The Greenspan Fed: a tragedy of errors

Mr Greenspan’s apologia pro vita sua in the Financial Times of Monday, April 7 2008 fails to convince.

  1. The Greenspan Fed (August 1987 – January 2006) did indeed contribute, through excessively lax monetary policy, to the US housing boom that has now turned to bust.
  2. The Greenspan-Bernanke put is real. It is an example of an inappropriate monetary policy response to a stock market decline.
  3. The Greenspan Fed focused erroneously on core inflation, rather than using all available brain cells to predict underlying headline inflation in the medium term.
  4. The Greenspan Fed failed to appreciate the downside of the rapid securitisation during the first half of this decade and acted exclusively as a cheerleader for its undoubted virtues.
  5. The Greenspan Fed displayed a naive faith in the self-regulating and self-policing properties of financial markets and private financial institutions.
  6. The Greenspan Fed, by enabling the rescue of Long Term Capital Management in 1998, acted as a moral hazard incubator.
  7. The failure of the Greenspan Fed to press, before or after LTCM, for a special insolvency resolution regime with prompt corrective action features for all highly leveraged private financial institutions that were likely to be deemed too big and too systemically important to fail, demonstrates either bad judgement or regulatory capture.
  8. During his years as Chairman of the Federal Reserve Board, Mr. Greenspan’s statements reflected a partial (in every sense of the world) understanding of how free competitive markets based on private ownership work. This partial understanding guided his actions as monetary policy maker and financial regulator. Mr Greenspan’s theories have been comprehensively refuted by the financial crises of 1997/98 and 2007/08.

Below, I shall elaborate on these eight bullet points, although some of them will be amalgamated and some will come up more than once.

1. The Greenspan Fed’s excessively accommodating monetary policy during 2003 – 2006

Mr Greenspan is correct that a major global decline in risk-free real interest rates was an important factor in the housing booms that occurred in a couple of dozen countries between, say, 2002 and the end of 2006. The Fed, indeed central banks in general, had little to do with this. The extremely high saving propensities of the rapidly growing economies in the Far East and of the Gulf states were a key contributor, as was the extreme conservatism, until recently, of the portfolio allocation policies of the current account surplus countries of the Far East and the Middle East.

But the fact that on top of these very low risk-free long-term real rates, credit spreads became extraordinary low, had something to do with the liquidity glut created by the Fed, the Bank of Japan and, to a slightly lesser extent, the ECB. The Fed kept the Federal Funds rate target too low for too long after 2003. Because of the unique role played by the US dollar in the global financial system, the US dollar liquidity shower not only soaked the US economy, but also many others. First those who kept a formal or informal peg vis-a-vis the US dollar. Then those whose monetary authorities, without pursuing a dollar peg, kept a wary eye on the exchange rate with dollar, and ultimately most central banks in the globally integrated financial system.

2. The Greenspan-Bernanke put: an example of cognitive state capture by vested interests

The Greenspan Fed brought us the Greenspan put (now the Greenspan-Bernanke put).[1] The term was coined as a characterisation of the interest rate cuts in October and November 1998 following the collapse of Long Term Capital Management (LTCM).

A complete definition of the Greenspan-Bernanke put is as follows: it is the aggressive response of the official monetary policy rate to a sharp decline in asset prices (especially stock prices), even when the asset price falls (a) are unlikely to cause future economic activity to decline by more than required to meet the Fed’s triple mandate and (b) do not convey new information about future economic activity or inflation that would warrant interest rate cuts of the magnitude actually implemented.

Mr Greenspan is correct in drawing attention to the identification problems associated with establishing the occurrence of a Greenspan-Bernanke put with a reasonable degree of confidence. The mere fact that a cut in the policy rates supports the stock market does not mean that the value of the stock market is of any inherent concern to the policy maker. This is because of the causal and predictive roles of asset price changes already alluded to.

