn’t until 1997 that the PWG received the name by which they are best know today: the Plunge Protection Team (PPT). That was the headline of a Sunday Washington Post article by staff writer Brett D. Fromson.3
For our purposes, the PPT is an irrelevant footnote.
Why? First off, it is hard to imagine a secret cabal manipulating markets, deploying billions or even trillions in capital, with a nary a shred of evidence ever surfacing. The Bush White House couldn’t illegally fire nine U.S. attorneys without the political motivation being discovered and a major investigation launched.4 Could the markets be supported via massive trading, and no one anywhere would ever see proof and come forward? It’s hard to imagine that big a secret being kept for so long.
Second, and more important, the PPT, well, they really suck at their jobs. If the conspiracy theorists are correct and this group is supposed to prevent market meltdowns, they are not exactly hitting the cover off the ball. The late George Carlin had a routine on American Indians’ military organizational structure. They weren’t bad fighters, he said, just because they started out defending Massachusetts and ended up in Santa Monica.
And so it is with the PPT. How is their fighting prowess? Well, consider that starting in 2000, the NASDAQ fell from over 5,100 to about 1,100—a plunge of nearly 80 percent in about two and a half years. And in 2008, the PPT performed even more miserably. Bloomberg reported that as of November 19, 2008, markets were suffering from “the worst annual decline in the Standard & Poor’s 500 index since 1931.”5 The carnage “dragged down every industry in the benchmark gauge and 96 percent of its stocks. Four hundred eighty-two companies slipped as the 500-stock index slumped 46 percent, poised for its biggest yearly retreat in eight decades.” And after the major indexes ended 2008 down more than 40 percent for the year, the first 10 weeks of 2009 saw the markets fall another 22 percent.
Worst annual decline in eight decades? Down another 22 percent in two months? Geez, how incompetent must a secret market-manipulating organization be before someone gets fired?
History teaches us that the development of Bailout Nation, Wall Street edition, was not done in secret meetings. Rather, it occurred in the very public functions of the Federal Reserve, and the subsequent results of its policy actions.
The Greenspan Fed created an endemic culture of excessive risk taking. The U.S. central bank created moral hazard not by targeting inflation or the business cycle, but instead by focusing on asset prices. From the squishy focus on psychology, it was merely a short hop to asset prices. After all, when prices go down, it negatively impacts sentiment, right? This was the Fed’s fatal flaw under Greenspan’s leadership. As we shall see, once those in the capital markets realized that the Fed stood ready to protect the downside via monetary reflation, all bets were on higher prices.
It’s worth recalling that the 1987 crash came mere months into Greenspan’s tenure. The rookie Fed chairman earned high praise for his handling of the situation. There were reports of a mysterious trader entering the S&P futures pits in Chicago to make a large buy order, which helped finally stem the decline; whether that person was an agent of the federal government or just part of Wall Street mythology remains a mystery. But the truth is enough people believed Greenspan’s Fed would approve such an intervention that it helped restore confidence in the markets.
Indeed, one can make a case that Greenspan learned early on that the solution to every problem was to throw money at it—liquidity in the parlance of central bankers—even though doing so ultimately leads to bigger problems down the road.
The 1987 crash was unusual, in that it was a market-based—as opposed to an economic—event. After a 40 percent rise in the first eight months of the year, prices had simply gotten way too far ahead of themselves.
The 1990-1991 recession was a more typical economic event.6 A variety of macroeconomic factors contributed to the slowdown: The S&L crisis, a real estate slump, the first Gulf War, and a spike in energy prices had all taken their toll. Chairman Greenspan found himself hobbled by a near open revolt of FOMC governors. The Fed “curtailed the authority of its chairman, Alan Greenspan, to reduce rates on his own” in between meetings.7
It seems that Greenspan couldn’t help himself: He cut rates half a point just days prior to the February FOMC meeting, despite signs of an economic recovery in the making. This upset the FOMC Board of Governors a great deal.
Why would a Fed chair risk the ire and support of his board—and only a few days before the next FOMC meeting? Perhaps a chart of the equity markets might provide some insight (see Figure 5.1).
Note: The small circles are quarter-point rate cuts; the large circle is a half-point cut. The last cut in 1990 and the first two in 1991 were intermeeting. There would be seven more quarter-point cuts in 1991, and a half-point “Christmas present cut” in late December 1991. By the end of 1992, Fed rates would be as low as 3 percent—and would stay that low until February 1994.
One cannot help but notice how unusual this action was: a half-point cut, made by a Fed chair acting alone, mere days before the next FOMC meeting and with the Dow already in rally mode. While one can never know exactly what another person is thinking, Greenspan’s actions certainly have the appearance of attempting to spur the equity markets.
