The Great Deformation (5 page)

TOO BIG TO FAIL SUPPLANTS THE FREE MARKET: THE FED'S VISIBLE HAND

By the time of the September 2008 crisis, however, these long-standing rules of free market capitalism had undergone fateful erosion: traditional rules of market discipline had been steadily superseded by the doctrine of Too Big to Fail (TBTF). The latter arose, in turn, from the notion that the threat of “systemic risk” and a cascading contagion of losses from the failure of any big Wall Street institution would be so calamitous that it warranted an exemption from free market discipline.

But there was no proof of this novel doctrine whatsoever. It implied that capitalism was actually a self-destroying doomsday machine which would first foster giant institutions with wide-ranging linkages, but would then become vulnerable to catastrophe owing to the one thing that happens to every enterprise on the free market—they eventually fail.

In fact, if TBTF implied an eventual catastrophe for the system, there was an obvious solution: a “safe” size limit for banks needed to be determined, and then followed by a 1930s-style Glass-Steagall event in which banking institutions exceeding the limit would be required to be broken up or to make conforming divestitures. Yet while the TBTF debate had gone on for the better part of two decades, this obvious “too big to exist” solution was never seriously put on the table, and for a decisive reason: the nation's central bank during the Greenspan era had become the sponsor and patron of the TBTF doctrine.

This was an astonishing development because it meant that Alan Greenspan, former Ayn Rand disciple and advocate of pure free market capitalism, had gone native upon ascending to the second most powerful job in Washington. In fact, within five months of Greenspan's appointment by Ronald Reagan, who had mistakenly thought Greenspan was a hard-money gold standard advocate, the Fed panicked after the stock market crash in October 1987 and flooded Wall Street with money.

For the first time in its history, therefore, the Fed embraced the level of the S&P 500 as an objective of monetary policy. Worse still, as the massive Greenspan stock market bubble gathered force during the 1990s it had gone even further, embracing the dangerous notion that the central bank could spur economic growth through the “wealth effect” of rising stock prices.

This should have been a shocking wake-up call to friends of the free market. It implied that the state could create prosperity by tricking the people
into thinking they were wealthier, thereby inducing them to borrow and consume more. Indeed, the Greenspan “wealth effects” doctrine was just a gussied-up version of Keynesian stimulus, only targeted at the prosperous classes rather than the government's client classes. Yet it went largely unheralded because Greenspan claimed to be prudently managing the nation's monetary system in a manner consistent with the profoundly erroneous floating-rate money doctrines of Milton Friedman.

Indeed, the Greenspan wealth effects doctrine sounded conservative and reassuring, especially since it was conducted behind a smokescreen of Friedmanite rhetoric about the glories of free markets and the wonders of the 1990s upwelling of new technology and productivity. In fact, Greenspan had made a Faustian bargain: once the Fed got into the stock market–propping and Wall Street–coddling business as tools of monetary policy and took on vast pretensions about its role as the nation's prosperity manager, it could not let the stock market fall back to free market outcomes.

The Greenspan Fed during the 1990s thus conducted a subtle assault on free market capitalism. The nation's level of employment, income, GDP, and general prosperity would no longer be an outcome of the invisible hand; that is, the interaction of millions of producers, consumers, and investors on the free market. Instead, the advance of the American economy now flowed from the visible ministrations of the Federal Reserve, which by the end of the decade had become the omnipotent overlord of daily economic life, influencing every nook and cranny of the nation's $14 trillion gross domestic product (GDP).

Under the maestro's wealth effects gospel, the nation's central bank orchestrated the financial markets, the stock averages, the Treasury yield curve, bank lending, housing credit, the dollar's exchange rate, the flow of merchandise trade, the movements of cross-border capital, and much more. Needless to say, this sweeping usurpation of economic power reflected a virulent outbreak of institutional hubris at the Fed and one of the greatest adventures in mission creep ever conducted by a public agency.

