The Great Deformation (63 page)

FREE MARKET CATECHISM AND THE ELEPHANT IN THE ROOM

So free market catechism, ironically, became an ideological cover for what amounted to reckless negligence by the central bank. Even long after the fact, when it was evident that capital markets had been turned into dangerous casinos, Greenspan did not hesitate to exonerate the Fed's failure
to rein in the very stock market bubble it had fostered: “I'd come to realize we'd never be able to identify irrational exuberance with certainty, much less act on it, until after the fact. The politicians to whom I explained this did not mind; on the contrary, they were relieved that the Fed was disinclined to try to end the party.”

It goes without saying that the occupational calling of politicians is enabling the party, not ending it. Yet by 1999, even Washington didn't need a central banker to explain the science of bubble detection—it was plainly evident that the Wall Street party had now succumbed to the madness of the crowd. The parabolic path of the NASDAQ index during that final period left nothing to the imagination.

In January 1997, when the Fed had been in the middle of its cogitation about irrational exuberance, the NASDAQ index had stood at 1,200. After it completed its post-LTCM panic-easing cycle in late 1998, the index had doubled to 2,400. And then it doubled again, reaching 5,000 just over a year later in early March of 2000.

In all, the punters on the NASDAQ had bid up the index by an insane magnitude: to wit, by 320 percent in just thirty-nine months. The legendary story of Japanese herd behavior on the eve of its own spectacular crash had now become operative on this side of the Pacific. “If we all cross the street together when the light is red,” the saying went, “how can we meet any harm?”

The catastrophic aftermath of the Japanese equity bubble was plainly evident by the final years of the 1990s, and the harm wasn't merely semi-benign, as the Fed's “wait till it crashes” stance implied. Instead, it was deeply injurious and debilitating, as demonstrated by Japan's post-crash economic stupor.

Japan had been viewed as the world's unstoppable engine of growth at the time Greenspan became chairman in August 1987, but when the Nikkei index plunged from a peak of 50,000 in 1989 to below 10,000 a few years later, the Japanese economy fractured. It recorded virtually zero GDP gain for the entire decade of the 1990s and its financial system collapsed into a smoldering heap of busted assets and unrepayable debts.

This lamentable breakdown did not happen because Japan's fabled “salary men” got tired of working, or because Japanese factories suddenly lost their competitive edge, or because Japan's total dependence on imported raw materials and energy became too burdensome. These were long-standing structural realities and nothing about them changed after 1989.

The Nikkei crash simply did not arise from the real economy. Rather, the Japanese fiasco was the handiwork of Japan's central bank and its reckless
attempt to engineer prosperity by flooding the economy with bank credit, especially after the 1985 Plaza Accord.

So, with the Japanese example squarely on its viewing screen, it was nothing short of astounding that the Greenspan Fed fostered a retracement of nearly the exact bubble path trod by the Bank of Japan. And it did so with about a ten-year lag, meaning it already knew how the movie was going to end.

Indeed, in what amounted to a replay of the Japanese banking bubble, the US banks and the various shadow banking institutions grew by leaps and bounds during the Fed's long money-printing campaign through the eve of the dot-com crash. When this campaign began at the time of the black Monday crash in October 1987, total bank loans and investments along with assets held by money market funds, GSE securities, commercial paper, and repo amounted to about $4.5 trillion.

By the time the NASDAQ began its violent descent in March 2000, however, this total had grown to $17 trillion. And the responsibility for this breakneck rate of expansion in financial assets, almost 11 percent annually over nearly a decade and a half, belonged squarely on the doorstep of the Fed.

In fact, it was self-evident that the $17 trillion in liabilities needed to fund these swollen asset footings had not been generated by a sudden surge in the propensity of households and businesses to save out of current income. The national savings rate had actually plummeted from about 10 percent to 4 percent during this thirteen-year period, meaning that households were putting less into savings accounts, not more.