Nevertheless, looking at the available data as a historian, and constructing plausible counterfactuals as a laboratory economist, it seems pretty self-evident to me that the Fed under both Greenspan and Bernanke has responded more vigorously with rate cuts to sharp falls in stock prices than can be rationalised with the causal effects of stock prices on household spending and private investment or with the predictive content of unexpected changes in stock prices.

To me, the LTCM and January 2008 episodes suggest that the Fed has been co-opted by Wall Street – that the Fed has effectively internalised the objectives, concerns, world view and fears of the financial community. This socialisation into a partial and often highly distorted perception reality is unhealthy and dangerous.

It can be called cognitive state capture, because it is not achieved by special interests buying, blackmailing or bribing their way towards control of the legislature, the executive, the legislature or some important regulator, but through those in charge of the relevant state entity internalising, as if by osmosis, the objectives, interests and perception of reality of the vested interest.

3. The Greenspan’s Fed unfortunate focus on core inflation

Monetary policy affects inflation with a lag. Monetary policy makers therefore try to influence expected or predicted future inflation over the horizon that they can influence it. Fed economists noted during the 1990s that when you decompose headline inflation into non-core components (energy, food and drink) and core components (everything else), non-core inflation tends to be both more volatile and less persistent than core inflation. From that they concluded that core inflation was the best (easy) predictor of future medium-term headline inflation. From that it was but a short step to focusing almost exclusively on core inflation and dismissing the behaviour of headline inflation when it differed from core inflation as being due to transitory volatility in non-core prices. It is, obviously, headline inflation that ultimately matters for policy makers interested in stabilising the cost of living: Americans do consume energy, food and drink – often to excess.

Predicting core inflation may be a good practical short-hand way to forecast headline inflation when the relative price of core and non-core goods and services is constant in the medium term. It is a lousy predictor and guide to policy when there a large and persistent changes in that relative price. This has been the case for most of the current decade, mainly as a result of globalisation. China and India entered the global economy as suppliers of core goods and services (manufactures, IT services) and as demanders of non-core goods (oil, gas, metals, food). As a result core inflation in the US has persistently under-predicted headline inflation and headline inflation has been above the Fed’s comfort zone for most of the past six years (see Buiter1, Buiter2 and Buiter3).

This is just technical incompetence compounded by institutional inertia and unwillingness to correct a mistaken intellectual framework, even when it obviously no longer makes sense to stick with it. Even now, the Fed has not been completely rid of this bug.

4. The Greenspan Fed’s failure to appreciate the downside of securitisation

Chairman Greenspan frequently extolled the virtues of securitisation, the process through which illiquid, non-marketable assets (like mortgages) or cash flows are pooled and have marketable securities issued against the pool. These securities then can be tranched in order of seniority and enhanced in a number of ways. And indeed, securitisation is an important tool for trading otherwise non-tradable risk.

There is, however, a downside to securitisation. Because it tends to be associated (because of a desire to avoid regulatory costs and constraints) with the sale of the underlying assets (mortgages, say) to some off-balance-sheet private purpose vehicle (SPV), the originator of the loan no longer works for the principal (the owner of the underlying assets or even the owner of the securities issues against them) but for an agent. The incentive to spend time, effort and other resources in discovering and verifying the creditworthiness of the ultimate borrower (the home owner that has borrowed through the mortgage instrument) is weakened. The incentive for subsequent monitoring of the ultimate borrower is also dulled. When the asset-backed securities (ABS) are sold by the SPV to investors like investment banks or hedge funds, after a couple of transactions neither the buyer nor the seller of the ABS has a clue about what the underlying assets are worth.

Securitisation therefore destroys information and misplaces the information it does not destroy. The securitised world so admired by Chairman Greenspan was one of opaque institutions holding obscure instruments. It was one of the contributors to the perfect storm that created havoc in the wholesale financial markets starting August 2007.