Under the new Greenspan doctrines, the Fed also came to believe that through deft maneuvering it could eliminate all the kinks from the business cycle and unlock virtually every dollar of “potential” GDP. But the Achilles heel to these pretensions could not be gainsaid: the keys to this exceptional macroeconomic performance were sustained financial stability and constantly rising asset prices—conditions which would generate a positive “wealth effect” and a resulting virtuous cycle of higher confidence, consumption, employment, and incomes.

Episodes of abrupt decline in the stock market averages and other financial asset prices were therefore distinctly unwelcome because they threatened
to undermine the “wealth effect” that was implicit in the Fed's new modus operandi. So an embrace of “Too Big to Fail” steadily crept into the Fed's prosperity agenda. It was made official by Greenspan's panicked interest rate cutting and arrangement for a Wall Street subscribed bailout of a reckless gambling hall called Long-Term Capital Management (LTCM) during the minor financial turbulence triggered by the Russian default in August 1998.

Then and there, the “Greenspan Put” was confirmed; that is, the Fed would now pleasure Wall Street with unlimited liquidity and other interventions in order to prop up the stock market averages in the event of a deep sell-off. The road to the Wall Street meltdown of September 2008 was now guaranteed. The only question was when it would occur and what lesser bubbles and busts would occur in the interim.

After the September 1998 LTCM intervention, the insidious idea of shielding financial markets from alleged “systemic risk” contagions became an open objective of monetary policy. Yet this promise of a financial safety net under the market was ultimately self-defeating: it functioned to vastly embolden Wall Street speculators and leverage artists, meaning that the amplitude of financial bubbles and busts would now be all the greater. It also meant that if the Greenspan Put were exercised, financial losses owing to bailouts would inevitably be socialized, thereby putting the innocent American public squarely, albeit involuntarily, in harm's way.

THE FED'S HORRID BAILOUT OF LTCM

The Fed's horridly indefensible rescue of Long-Term Capital Management became the paradigm for what has become a permanent régime of bailouts and central bank rigging of the nation's money and capital markets. To be sure, unwise financial market interventions by Washington had ample precedent, reaching back to the rescue of the money-center banks during the 1994 Mexican peso crisis, the 1984 takeover of Continental Illinois Bank, the 1979 (first) bailout of Chrysler, and the early 1970s bailouts of Franklin National Bank, Penn Central, and Lockheed, among others.

But at least these had been long-standing national institutions with tens of thousands of employees. By contrast, LTCM was a Greenwich-based financial gambling shop that had been in existence less than four years, had a few hundred employees, and supplied nothing useful to the economy except easily replicable trading services. Its Fed-arranged bailout thus had an insidious implication: if in its wisdom the Fed determined that systemwide financial stability was imperiled, then the merits of the firm being rescued were irrelevant—no matter how odious its behavior might have been.

Long-Term Capital Management, in fact, was an egregious financial train wreck that had amassed leverage ratios of 30 to 1 in order to fund giant speculative bets in currency, equity, bond, and derivatives markets around the globe. The sheer recklessness and scale of LTCM's speculations had no parallel in American financial history, easily dwarfing the worst financial pyramids and gambling schemes erected before the 1929 crash by the likes of Samuel Insull, Goldman Sachs, and the American Founders Group, among many notorious others. In short, LTCM stunk to high heaven, and had absolutely no claim on public authority, resources, or even sympathy.

Its tower of leveraged speculation had been enabled by Wall Street's premier financial institutions through massive credit extensions—more than $100 billion. Through every available channel, including prime brokerage, repo desks, and over-the-counter swaps, Wall Street had raced to pump more debt into LTCM's incomprehensible trades. Given those frightful facts, any central bank worth its salt (say, one run by a Paul Volcker) would have permitted, even encouraged, LTCM to undergo a swift and harsh demise.