Instead, the Fed's constant injection of high-powered reserves into the banking system, coupled with the ever increasing visibility and credibility of the Greenspan Put, had fostered a financial chain reaction: newly minted central bank money stimulated rapid private debt extensions, which was used to bid-up asset prices, which elicited more collateralized credit, which drove asset prices still higher.

HONEST SAVINGS VS. CONJURED CREDIT

The Austrian economist Ludwig von Mises had explained this type of credit boom cycle way back in 1911, but by the 1990s the hubris of monetary central planners superseded the plaintive monetary wisdom of an earlier age. In those benighted times, economists and legislators alike knew the difference between the honest savings of the people and bank credit made out of thin air.

To be sure, this staggering explosion of credit money in the banking system had not been a deliberate objective of policy. It happened by default
because by the mid-1990s the Fed had become totally preoccupied with fomenting prosperity by fiddling the funds rate. It had ceased to really care about the growth rate of money and credit.

Indeed, Greenspan had by then put a Nixonian kibosh on Friedman's fixed-rate rule of money supply growth; that is, he had declared it “non-operative,” and for good reason. As indicated, once the Fed permitted overnight “sweep” accounts, whereby demand deposits are turned into savings accounts while we are sleeping, the Fed could no longer measure “money supply” accurately.

Thus, as the now published minutes of its deliberations show, the Fed staff assiduously tracked hundreds of economic variables, including obscure indicators like rail car loadings of crushed stone and gravel. But as the records of its proceedings also show, the FOMC gave short shrift to tracking and assessing the actual mother of all economic variables, which, of course, was credit in all its traditional and shadow banking permutations.

So as the Greenspan era settled in at the Fed, all the historic rule-based approaches to central bank policy, including even Milton Friedman's fixed M1 growth rate, were abandoned. The fusty notions of sound money and financial discipline embodied in the Greenspan 1.0 doctrine had no resonance whatsoever.

Instead, the Fed had declared itself to be in the immodest business of macroeconomic growth and prosperity management. This was the Greenspan 2.0 agenda, and it was to be pursued purely from the ad hoc wisdom and judgment of the twelve members of the FOMC as they parsed and cogitated on the “incoming data.”

Needless to say, there was no small irony in the fact that Ayn Rand's disciple had turned the Fed into a monetary politburo. With a self-assigned mandate to rule the US economy in a manner which was at once plenary and ultimately based on a capricious stab at the unknowable future, the Greenspan Fed insouciantly ambled forward, permitting a huge, boisterous party to rage on Wall Street when every signal light was flashing red with the same warnings that had accompanied the final years of the Japanese bubble.

HOW THE FED TOOK ITSELF HOSTAGE TO WALL STREET

This stance, heedless of history, was rooted in a fatal illusion, widely shared in the Eccles Building, about the Fed's powers to control the American economy. The nation's monetary politburo had come to believe it could deftly maneuver the course of a then-$10 trillion economy through a combination of open market and open mouth operations. Main Street could
then be steered, stimulated, boosted, and braked along whatever glide path of growth, jobs, and inflation the Fed deemed appropriate.

All of this grandiose central planning assumed, of course, that the FOMC had a reliable and efficacious transmission mechanism through which it could implement its intentions. But that is something it did not possess, not by any stretch of the imagination. All of its commands and signals had to be processed by Wall Street, which is to say, the money and capital markets. However, in reacting to the Fed's buying and selling of securities and its targets for the federal funds rate or verbal cues and smoke signals with respect to future policy moves, Wall Street was not positioned as an honest broker.

In fact, it functioned as an aggressive counterparty engaged in trading, arbing, and front running everything the Fed did or said. Moreover, as the Fed pumped more and more reserves into the banking system and displayed an increasing disinclination to lean hard against the resulting bubble in credit and equity prices, its policy target drifted. Stabilization of its Wall Street transmission mechanism, rather than management of the macroeconomy, progressively took control of monetary policy.