Figure 5.1 Dow Jones Industrial Average, 1990-1991
By itself, this action can be in part rationalized by other factors—the economic slowdown, the high price of oil, perhaps even the presidential election the following year. However, placing this into the context of Greenspan’s tenure as Fed chairman, one gets a very different impression. This was standard operating procedure for Greenspan throughout his Fed career. Targeting asset prices is seen consistently throughout the 1990s. Even his nickname, “the Maestro,” came about due to the way he skillfully “conducted” the markets.
The Fed’s power to change interest rates as a way to promote and protect asset prices is the key to understanding the Greenspan era. Indeed, it is the crucial economic element that was the precursor to the late 2000 bailouts. Rather than seeing markets as a sign of the economy’s health, the Fed chair tended to see asset prices as an end unto themselves. What this led to was
the treatment of symptoms, rather than underlying causes. The markets’ health, rather than the economy’s, seemed to be what was of paramount importance.
Nobel laureate Paul Krugman, writing presciently in U.S. News & World Report in April 1991,8 noted the sticky issues that the Fed would be facing in the near future:
Even if the U.S. economy begins to recover soon, the current recession will leave a lasting legacy in economic policy making. The downturn has undermined public confidence in the Federal Reserve Board because the Fed missed the slump’s early warning signs. A weaker Fed will now find it harder to resist political pressures to keep interest rates low and growth high. (emphasis added)
Krugman was way ahead of the curve: The public faith in the Fed didn’t falter until after the market crash was well under way (2000-2002). And Greenspan’s reputation didn’t really unravel until the credit crisis and housing collapse were in full bloom (circa 2006-2007). By 2008, the man formerly known as the Maestro saw his reputation in tatters.
But the key to our tale was the low interest rates. Whether it was a result of political pressure or by his own hand, the story of the Federal Reserve under Greenspan is a tale of acquiescence to those pressures. By February 1994, it had been five years since the Fed had last tightened rates.9 It was a preview of what would occur a decade later—only the rates would be taken even lower, and the economic damage would be immeasurably greater.
The tail was just starting to wag the dog.
Over the next few years, numerous events would test the bull market that began in 1982. After the recession of 1990-1991, the next major wobble would be the bankruptcy of Orange County, California, late in 1994. That story is yet another book—try Big Bets Gone Bad by Philippe Jorion (Academic Press, 1995)—but for our purposes, we need only note that it caught the Fed’s attention.
Two weeks later Mexico devalued the peso.
Markets shook off the bad news. The Dow ended the year under 4,000, but began rising shortly after the calendar flipped. By the middle of 1995, the blue chips were well over 4,500—more than a 13 percent gain in half a year. But concerns about Mexico’s stability and its currency issues began to catch up with the indexes. Markets began to stall in midsummer (see Figure 5.2).
On July 6, 1995, Federal Reserve Chairman Alan Greenspan reversed the string of seven rate increases of the prior 12 months and cut the federal funds rate 25 basis points. The Fed would follow with another 25 basis point rate cut in December and yet another in January of the following year.
The Fed justified the July and December rate cuts as done to “decrease slightly the degree of pressure on bank reserve positions.” The January 31, 1996, rate cut was put forth because “moderating economic expansion in recent months has reduced potential inflationary pressures going forward. With price and cost trends already subdued, a slight easing of monetary policy is consistent with contained inflation and sustainable growth.”
Wall Streeters saw it as Alan Greenspan helping them out.
And it was just the beginning.
Figure 5.2 Dow Jones Industrial Average, 1994-1995
Chapter 6
The Irrational Exuberance Era (1996-1999)
[The Fed chairman’s job is] to take away the punch bowl just as the party gets going.
—William McChesney Martin Jr.
All in all, 1995 had been a damned good year for the markets. The broad indexes gained over 34 percent, more than triple the average annual return. It was the first 30+ percent gain for the S&P 500 in 20 years. The last rally as strong was in 1975 (31.1 percent), following the disastrous recession bear market of 1974 (-29.6 percent).
The 1990s sure weren’t the 1970s. This was the early days of a huge tech boom: Semiconductors, software, PCs, the Internet, mobile communications, data storage, and related technologies were all in the early “hockey stick” phase of their growth. When Netscape floated its initial public offering (IPO) in August 1995, it exploded, gaining nearly 500 percent during the first day’s trading. Even bigger IPO opening days would soon follow.
The gains were all the more remarkable considering how 1994 had ended: bankruptcy for the nation’s wealthiest county (Orange County, California) and a rapidly developing Mexican peso crisis. But the economy was expanding and the Federal Reserve was cutting rates—all was right in the world of stocks and finance.
