Alan Greenspan is the great guru of the American economy, the spell-master over the fortunes of multitudes the world over. Chairman of the U.S. Federal Reserve for nearly 19 years under Presidents Reagan, G. H. W. Bush, Bill Clinton and George W. Bush, he has attained the status of what George Will once called a “fourth arm of government.”As veteran curator of that realm of American national power upon which all others ultimately depend, Greenspan has inspired remarkable deference. He long ago tamed the legislature, to the point that, instead of exercising oversight over his tenure, Congress has ritually idolized rather than interrogated him. Greenspan’s aura has extended even to presidents of the United States. Bill Clinton went so far as to ask Greenspan in 2000 if he would like to be appointed to a fourth term as chairman, or whether he’d prefer to “go out now on top.” The then 73-year-old replied: “Oh, no. This is the greatest job in the world. It’s like eating peanuts. You keep doing it, keep doing it, and you never get tired.” This past July, in the approach to his retirement on January 31, 2006 — mandated by neither age nor fatigue but by statute — Mr. Greenspan made the final scheduled congressional appearance of his remarkable career. Congressmen fell over one another to offer their praise and gratitude. Rep. Artur Davis (D-AL) lauded Greenspan as “a living seminar on economic policy”, while Rep. Steve Pearce (R-NM) put an unbearable strain on the truth in the service of hagiography by describing Greenspan as “a handsome man.” Of course, Greenspan has been subject to criticism from time to time. Senate Minority Leader Harry Reid (D-NV) not long ago called him a “political hack” for endorsing President Bush’s deficit-plumping tax cuts. But general criticism of Greenspan is rare, and he is no less worshipped in the more esoteric world of America’s central banking fraternity. When the Fed’s former vice-chairman, Alan Blinder, was drafted to critique Greenspan’s performance, a thrill of excitement ran through the Fed-watching world. Blinder was known to have resigned from the Fed in a huff, frustrated by the way Greenspan monopolized power. As the stars and close-orbiting satellites of the Fed universe gathered for their annual retreat at Jackson Hole in August, many wondered whether they would be witness to a rare act of central banking apostasy: Would Blinder be so treacherous as to deliver a harsh verdict on The Chairman? Not a chance. Blinder defended Greenspan against his critics and praised his performance as “impressive, encompassing and overwhelmingly beneficial — to the nation, to the institution, and to the practice of monetary policy.” His climactic flourish was to pronounce Greenspan the “greatest central banker who ever lived.” Is he really? Now that his tenure is drawing to a close, it is time to ask how well Greenspan has used his great power, whether his performance has been as good as so many presume, and whether, perhaps, there are some cautionary lessons in his tenure for his successor-designate, Ben Bernanke. We have a first hint of a sober assessment from Allan Meltzer, Greenspan’s friend and colleague of 40 years. Meltzer summarizes the chairman’s record:
The Reagan-Volcker expansion and the Clinton-Greenspan expansion are the two greatest expansions in U.S. history; so he bears some of the praise for that big, long expansion. But on the negative side, it clearly worries him to what extent he was responsible for the rise in stock prices. In other words, Greenspan deserves praise for aiding the long boom that the United States enjoyed from March 1991 to March 2001; but perhaps he shares blame, as well, for the dramatic bust that followed. Meltzer is right on target.