In pursuit of its prosperity agenda, however, the Greenspan Fed had fallen prey to the spurious doctrine that bull market speculation was evidence of general economic health. Indeed, by keeping the stock indices high and climbing, the Fed presumed it could ensure robust and unending GDP growth, a complete reversal of earlier central banking traditions that worried about “irrational exuberance” on the stock exchanges and embraced the need to timely remove the “punch bowl” before speculation got out of hand.

In a sharp rebuke to the Fed's initial 1990s exercise in bubble finance, the turmoil triggered in global financial markets by the Russian default in August 1998 took the stock averages down by nearly 20 percent in a matter of weeks. While this unexpected market swoon put LTCM and legions of lesser speculators on the ropes, such jarring corrections had previously been largely accepted as a necessary and natural check on greed, debt, and delusion in the financial markets.

In its recently acquired and purportedly superior wisdom, however, the Greenspan Fed nullified this 1998 market correction entirely by a burst of money printing and a sharp reduction in interest rates, in the context of a perfectly healthy and expanding economy (see
chapter 15
). When this dramatic but artificial easing of money market conditions was coupled with the $3 billion collection from Wall Street dealers arranged by the New York Fed for LTCM, it became quickly evident that the “bottom” was in and that henceforth speculators would be riding a one-way escalator ever higher.

During the next fifteen months, the S&P 500 soared by 50 percent, but not because the profit outlook for American companies had suddenly improved by half. Rather, Wall Street had come to believe that investment errors would no longer be punished and that the risk of loss and the interest expense of carrying leveraged trading positions had been dramatically reduced.

Accordingly, valuation multiples on stocks and other equities rose sharply, meaning that the same earnings were now worth a lot more. In fact, just before the dot-com bubble finally broke, the multiple on the NASDAQ had reached 100 times earnings, a level which was nearly sixfold greater than average historical valuations. These nearly lunatic stock prices reflected Wall Street's growing confidence that it had a “friend at the Fed” which could be relied upon to choke off any unwelcome downdraft in asset prices.

This financial safety net became known as the “Greenspan Put,” and according to Wall Street's pitchmen it tilted the stock market toward much reward and little risk. Yet the frothy bull market which it engendered did not evidence a new era of vibrant capitalist prosperity, even if the fawning financial press endlessly proclaimed it. What had arisen, instead, was an ersatz capitalism, a financial régime in which the stock market averages reflect expected monetary juice from the central bank, not anticipated growth of profits from free market enterprises.

Worse still, by ingratiating itself to Wall Street in this manner, the Fed had broadcast an unmistakable message: namely, that there was no imaginable limit to the amount of speculative excess and reckless leverage it would tolerate and backstop if necessary. There was no other plausible inference. The financial recklessness which had been embodied in LTCM was without peer.

A few months later the dot-com bubble reached a fevered top in March 2000—the index for such issues having risen by 900 percent in a mere half decade. Even the Greenspan Put could not sustain the sheer madness that gripped large precincts of the NASDAQ at its parlous peak. Still, the Fed did not grasp how stock prices had gotten to such extreme levels in the first place, nor that its cheap money policies and TBTF promises had eviscerated the natural mechanisms by which financial market speculation is held in check.

Indeed, in response to a barely measurable downturn in the GDP metrics during 2001, the Federal Reserve unleashed a renewed torrent of money printing over the next several years, thereby driving down short-term interest rates to 1 percent, a level which had not been seen since the Great Depression. Soon the cycle of one-way speculation returned with a
vengeance, fueling a boom in real estate and mortgage lending that had no precedent.

During the midst of the housing boom, of course, Fed policy makers insisted that nothing was amiss. Notwithstanding the 100 percent increase in national housing prices since the turn of the century, and the white-hot gains of 200 to 300 percent being recorded in many “sand state” markets, there simply was no visible bubble, according to both Alan Greenspan and his successor, Ben Bernanke.

By their lights, the meteoric rise in housing prices reflected nothing more than a buoyant economy and public confidence in Washington. What they neglected to note, however, was that housing prices were up in the nosebleed section of economic history precisely because the Fed had pushed interest rates down into its sub-basement.