5. The Greenspan Fed as moral hazard incubator
In 1998, the Federal Reserve System played an important role in orchestrating the private sector bail-out of Long Term Capital Management (LTCM), a hedge fund brought down by hubris, incompetence and bad luck. Although no Fed money, and indeed no public money of any kind, was committed in the rescue, the Federal Reserve System, through the Federal Reserve Bank of New York and its President, William J. McDonough, played a key role in brokering the deal, by offering its good offices and using its not inconsiderable powers of persuasion to achieve agreement among its 14 major creditor banks (ironically, Bear Stearns refused to participate in the rescue). The reputation of the Fed therefore was put at risk.

The reason given by the Fed for its orchestration of this bailout was the fear that, in a final desperate attempt to forestall insolvency, a fire-sale by LTCM of its assets would cause a chain reaction. This rushed liquidation of LTCM’s securities to cover its maturing debt obligations would lead to a precipitous drop in the prices of similar securities, which would expose other companies, unable to meet margin calls, to liquidate their own assets. Such positive feedback could create a vicious cycle and a systemic crisis.

This is the same vicious cycle leading to systemic risk story that was trotted out by Timothy F. Geithner, the current President of the New York Fed, to rationalise the bail out of Bear Stearns.

Notable features of the LTCM bailout were (1) that the existing shareholders retained a 10 percent holding, valued at about $400million, and (2) that the existing management of LTCM would retain their jobs for the time being, and with it the opportunity to earn management fees. A rival (rejected) offer by a group consisting of Berkshire Hathaway, Goldman Sachs and American International Group, would have had the shareholders lose everything except for a $250 mln takeover payment and would have had the existing management fired.

One reason given for allowing the existing shareholders to retain a significant share and for keeping the existing managers on board was that only these existing shareholders-managers could comprehend, work out and unwind the immensely complex structures on LTCM’s balance sheet. These were the same people, including two academic finance wizards, Myron Scholes and Robert C. Merton, joint winners in 1997 of the Nobel Memorial Prize in Economics, whose ignorance and hubris got LTCM into trouble in the first place.

Any handful of ABD graduate students from a top business school or financial economics programme could have unravelled the mysteries of the LTCM balance sheet in a couple of afternoons. The bail-out of LTCM smacks of crony capitalism of the worst kind. The involvement of the Fed smacks of regulatory capture.

The nature of the bail-out of LTCM meant that there was never any serious effort subsequently to address the potential conflicts of interest arising from simultaneously financing hedge funds, investing in them, and making money executing trades for them, as many investment banks did with Long-Term Capital. Things were even worse because, apart from the inherent potential conflict of interest that is present whenever a party is both a shareholder in and a creditor to a business, the bailout created a serious corporate governance problem because executives of one of the financial institutions that funded the bailout had themselves invested $22 mln in LTCM on their personal accounts. Using shareholder resources for a bail-out of a company to which you have personal exposure is unethical, even where it is legal.

For the Fed to have been involved in this shoddy bailout was a major mistake that soiled its reputation. If the Fed becomes involved (as an ‘enabler’ and/or by putting its financial resources at risk) in the rescue of a highly leveraged private financial institution, be it a hedge fund, an investment bank or a commercial bank, that private institution should immediately be subject to a special resolution regime, including the appointment of a special public administrator. That is, what is needed is an arrangement for all highly leveraged private financial institutions ddeemed too big and too systemically important to fail, akin to the treatment of (insured) commercial bank insolvencies under the Federal Deposit Insurance Act.

Under the rules established by the FDIC Improvement Act of 1991, a legally closed bank’s charter is revoked and the bank is turned over to the FDIC which serves as receiver or conservator. Typically, the old top management are fired and shareholder control rights are terminated. The shareholders do, however, keep a claim on any residual value that remains after all creditors and depositors have been paid off. [2]

From a longer-run perspective, the LTCM bail-out can be seen as a key enabler of the 2008 bailout of the investment bank Bear Stearns, another type of highly leveraged financial institution deemed too big to fail by the Fed. In the case of Bear Stearns too, shareholders were left with something ‘up front’ (two dollars per share initially, subsequently revised to ten dollars per share) and the old management is still in situ. In addition, in the Bear Stearns case, Fed money is directly at risk – the Fed is funding the senior $29 bn of a $30 bn off-balance sheet facility created to warehouse Bear Stearns’ most toxic assets.