What Goes Up…The American stock market boom of 1996-2000 was the greatest speculative mania the world has ever seen. It was a dizzying display of one of the persistent problems of financial capitalism: the tendency of a rising market to grow beyond all reason into near-hysterical excess. Stock prices tripled in nine years. This was unprecedented, and yet somehow it felt natural. Indeed, the longer the rise ran, the more normal it seemed. “Americans came to expect rising stock prices as their right. It was extraordinary. Everything was perfect, and yet improving”, remarked Wall Street wit James Grant, publisher of Grant’s Interest Rate Observer. The delusion of an eternally expanding stock market spread through the society. Pat Smith and Lynn Roney — the founders of StockmarKids, an investment club for American children-apparently believed that the market’s rising trajectory was so assured that it was as inevitable as growing up: “How else can you help your child put this astounding growth into context?” they asked in their book Wow the Dow! The Complete Guide to Teaching Your Kids How to Invest in the Stockmarket, published in the market’s peak year of 2000. Their answer:
We’ve come up with another one of our handy visual aids that help personalize the Dow for your child. By taking the Dow Jones Industrial Average for each of her birthdays and plotting these numbers to form a growth curve, you can see how the Dow grows along with your child. Yet the stock market rise was far from normal, as many outside observers noted. For example, the top finance official in the Japanese government, Dr. Eisuke Sakakibara — the famous “Mr. Yen” — started referring to the U.S. economy as “bubble.com.” One simple comparison gives a picture, not of the price of individual stocks, but of how a society can allow speculation to grow beyond manageable dimensions — of how the stock market tail can grow so big that it can wag the national economic dog. The scale of the stock market may be gauged by measuring it against the size of the American economy as a whole. Since 1925, the value of all shares has averaged the equivalent of 55 percent of U.S. GDP. Sometimes the stock market has run up to levels well above this. Just before Wall Street’s Great Crash of 1929, for example, stocks were valued at the equivalent of 81 percent of GDP. But that was the highest the ratio reached for another 66 years-that is, until September 1995, when it hit 82 percent. Using the 55 percent average since 1925 as a historical benchmark, 82 percent was clearly a dangerous level, the market’s historical extremity, an omen of collapse. But the mania was just beginning. In 1996, the ratio of the stock market’s total value as a proportion of the economy reached 100 percent. It was at this juncture that Alan Greenspan issued his famous and well-founded warning of the dangers of “irrational exuberance.” The next year the market vaulted to 120 percent of GDP; in 1998, it hit 140 percent; in 1999, it broke 170 percent. At its zenith in March 2000, the market hit a level equal to a whopping 183 percent of U.S. national economic production. If the market had been in line with its long-run average, it would have been valued at $5.3 trillion in 2000. Instead, investors had pushed it to a peak valuation of $17.7 trillion. Three years later, $7.8 trillion of that value had evaporated, making the stock market’s crunch in 2000-03 the most expensive event in the country’s history. For proportion, the second-most expensive event, World War II, cost the country $3.4 trillion in today’s dollars. The two episodes aren’t comparable, of course; wars kill people. But in strictly monetary terms, the bursting of the bubble on Wall Street cost America twice as much as World War II. It was a stunning blow, for the damage was not limited to the investors who had actively taken the risk by putting their money into the market. The national economy itself had been gambled on the fate of the stock market. The stock bubble and the wealth it generated lifted the entire economy aloft, and its bursting dashed the economy into recession. For the three years that followed the crunch, America’s economy grew at an average of half the rate of the previous three — 1.9 percent a year compared to 4.1 percent. More than 2.3 million people were thrown out of work. At the epicenter, New York City, the damage from the collapse of the Great American Bubble eclipsed even the economic cost of the terrorist attacks of September 11, 2001, according to an economist at the New York Federal Reserve, Jason Bram. So what was Alan Greenspan doing while all this was going on? He was watching in full comprehension and quiet apprehension. The transcripts of the Fed’s pivotal policy committee, the rate-setting Federal Open Market Committee, describe a meeting on September 24, 1996, in the Fed’s splendid boardroom in Washington, D.C., in which one of the 12 members of the committee was particularly gripped with anxiety over the state of the stock market. Lawrence Lindsey, former Harvard professor and future economic advisor to George W. Bush, told the committee:
Everyone enjoys an economic party, but the long-term costs of a bubble to the economy and society are potentially great. . . . As in the U.S. in the late 1920s, and Japan in the late 1980s, the case for a central bank ultimately to burst that bubble becomes overwhelming. I think it is far better that we do so while the bubble still resembles surface froth, and before the bubble carries the economy to stratospheric heights. Whenever we do it, it is going to be painful, however. Greenspan responded: “I recognize that there is a stock market bubble problem at this point, and I agree with Governor Lindsey that this is a problem that we should keep an eye on.” The chairman ruminated that it would be tricky to raise interest rates to deflate the bubble. But he canvassed other options:
We do have the possibility of raising major concerns by increasing margin requirements [forcing stock market investors to pay for their shares with more cash and less debt]. I guarantee that if you want to get rid of the bubble, whatever it is, that will do it. My concern is that I am not sure what else it will do. But there are other ways that one can contemplate. He did not elaborate on them.
Somnolence and ExuberanceThere was no failure of comprehension, then, on Greenspan’s part. Five years ahead of the bust, the Fed chairman had correctly diagnosed the bubble. He convened a private hearing on the state of the stock market at the Fed’s headquarters on December 3, 1996. Among those invited were one of the market’s most consistent cheerleaders, Abbey Joseph Cohen of Goldman Sachs, and one of its foremost skeptics, Yale University economist Robert Shiller. The bearish case evidently proved more persuasive than the bullish. The in-house seminar confirmed for Greenspan his view that a dangerous bubble had formed in the stock market. Two days later he took the first public step to do something about it. The occasion was the annual dinner of the American Enterprise Institute, a conservative Washington think tank and incubator for some 30 Bush Administration officials. The speech Greenspan gave that evening, December 5, 1996, was about to present him with the biggest and most dramatic test he had ever faced. For the 1,300 dinner guests who had to suffer through it, however, drama was not the word that came to mind. To those at the black-tie dinner, the speech was interminable, an excruciating survey of two centuries of economic policy. The delivery was every bit as electrifying as the title: “The Challenge of Central Banking in a Democratic Society.” As midnight approached, eyelids drooped. “These occasions are usually very entertaining and lively”, said one regular attendee, Owen Harries, then-editor of The National Interest.