The year 1996 was nearly as good, tacking 20.3 percent on top of the prior year’s gains. In less than two years, the Dow had soared from 3,800 to over 6,600. The market was hot that year—and getting hotter.
It was in this environment that Alan Greenspan first floated the phrase “irrational exuberance.” In a December 1996 speech, Greenspan raised the exuberance issue—and then nearly as quickly dismissed it.
But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade? And how do we factor that assessment into monetary policy? We as central bankers need not be concerned if a collapsing financial asset bubble does not threaten to impair the real economy, its production, jobs, and price stability.1
That speech became infamous for introducing the “irrational exuberance” phrase to the financial lexicon. To the Bailout Nation, there were even more profound reasons the speech was notable. In it we find the basis of not one, but two major Greenspan policies—both of which would emerge to significantly impact markets in the future. They were not recognized as such at the time, but with the benefit of hindsight—and an ensuing decade of Greenspan’s Federal Open Market Committee (FOMC) policy—they are readily apparent to us today.
The first policy shift was Greenspan’s focus on asset prices. This wasn’t a subtle or abstract implication; Greenspan explicitly stated as much in the same speech:
Indeed, the sharp stock market break of 1987 had few negative consequences for the economy. But we should not underestimate or become complacent about the complexity of the interactions of asset markets and the economy. Thus, evaluating shifts in balance sheets generally, and in asset prices particularly, must be an integral part of the development of monetary policy.2
The Fed’s previous rate cuts had only implied a concern over asset prices; now, the chief explicitly affirmed the fact. The Fed was not concerned just about inflation and employment; asset prices were an “integral part” of its calculus, too.
This was revolutionary. Fed chiefs didn’t usually care so much about stock prices; they were more concerned with the bond market. After all, it was the fixed-income traders—known as bond ghouls for their morbid affection for bad economic news—who set interest rates. Worries about deficits, inflation, and trade balances all found a receptive audience among the bond traders.
Once Wall Street figured out Greenspan was concerned about equity prices, it wasn’t too long before it learned how to play the Fed like the devil’s fiddle. When rate cuts did not materialize, the Street would have itself a hissy fit. It is always ill advised to anthropomorphize markets, but observing the market kick and scream when cuts weren’t forthcoming was akin to watching a two-year-old throw a tantrum.3 It may be illegal to manipulate markets, but no trader will ever get thrown in jail for manipulating Alan Greenspan.
The other policy shift hinted at in the “irrational exuberance” speech was the concept of cleaning up after, rather than preventing, asset bubbles and their aftermath. That was precisely what Greenspan implied when he made the incredible statement that “central bankers need not be concerned” about a bubble collapse, so long as it doesn’t leak into the real economy.
Years later Greenspan said: “It is far from obvious that bubbles, even if identified early, can be preempted at lower cost than a substantial economic contraction and possible financial destabilization—the very outcomes we would be seeking to avoid.”4
This is, as any student of market history will tell you, an utterly absurd statement. As we have seen time and again, manias and panics invariably sp
ill over into the real economy. The speech suggests that Greenspan learned precisely the wrong lesson from the 1987 crash. Market bubbles always destroy capital, ruin speculators, and cause all manner of heartache. From the Dutch tulip craze in 1636-1637 and the South Sea bubble in 1720 to the Nifty Fifty stocks in the 1960s, the dot-com bubble in 2000, the housing and credit boom and bust in the 2000s, and the credit and derivatives debacle in 2008, the final results of all investment crazes are lost treasure, blood, and tears.
What the astute student learns from the history of speculative frenzies is that the 1987 crash was a unique aberration, an unusual outcome relative to past collapses. The combination of a hot equity market and the new innovation called portfolio insurance combined with the messy New York Stock Exchange (NYSE) plumbing to create an unusually short-lived, market-driven event in an otherwise robust economy.
The 1987 crash seemed to be the only crash that was (sorry to use a dirty word) “contained.”
Greenspan completely missed this point. The 1987 crash was the rare exception, not the rule. That the chairman of the Federal Reserve failed to recognize this is nothing short of astonishing. Prior to 1987, numerous books had detailed the phenomenon of manias, and the economic fallout that occurs upon their collapse.5 Greenspan was evolving a belief system unsupported by facts or history—and not for the last time, either. That a false premise became the cornerstone of his monetary philosophy goes a long way in explaining what happened next.
But we do not need to theorize to test Chairman Greenspan’s hypothesis. We have explicit proof of the falsity of the thesis: The costs of the 2008-2009 credit bubble and collapse have been astronomical. As of December 2008, the United States has rung up over $14 trillion in bailout-related expenses—and counting.
Bailout Nation Page 7