13 Bankers: The Wall Street Takeover and the Next Financial Meltdown (18 page)

The crucial question was whether to increase spending on social programs and follow through on the campaign pledge of a middle-class tax cut, or to balance the budget in order to keep interest rates low. Rubin was a political liberal in many ways, supporting government social programs and opposing the welfare reform bill of 1996.
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But he believed even more in fiscal responsibility and the importance of building a friendly relationship with the “bond market” in order to provide a foundation for long-term growth. The theory was that the bond market was distrustful of Democratic presidents; if it suspected Clinton of fiscal irresponsibility, it would demand higher yields on U.S. government debt, pushing up interest rates across the economy and stifling economic growth.

At a January 1993 meeting, the Clinton economic team agreed that deficit reduction should be their top priority, in order to establish credibility with Wall Street.
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(This policy prompted Clinton adviser James Carville to say, “I used to think that if there was reincarnation, I wanted to come back as the President or the Pope or as a .400 baseball hitter. But now I would like to come back as the bond market. You can intimidate everybody.”)
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They were betting that by increasing taxes and bringing budget deficits under control, they could reduce interest rates and stimulate growth. These policy choices approximately coincided with the beginning of one of the longest economic booms in recent history—from 1993 to 2000, annual real GDP growth averaged 3.9 percent, while inflation averaged only 1.8 percent
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—although other factors probably contributed to the boom, including the increasing use of computer technology and the impact of globalization.

In early 1995, Rubin succeeded Bentsen as treasury secretary, becoming the administration’s primary economic policymaker, at a crucial moment for the White House. After its resounding defeat in the 1994 congressional elections, many insiders felt that the Democratic Party needed to turn to the left and advocate more populist economic policies. Rubin, however, favored the administration’s centrist course, maintaining a pro-business stance and focusing on deficit reduction. Clinton sided with Rubin, confirming the Democrats’ transformation into a market-oriented, business-friendly party that could be trusted by Wall Street.
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The ascendancy of the former co-chair of a premier investment bank also sent a signal that the administration would be sympathetic to Wall Street. While big business and big banks could historically count on the support of the Republicans, now they could rely on the Democrats as well. With Rubin in place, the government was unlikely to go after any of the new cash cows the financial sector had created in the last two decades, such as securitization, derivatives, or quantitative proprietary trading.

In addition to shaping the economic policies of the Clinton administration, Rubin mentored a generation of Democratic policymakers who are largely sympathetic with his views. He brought in some key Treasury officials directly from Wall Street, including Gensler from Goldman Sachs (now chair of the CFTC) and Lee Sachs from Bear Stearns (now a counselor to the treasury secretary). In contrast, Rubin’s two top protégés did not come from Wall Street, but they largely adopted his perspective on economic and financial issues. Larry Summers, deputy secretary under Rubin and his successor as treasury secretary, was an academic economist and former chief economist at the World Bank. Tim Geithner, assistant secretary and then undersecretary for international affairs, was a career civil servant. But they shared Rubin’s opinion that financial innovation and free markets were generally good for America. Summers opposed derivatives regulation even more strongly than Rubin; in his 2003 memoir, Rubin wrote, “Larry characterized my concerns about derivatives as a preference for playing tennis with wooden racquets—as opposed to the more powerful graphite and titanium ones used today.”
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(Summers and Geithner are now director of the NEC and treasury secretary, respectively.) Rubin was also a founder of the Hamilton Project, a centrist study group based at the Brookings Institution, which served as a way station for rising economy policy specialists such as Peter Orszag (now director of the OMB) and Jason Furman (now deputy director of the NEC). The end result was a Democratic policy establishment that no longer took its cues from unions and consumer advocates, but was now open or even friendly to the positions of Wall Street.

This political realignment was, in many ways, a huge boon to the Democratic Party. “Rubinomics” established the party’s credibility in the eyes of the business and financial communities, repairing the damage done by the perceived economic mismanagement of the Carter administration and helping to balance the fund-raising scales against the Republicans. The long boom of the 1990s, whether or not it should be credited to Clinton-era policies, looked especially good when compared to the record of the George W. Bush administration, which saw slower growth (average real GDP growth of 2.2 percent, down from 3.9 percent under Clinton) and declining median income (falling from $52,500 in 2000 to $50,300 in 2008, both in 2008 dollars).
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The shift of the Republican Party toward “cultural” issues also helped throw more investment banking and hedge fund moguls into Democratic arms.

The story of the Clinton administration demonstrates the key role that influential Wall Street insiders could play in reshaping the landscape of national politics. By 2008, the economic consensus of the Democratic establishment was based on the policies of Clinton, Rubin, and Summers.

In the 1990s, only one figure in the Washington economic elite surpassed Rubin in stature: Alan Greenspan, chair of the Federal Reserve from 1987 until 2006 and one of the most important legacies of the Reagan administration. Although Greenspan was not a Wall Street banker—he headed a New York economic consulting firm for nearly thirty years before becoming Fed chairman—there came to be no truer believer in the ideology of free markets, financial innovation, and deregulation.

Greenspan was a “lifelong libertarian Republican” and a longtime associate of Ayn Rand, the philosopher and novelist who argued for pure laissez-faire capitalism.
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He believed in both the doctrine of efficient markets and the Reagan Revolution against governmental interference in the economy. He looked forward eagerly to a world without government regulation:

Regulation is inherently conservative. It endeavors to maintain the status quo and the special interests who benefit therefrom.… With technological change clearly accelerating, existing regulatory structures are being bypassed, freeing market forces to enhance wealth creation and economic growth.