They usually have star performers, and there is a lot of laughter and applause. Greenspan was the dullest I can remember, and I went to eight or nine. It was a most unsuitable lecture-heavy, boring and long. It was an evening of yawns and raised eyebrows. Clearly, the guests did not realize that they had been present at a major news event until they picked up their newspapers the next morning. Here, essentially, is what Greenspan said. First, he reminded his audience that the Fed’s task was to keep prices stable while pursuing the maximum sustainable economic growth. Then he prepared the ground by asking this question: Which prices, exactly, should we be keeping stable? This, he explained, was not a simple question. He suggested that the Fed might have to consider stabilizing not just the price of traditional items — food, clothing, shelter, energy, a haircut — but the price of assets, too, including stock prices. This was a major conceptual shift for a central bank, one thoroughly at odds with prevailing orthodoxy. The orthodoxy said that central banks should only target the price of goods and services, and never the price of assets. The reason? Traditional inflation would cause distortions in economic behavior that would punish investment and destroy long-run growth, but asset prices didn’t matter to the so-called real economy, where businesses invest and produce and people shop and work. Greenspan could see, however, that the risks to the economy had shifted away from traditional inflation to asset price inflation. Indeed, years earlier Greenspan had ventured his own definition of inflation. He said that the Fed aimed to achieve price stability, which he defined this way: “For all practical purposes, price stability means that expected changes in the average price level are small enough and gradual enough that they do not materially enter business and household financial decisions.” It was now plain that while price stability of this sort held for consumer price inflation, it should have been ringing alarms when it came to asset price inflation. The inflation on the stock market had become the dominant influence on consumer spending and on business investment, making it the single biggest force in the economy. In the words of Ed Hyman, a respected economist at the New York consultancy ISI, “The stock market is the economy” — and it was generating vast distortions. Greenspan was alert to the danger, and he demonstrated intellectual and institutional leadership in confronting it. The December 5, 1996 speech was Greenspan at his best:
But how do we know when irrational exuberance has unduly escalated asset values which then become the subject of 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. 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. As Greenspan ground through all 5,000 words of the lecture in his raspy monotone, very few even noticed the two words that were about to reverberate around the world, move trillions of dollars, and enter the English language as a new expression, a new mantra. (Eight years later, those words recur 19,300 times in the Factiva database of English-language newspaper articles and 96,000 times in a Google search.) Financial news reporters, however, picked up the key words instantly and sent them worldwide on the newswires in minutes. The news: The chairman of the U.S. Federal Reserve had publicly questioned whether the stock market was in the grip of “irrational exuberance.” As Greenspan stooped his way back to his seat and grateful guests began to revive, his wife, Andrea Mitchell, asked the dignitaries at the head table whether they had noticed anything newsworthy in the great man’s remarks. Driven to narcolepsy by Greenspan’s delivery, none had been struck by the words that Greenspan had deliberately calibrated to jolt the markets. But investors on the other side of the globe on Tokyo’s then open market floor noticed, and were thunderstruck. The Nikkei average fell by 3 percent that day, its biggest loss of the year. Investors in Hong Kong noticed, too. Stock prices fell by nearly 3 percent. They also noticed in Australia, down 3 percent; in Germany, down 4 percent; and in London, down 2 percent. When the markets opened in New York the next morning, the Dow Jones Industrial Average of 30 leading companies’ stock prices fell by 2 percent — 144.6 points — in the first half hour of trading and ended the day down 55 points.