As Greenspan candidly admitted in his memoirs, the Fed eventually took itself hostage because it could not rein in its agents on Wall Street. He thus noted that when the Fed's first tightening episode came to an end in February 1995, stock prices had swiftly reverted to their upward path and that “when we tightened again in 1997 … prices again resume[d] their rise after the rate move.”

As the maestro saw it, the Fed was caught in a “puzzle palace” where tightening would have the same effect as easing: “We seemed in effect to be ratcheting up the price move…. If Fed tightening could not knock down stock prices … owning stocks became an ever less risky activity.”

The giant defect in this ratchet theory, however, is that it was based on the Fed's tepid quarter-point federal funds rate moves and its well-telegraphed warnings ahead of time. By contrast, a Volcker-style surprise in which money market rates were dropkicked skyward would not have been so impotent. Greenspan acknowledged as much: “A giant rate hike would be a different story … [With that] we could explode any bubble overnight.”

Not surprisingly, Greenspan rejected that option out of hand because it was in direct conflict with the Fed's prosperity management agenda. Any stringent moves to discipline the financial system and curtail the rampant asset inflation then under way would have been “devastating [to] the economy, wiping out the very growth we sought to protect. We'd be killing the patient to cure the disease.”

Disease was an excellent, if inadvertent, choice of metaphor. By 1998 the US financial system had, in fact, become disease ridden, exhibiting a
metastasizing growth of leverage and speculation which the Fed's own printing-press policies had caused. But in Richard Nixon's memorable phrase, the Fed now found itself to be a “pitiful helpless giant,” fearful of confronting the very bubble it had spawned.

THE HOUSING BUBBLE WAS WAITING IN THE FED'S DRAWER

As conceded by the maestro in slightly more delicate terms, “The idea of addressing the stock market boom directly and preemptively seemed out of reach…. Instead, the Fed would position itself to protect the economy in the event of a crash.”

As will be seen below, the Fed's election to wait it out ignored all of the collateral damage that was being engendered by the 1990s stock market bubble while it was still inflating. Worse still, there had already developed a “consensus within the FOMC” to implement an aggressive money-printing campaign on a post-crash basis.

Greenspan later recalled that having put such a plan in the drawer, the Fed essentially stood around waiting for the stock market to crash; then after the bubble broke “our policy would be to move aggressively, lowering interest rates and flooding the system with liquidity to mitigate the economic fallout.”

Needless to say, what the Fed actually had in the drawer was the next bubble—the housing and real estate mania that would spread the speculative fevers across the length and breadth of Main Street America. Self-evidently, the Fed learned nothing about the danger of keeping interest rates too low and policy too friendly to Wall Street during the stock market boom.

The Fed's panicked reaction to the dot-com crash and the subsequent collapse of telecoms and other high-flying sectors in its aftermath make this abundantly clear. The federal funds rate stood at 6.5 percent on Christmas Eve of December 2000. During the following year rates came tumbling down the monetary chimney, as it were, with a clatter.

THE GREENSPAN RATE-CUTTING CAMPAIGN OF 2001:

CENTRAL BANK PANIC WITHOUT REASON

The Fed cut its policy target rate on eleven separate occasions, so that by Christmas Eve 2001 it had plunged to 1.75 percent. If Wall Street ever had any doubt about the Fed's capacity for panic, this inglorious retreat removed it.

Never in the history of the Federal Reserve had there been anything close to a 75 percent reduction in the policy rate in such a brief time. Yet
there was absolutely no emergency on Main Street. Real personal consumption expenditures during the fourth quarter of 2001 were actually 2.8 percent higher than a year earlier when the rate-cutting panic was initiated. Likewise, real GDP was still at its highest level in history, notwithstanding a heavy liquidation of business inventories during the final four months of 2001 in response to the 9/11 shock.

Thus, the Fed's furious money printing was about braking the fall of the stock averages, not keeping the national economy afloat. And this unnecessary money-printing campaign was indeed furious. By the time the S&P finally hit bottom in February 2003, the Fed's hand-over-fist buying of Treasury debt totaled $120 billion. This represented a 24 percent expansion of its holdings in just twenty-four months.