The Great Deformation (59 page)

In reality, however, it was not so simple. As Wayne Angell had intuitively understood from the very beginning, the markets would constantly arbitrage between the cash price and the futures price of the same security or market basket index. That meant that a strong wave of selling or buying in one market would beget a similar pattern in the other. If the wave gathered enough momentum, therefore, this crisscrossing market arbitrage would become a frenzied, self-fueling doomsday machine.

By early 1987, Jim Baker's Texas-style monetary chainsaw had generated a global currency crisis, with the dollar plummeting against virtually every other monetary unit on the planet. So the treasury secretary called another international conference in Paris where he changed the game plan from “student body left” to “student body right.”

Now the dollar was to be supported, not trashed. At the center of the so-called Louvre Accord was an interest rate harmonization initiative: the Fed was to snug up interest rates while the Germans did the opposite. New to his post and not cognizant of the financial chaos that lurked beneath the surface of Milton Friedman's floating money contraption, Greenspan did the right thing under the circumstances.

Pursuant to the classic remedy for a weak currency, he began to raise interest rates. In short order it became evident to market veterans that the Fed's efforts to stabilize the dollar could bring the Reagan boom to a halt, which would then widen the already huge federal deficit and thereby drive interest rates even higher.

THE GREENSPAN PANIC OF OCTOBER 1987:

THE ROAD TO THE BLACKBERRY PANIC OF 2008

In response to these darkening financial clouds, the smart money began to sell in September and the first half of October, thereby bringing the stock market's exuberant advance to a grinding halt. Then during the week of October 12, the dumb money began to sell; that is, the portfolio insurance policies which had spread like wildfire began to kick in, causing the S&P futures pits to be swamped in a wave of sell orders that exceeded Melamed's wildest imagination.

On Black Monday, October 19, the doomsday machine which had become implanted in the Merc's S&P pits literally scorched the earth. By the end of the most violent trading day in world history, the S&P futures contract had plummeted by 29 percent, crushing anything which could be arbitraged against it, including the market basket of stocks known as the S&P 500.

Black Monday was the true inflection point in modern financial history. Then and there Greenspan and Angell had a chance to stop the casino by letting the chips fall. Instead, they hit the panic button, ordering the Fed's
open market desk to flood Wall Street with cash. Many years later, Greenspan recalled that some of the younger staff at the Fed had counseled, “Maybe we're overreacting. Why not wait a few days and see what happens?”

Ironically, Ronald Reagan's initial response had been identical to these unnamed voices toiling in the Eccles Building. The president had counseled “steady as she goes” and added, “I don't think anyone should panic, because all of the economic indicators are solid.”

In fact, they were. The yawning fiscal gap notwithstanding, the nation's economy was not about to plunge into a depressionary spiral. There was a booming 7 percent GDP growth rate in the fourth quarter of 1987 and two more quarters of growth north of 5 percent in 1988.

Perhaps Greenspan knew too much history. Judging that Reagan's statement sounded like Herbert Hoover's infamous “sound and prosperous” pronouncement shortly after the 1929 crash, the new Fed chairman met with Reagan on Tuesday “to suggest he try a different tack.” Meanwhile, the Fed plowed ahead in a firefighting mode, ignoring the fact that the economy was in no real danger.

WRONG-WAY CORRIGAN'S LAUNCH OF “TOO BIG TO FAIL”

Worse still, the Fed initiated all the bad habits of seat-of-the-pants meddling by financial officialdom that later became standard operating procedure in subsequent crises. Yet as gratuitous as these 1987 interventions were proven by history to have been, they were not harmless. Garroting the market's effort to clear bad bets and bad behavior, they most surely sowed the seeds of “too big to fail.”

As would be the case over and over in the future, this mischief was led by the New York Fed. Its president and future Goldman Sachs partner, Gerald Corrigan, frantically made the rounds on Wall Street, bullying banks and trading firms, demanding that they trade with counterparties they didn't trust. Needless to say, this kind of nanny state operation made a mockery of the very principle that Herb Stein cited in behalf of the cash settled futures ruling: namely, that the state has no business interfering in capitalist acts between consenting adults.

In these instances, of course, one of the adults involved didn't wish to consent. Yet here was the New York Fed issuing marching orders for counterparty trades to be cleared anyway, thereby institutionalizing a kind of paternalistic busybody role which became more blatant with each subsequent financial panic.

It also sowed incalculable moral hazard. Since the Fed manhandled all disputed payments to completion, none failed and no one got fired for
unsafe counterparty arrangements. These lax practices were simply allowed to gestate further until the next crisis.

Unaccountably, Alan Greenspan saw no contradiction between his free market philosophy and this kind of capricious meddling. In his memoirs he described Corrigan as “the hero of this effort” and that it was “his job as head of the New York Fed to convince … Wall Street to keep lending and trading—to stay in the game.”

Stay in the game! Eighteen years later, Chuck Prince, the hapless lawyer put in charge of the Citibank train wreck, said the same thing; that is, that he would keep his traders and bankers dancing until the music stopped.

In the cold light of day, it is evident that Greenspan had already fallen into splitting hairs after less than three months on the job. While acknowledging that “ordering a bank to make a loan … would be an abuse of government power,” he also approvingly recited Corrigan's standard speech. He purported to instruct hardened Wall Street financiers on the rudiments of customer relations: “We're not telling you to lend … just remember people have long memories, and if you shut off credit to a customer … he's going to remember that.”

You think? Indeed, why this kind of patronizing Business 101 reeducation message should have led Corrigan to “bite off a few earlobes,” according to Greenspan's description of Corrigan's technique, is not exactly clear. But the real issue was not whether the New York Fed was “urging” as opposed to “ordering” bankers to accept unwelcome counterparty risks. The question was, why did Wall Street need a governmental nanny to help assess risks and clear trades, even in the heat of a sell-off?