In finance, regulatory restraints against interstate banking and combinations of investment and commercial banking are being swept away under the pressures of technological change.…

As we move into a new century, the market-stabilizing private regulatory forces should gradually displace many cumbersome, increasingly ineffective government structures. This is a likely outcome since governments, by their nature, cannot adjust sufficiently quickly to a changing environment, which too often veers in unforeseen directions.

The current adult generations are having difficulty adjusting to the acceleration of the uncertainties of today’s silicon driven environment. Fortunately, our children appear to thrive on it. The future accordingly looks bright.
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Greenspan was naturally predisposed to be friendly toward the financial sector and its desire to be left alone by government. As a central banker, he first made his mark injecting liquidity into the financial system to pull the stock market out of its 23 percent fall on Black Monday, October 19, 1987. This was the first example of what came to be known as the “Greenspan put”—the idea that if trouble occurred in the markets, the Fed would come to their rescue.
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Greenspan cut interest rates sharply in 1998 following the Russian crisis and in 2001 following the collapse of the Internet bubble, each time helping to cushion the impact of the downturn and arguably pumping up the next bubble. The underlying theory, set out in Greenspan’s famous 1996 “irrational exuberance” speech, was that the Fed should not attempt to head off bubbles, but instead should focus on helping the economy recover when those bubbles popped: “[H]ow 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? … 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.”
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This position was an endorsement of the Efficient Markets Hypothesis and the idea that the Fed should not attempt to determine if prices are accurate, but should leave that function to the markets.

Wall Street appreciated Greenspan’s monetary policy, because it meant that he would not raise interest rates preemptively to choke off a boom (unless that boom was also creating higher inflation). But it appreciated his hands-off regulatory policy even more. The Federal Reserve is one of the most important financial regulatory agencies, not only regulating bank holding companies but also enforcing consumer protection laws. But for almost two decades it was led by a man whose faith in financial innovation outweighed any interest he had in regulating the financial sector, and who had entered public life in order to “engage in efforts to advance free-market capitalism as an insider.”
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For example, Greenspan strongly believed that financial derivatives served a valuable role in dispersing risk throughout the financial system, and that market participants were sophisticated enough to manage the risks created by derivatives. In July 2003, he told the Senate Banking Committee,

What we have found over the years in the marketplace is that derivatives have been an extraordinarily useful vehicle to transfer risk from those who shouldn’t be taking it to those who are willing to and are capable of doing so.… The vast increase in the size of the over-the-counter derivatives markets is the result of the market finding them a very useful vehicle. And the question is, should these be regulated? Well, indeed, for the United States, they are obviously regulated to the extent that banks, being the crucial creators of these derivatives, are regulated by the banking agencies, but not beyond that. And the reason why we think it would be a mistake to go beyond that degree of regulation is that these derivative transactions are transactions amongst professionals.
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For Greenspan, the rapid growth of the derivatives market was
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that they were socially beneficial. He believed, like many free market purists, that markets are self-regulating, and that as long as market participants have sufficient information, they will be aware of any potential dangers and protect themselves from them, and therefore outcomes in an unregulated market are necessarily good. This attitude even extended to fraud; as Brooksley Born recounted, “He explained there wasn’t a need for a law against fraud because if a floor broker was committing fraud, the customer would figure it out and stop doing business with him.”
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Greenspan dominated the Fed during his tenure, and his views became close to dogma on the Board of Governors. At an August 2005 symposium held by the Kansas City Federal Reserve Bank to honor Greenspan, Raghuram Rajan presented a paper asking in prophetic detail whether deregulation and innovation had increased rather than decreased risk in the financial system.
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Rajan, then chief economist of the International Monetary Fund, was met with a torrent of attacks by Greenspan’s defenders.
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Fed vice chair Donald Kohn responded by restating what he called the “Greenspan doctrine.” Kohn argued that self-regulation is preferable to government regulation (“the actions of private parties to protect themselves … are generally quite effective. Government regulation risks undermining private regulation and financial stability”); financial innovation reduces risk (“As a consequence of greater diversification of risks and of sources of funds, problems in the financial sector are less likely to intensify shocks hitting the economy and financial market”); and Greenspan’s monetary policy resulted in a safer world (“To the extent that these policy strategies reduce the amplitude of fluctuations in output and prices and contain financial crises, risks are genuinely lower”). Kohn’s conclusion reflected the prevailing view of Greenspan at the time: “such policies [recommended by Rajan] would result in less accurate asset pricing, reduce public welfare on balance, and definitely be at odds with the tradition of policy excellence of the person whose era we are examining at this conference.”
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Larry Summers more directly said he found “the basic, slightly lead-eyed premise of [Rajan’s] paper to be misguided.”
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Besides his considerable powers as steward of U.S. monetary policy and one of the chief regulators of the financial sector, Greenspan also mattered because of his tremendous public stature. As the U.S. economy settled into a long boom with falling unemployment and low inflation, he became probably the world’s most famous and respected economist. If Greenspan said that derivatives improved the management of risk and financial innovation was always good, that provided cover for anyone in Washington who didn’t know what to think about the issue.