…Must Come DownAs soon as Greenspan had delivered his oration, he chatted with one of the few guests able to actually follow it, Joseph Stiglitz, a member of the Clinton Administration’s Council of Economic Advisers. “When I approached him after his speech to discuss several of the ideas that he had thrown out, it was clear that he was fixated on the ‘irrational exuberance’ remark”, reported Stiglitz. “He knew that the pundits would know that it was the U.S. rather than Japan that he had in mind. He was worried about the stock market, which was having a blow-out year.” But Stiglitz was puzzled about what came next. “And then…nothing happened”, he wrote in his 2003 retrospective, The Roaring Nineties. “What exactly had Greenspan been up to? If he thought share prices were heading out of control — if he feared the wider effects of a bubble — why didn’t he go ahead and act?” It’s a good question. The market shockwave had been powerful and positive. The hit to share prices was precisely the effect that Greenspan had been seeking. He had indeed injected an element of risk for speculators. The one-way bet of ever-rising stock prices was suddenly in doubt — and that made some of the most powerful men in Washington quite furious. The angriest public reaction came from Senate Majority Leader Trent Lott (R-MS). Three days after the speech, Lott appeared on Fox News Sunday where he was asked, “Does it scare you that one man has that much power?” Lott replied:
You know I’ve always been a little nervous about the Fed, quite frankly. I try not to be a Fed-basher, but I sometimes think they focus too much on one side of the equation, rather than the broader basket of things. And I’m a little nervous about the degree of [their] independence. This was a plain, public threat against the Fed’s independence. The Federal Reserve is a creation of the Congress, Lott was reminding Greenspan, and Congress has the power to redraw the boundaries of the Fed’s freedom. “And I think probably the chairman would say, ‘I wish I had chosen some other words'”, Lott concluded. There was a clear sign of displeasure from the Clinton Administration, as well. It came from Treasury Secretary Robert Rubin, Greenspan’s primary point of contact with the Administration. Rubin’s discontent was even more significant than Lott’s because Rubin had been protecting Greenspan’s Fed from Administration interference for years. Rubin remarked in a television interview, “The chairman was simply raising a question, not suggesting an answer. He was just seeking to widen the intellectual debate over the level of the markets.” Greenspan had made a point of injecting risk into the stock market; now Rubin was taking it out again. It was safe for irrational exuberance, he seemed to be saying. Greenspan is just waffling; there’s no chance that he’ll actually do anything. The chief of the Federal Reserve thus found himself politically surrounded. The Republicans in Congress were angry with him and the Democrats in the Clinton Administration were no longer prepared to protect him. Those two words had put him in a cursed circle, standing alone. No politician would stand by an official whose policy, even if it were in the national interest, could anger his constituents. The situation recalled a rebuke that a Texas Baptist pastor once made of his congressman, Bill Sarpalius, in 1993: “We didn’t send you to Washington to make intelligent decisions. We sent you to represent us.” Twelve days after the celebrated speech, the Federal Open Market Committee met again. The chairman had nothing to say on the subject of the stock market bubble. He did not propose to raise interest rates, reconsider margin-lending requirements, or take any other action. Greenspan’s only remark about his speech was a jocular aside, and the market never looked back—until the ground fell away from under its feet some three years later. Lawrence Lindsey, who had pressed Greenspan to act on the bubble, explained the events of the time this way: “People said, ‘How dare you take our bubble away!'” Lindsey continued: The political reaction was extremely hostile. Greenspan decided that he didn’t have a mandate. The lesson from the irrational exuberance speech was that you have a democratic society in which the vast majority of people benefit enormously from something that may be hazardous in the long run. But that’s supposed to be the whole point of the Fed. Congress gave control of monetary policy to an independent central bank so that the technocrats could make difficult, but necessary, decisions about managing the economy. If Congress just wanted popular economic decisions, it could abolish the Fed and run the economy itself—as it used to do before 1913. Greenspan had set out on a course of what he judged to be wise policy, but then had allowed himself to be cowed by political pressure. During a congressional committee meeting in 2002, one congressman told Greenspan he was “the best politician I have ever seen in Washington.” Greenspan seemed to take it as a compliment: “Thank you” was his only response. Having abandoned his efforts to contain the bubble, the chairman of the U.S. Federal Reserve now became the bubble’s most important accomplice. He did not take a middle course. Rather, he changed direction completely and clasped the whole madness to his aged breast with the zeal of a convert. He provided three essential commodities to bloat and blister the Great American Bubble beyond all American historical experience. First, he went to great lengths to continue supplying the cheap money that all bubbles feed upon. Second, he endorsed the mania and dignified it with his patronage, affirming the sense that the market was correctly recognizing a great historical transformation. And third, he lent an air of assurance to investors, a notion that the Fed would somehow protect them against disaster. The man who was supposed to be the guardian of economic stability and financial prudence became the charismatic leader of a manic cult. Greenspan became so closely identified with the tech frenzy that President Clinton lightheartedly likened him to the object of the speculative mania of the time — a dot-com. He poked gentle fun at the chairman’s enthusiasm: “His devotion to new technologies has been so significant, I’ve been thinking of taking Alan.com public; then we can pay the debt off even before 2015.”