WHEN GREENSPAN WHIFFED:

THE END OF FREE MARKET FINANCE

The implication was that free markets don't work when they are most needed, and that the financial system was already broken, dangerously unstable, and not to be trusted in a crisis. And this was at a time in October 1987 before credit default swaps, collateralized debt obligations (CDOs), and many of the other “financial weapons of mass destruction,” as Warren Buffet would later call them, had even been invented.

In fact, Greenspan whiffed on his first time at bat, and in so doing he began to eviscerate the market's capacity for self-correction. This breakdown, in turn, ensured that “free money” liquidity–pumping campaigns would be needed repeatedly to offset future panics in the free market. The Fed was already on the slippery slope.

An even more damaging nanny state intervention occurred the day after the crash. On Tuesday, October 20, the market staged an initial dead-cat
bounce rally but by midday hit an air pocket as buy orders dried up for even the big-cap names of the day. During a frenzied two-hour interval around midday, the New York Stock Exchange came within minutes of closing, and the Merc actually did halt trading for thirty-five minutes because the markets were bidless and in free-fall.

Then suddenly around 12:30
P.M.
the market reignited. It was almost as if the ghost of J. P. Morgan had sent his emissary to the US Steel post and placed a buy order, as he did when he single-handedly stopped the Panic of 1907.

But it was no ghost that placed a flood of buy orders during the post-Tuesday-morning rebound, nor was it even Adam Smith's invisible hand of the market looking for a bargain price. Instead, it was the visible hand of Washington that had begged, browbeaten, and bullied corporate CEOs to rush into the stock market in unison to buy back their own shares.

Apologists might be inclined to excuse this assault on the free market as representing the overwrought emotions of bunkered-down officialdom. Arguably, even the scholarly Greenspan may not have known about Teddy Roosevelt's superb example from the 1907 Wall Street turmoil, when he stayed in the swamps of Louisiana on his bear hunt rather than trouble himself with the commotion at the New York Stock Exchange.

Most assuredly, however, Greenspan and the other officials did not begin to appreciate how booby-trapped the capital markets were with leveraged gambling schemes and speculative computerized trading programs. In fact, by not allowing the market to burn itself out on October 20 and the days that followed, the Fed was actually catalyzing another even more dangerous phase of the speculative bubble.

The market needed an aloof disciplinarian at that historical inflection point. What it got instead was a hand-wringing central bank nanny giving the “all clear” sign when none was warranted.

In truth, the October 1987 crash would have done no lasting damage to the American economy. As in the case of the BlackBerry Panic of 2008, the archives of the Fed and Treasury do not hold even a hastily scribbled analysis of the transmission process by which pricking an immense, artificial bubble in the stock market would have driven the Main Street economy into the drink. As shown in the next chapter, there was no such prospect.

Nor did the Fed even consider the long-run gains foregone due to its market-propping interventions. Portfolio insurance had been an exercise in sheer stupidity, enabled by the cowboys in the S&P pits who were speculating with 5 percent down payments. Mr. Market's vengeful punishment, therefore, was not an irrational outbreak of “animal spirits” as the Fed
implicitly held, but simply a necessary and unavoidable purge of the speculative excesses that had been fostered by the central bank itself. The true meaning of Black Monday was that the monetary system was fundamentally broken and that the cronies of capitalism had been steadily booby-trapping the marketplace with dangerous and unstable financial instruments.

THE MOST THUNDEROUS WAKE-UP CALL IN FINANCIAL HISTORY—IGNORED

The 23 percent stock index drop on Black Monday had been double the 13 percent drop during the worst day of the 1929 crash. The $500 billion in paper losses approximated the GDP of France. Could the nation's central bank have gotten a more urgent warning that the US financial system was already drastically out of kilter?

But the Greenspan Fed misunderstood the most thunderous wake-up call in financial history. Had it not been so attentive to the wails and moans from the trading pits in both New York and Chicago, it might have seen that the post–Camp David régime of printing-press money was also an incubator for speculation and leveraged trading schemes of magnitudes and riskiness that had been theretofore unimaginable.

Greenspan, Angell, and most of the rest of the Fed were perhaps too smitten with the wonders of the free market. Somehow they totally ignored the corrupting influence of the freely printed money they were dispensing.

It's notable that writing about the traumatic events that greeted his first months in office more than twenty years later, Greenspan offered not a single clue as to why the rabid market animal which had bared its teeth on Black Monday had appeared out of the blue. Certainly the Fed had never asked whether the crash had anything to do with its own conduct of monetary policy under the new floating money régime and the now vast marketplace of hedging machinery that had arisen to cope with it.

Instead, the financial futures market was given a clean bill of health, which under the circumstances was preposterous. Leading a whole posse of Wall Street notables gathered to assess the crash, Nick Brady, head of Dillon Read and therefore the managerial heir of the great Douglas Dillon, did not live up to his pedigree. The S&P 500 futures pits had become a raging financial cyclone, dropping by 29 percent in a single day, yet the Dillon Commission did not find much wrong except the need for ameliorative gimmicks like circuit breakers.

So no lessons were learned and seat-of-the-pants monetary policy went on its merry way, functioning increasingly as a central economic planning scheme. For several more years Greenspan remained the incessant data
hound, alert to every movement of scrap iron prices, containerboard shipments, and any sign of incipient goods and services inflation. Ironically, however, he largely ignored the growing menace in the financial markets.

So the age of the Greenspan Put began, even if that was the furthest thing from the chairman's intention. Rather than permit the market to purge the first great speculative bubble which had emerged from the Friedmanite régime of floating central bank money, the Fed had charged forward in just the opposite direction.