GreenspanismTo return to the question that Professor Meltzer said has been troubling his friend, to what extent was the Fed chairman responsible for the bubble? A group of economists has tried to calculate exactly that. Citing surveys taken in the bubble’s peak year of 2000, the economists pointed out that Greenspan had created the impression in the minds of many investors that he would offer some protection, or insurance, against the risk of a fall in stock prices. Investors believed that Greenspan’s Fed could be relied upon to cut interest rates if the stock market were in trouble, but that it would not raise rates to constrain a bubble. In short, Greenspan had created the idea that the stock market had no downside. “We argue that the asymmetric behavior of the monetary authorities has played a key role as investors came to believe that there was a floor to market prices, but no ceiling”, wrote Marcus Miller and Lei Zhang of the University of Warwick and Paul Weller of the University of Iowa in a paper presented on September 7, 2001. In a computer modeling exercise, the three arrived at the conclusion that investors perceived that Greenspan’s Federal Reserve had reduced the riskiness of investing in stocks by up to 40 percent. “What we describe is not so much ‘irrational exuberance’ as exaggerated faith in the stabilizing power of Mr. Greenspan and the Fed”, the economists concluded. They were not expressing an eccentric or uncommon view. They were merely trying to put a specific value on a phenomenon widely recognized in the market during the bubble years. Call it Greenspanism. As Robert J. Samuelson wrote in the New Republic in 2002, “Trust in Greenspan became, in the late 1990s, almost a religion. The economy might have bad moments, but Alan would find a way out. He was a magician.” Even Robert Rubin was unsettled by the cult of Greenspanism. He wrote in his memoir that, after stepping down from his post as Secretary of the Treasury, “What had struck me after returning to New York was the pervasive assumption that everything would always be well and that any interruptions in the advance of prosperity would be temporary and mild — solvable, in any case, by the Federal Reserve Board.” This was certainly the message that made its way into the minds of ordinary investors. In a 2001 survey of 933 stock market investors conducted for the Securities Investor Protection Corporation, five out of six investors said they believed there was or might be some kind of government insurance for any losses they might suffer in the stock market. These people were, in short, disastrously misinformed. Greenspan, meanwhile, has vigorously defended himself against charges of responsibility for the bubble and its aftermath, and opinion polling shows that he’s been remarkably successful at evading blame. Nonetheless, the legacy of Greenspan’s failure to curb the bubble is clear. That legacy has been threefold. First, as the bubble burst and collapsing stock prices dragged the economy down into recession, the Fed cut interest rates in a dramatic, staccato fashion. Low rates were essential to aiding economic recovery, but they also created a vast pool of cheap money. Where did that money go? Much of it went into housing, inflating a new American bubble, this time in real estate rather than stocks. So to help the economy recover from one bubble, Greenspan created another. Second, the federal government used the national budget to stimulate the economy. It cut taxes and spent money it didn’t have. The consequence was that the federal budget, which had been in balance in 2001, was in deficit by almost half a trillion dollars by 2004. Third, because Greenspan has been busy defending himself, there has been no rethinking of economic doctrine by U.S. authorities. A rethinking has emerged in official circles in other developed countries. In Britain, the European Union, Canada, Australia, Norway, New Zealand and the Swiss-based organization known as “the central bankers’ central bank”, the Bank for International Settlements, a conceptual breakthrough has occurred: an acknowledgment that the authorities do have a legitimate role in managing bubbles to minimize the damage they can inflict. The Great American Bubble has thus been a turning point in the modern world’s understanding of how to manage an economy, but the United States has missed the turn. In a capitalist system, the allocation of capital is central to the organization of the economy and society. One of the main lessons of the 20th century is that the market is the best mechanism to do the allocating. One of the main lessons of the last 400 years of financial capitalism, however, is that this mechanism can be pushed to malfunction by a speculative mania. So it is of central importance to examine epic misallocations to comprehend what went wrong and how they might be avoided in the future. This is the challenge of the times, and it is the challenge that Alan Greenspan was prepared to meet in 1996, before he retreated in the face of political difficulty. Instead of fulfilling his mandate in the face of opposition, he hid himself in the orthodoxy of the day, and in the madness of the crowd. Despite his many signal accomplishments, Alan Greenspan failed this vital test. He will go into retirement a national hero, yet with the uneasy knowledge of this failure no doubt weighing on his mind. He is a brilliant, powerful and successful man, and yet he lacks the leadership and the boldness to be remembered as a great man. He has won many awards and accolades, and the Federal Reserve proudly lists them on its website. But there is one honor he was granted that his official biography does not record: the Enron Award for Public Service in 2001. It was an appropriate tribute for the times.