If the” too big and too systemically important to fail” argument for bailing out large deposit-taking commercial banks is now also applied to other highly leveraged private financial institutions, including but not limited to, investment banks and hedge funds, then a similar special resolution regime, including prompt corrective action provisions must be in place if rampant moral hazard is not to be encouraged. The Greenspan Fed failed to make the case for or press for such reforms, even after the LTCM debacle. They bear a heavy responsibility for the moral hazard created in 1998 and in 2008, and for the future financial crises that will be encouraged and exacerbated by these failures.

Conclusion

During his years as Chairman of the Federal Reserve Board, Alan Greenspan’s statements reflected a partial (in every sense of the world) understanding of how free competitive markets based on private ownership work. This partial understanding also guided his actions as monetary policy maker and financial regulator.

Mr Greenspan consistently saw but half the picture when it came to what makes competitive market capitalism work. He recognised the central roles of greed, self-interest and competition. He failed to appreciate the complementary roles of non-strategic/non-opportunistic forms of altruism, solidarity and cooperation. Both competition and cooperation must be monitored and regulated, lest they become predation and collusion respectively.

Chairman Greenspan emphasized self-regulation, spontaneous order and the disciplining effect of reputation. He failed to appreciate the essential role external or third-party (i.e. state) enforcement of laws, rules and regulations. He did not understand the weakness of reputational concerns as an enforcement or self-discipline mechanism ensuring good behaviour, when credible commitment is limited at best in a world with short horizons and easy exits.

He failed to appreciate the essential role external/third-party (i.e. state) enforcement of laws, rules and regulations, and the indispensability of collective action when faced with the threat of the breakdown of trust and confidence.

Alan Greenspan’s period as Chairman of the Board of Governors of the Federal Reserve System represents to me the nadir of central banking in advanced economic-financial systems during modern times. While monetary policy was only mildly incompetent, the regulatory failures were horrendous. The US and the world economy will pay the price for Mr Greenspan’s misjudgements and errors for years, perhaps decades, to come.

By overselling, at home and all over the world, the virtues of American-style transactions-based financial capitalism and light-touch regulation, Mr. Greenspan has done more to harm the cause of decentralised, competitive market-based financial systems based on private ownership, than even Charles Ponzi.

The spectacular failures, first in 1997/98 and then in 2007/08, of the global tests of Mr Greenspan’s theory that global financial markets do not require global regulators and that even national regulators should use only the lightest of touches, did more to discredit financial globalisation and competitive market systems based on private ownership generally than any event since the 1930s.


[1] The clearest example of the Bernanke put was when the Fed cut the target for the Federal Funds Rate by 75 basis points, from 4.25 percent to 3.50 percent on January 22, 2008. This decision was made in the absence of any news other than collapsing stock markets in Europe and with futures markets predicting a sharp fall in US stock prices. The announcement was made outside normal hours and between normal scheduled FOMC meetings.
[2]
(This footnote paraphrases Robert R. Bliss and George G. Kaufman “U.S. Corporate and Bank Insolvency Regimes: A Comparison and Evaluation”, Virginia Law & Business Review, Volume 2, Spring 2007, Number 1, pp. 144-177) The FDIC Improvement Act (FDICIA) of 1991 enhanced, expanded and strengthened the powers of the primary federal regulators to close a bank for reasons other than insufficient assets to meet its financial obligations, unsafe and unsound banking practices, or threatened losses that would exhaust the bank’s capital. Primary federal regulators are the Office of the Controller of the Currency for nationally chartered banks, the Federal Reserve for state chartered member banks, the FDIC for state chartered non-Federal Reserve member banks, or the Office of Thrift Supervision for federal thrifts. The FDIC may also appoint itself conservator or receiver. Under the new prompt corrective action (PCA) provisions of the FDICIA a commercial bank need not be book-value insolvent or even predicted to be so in order to be considered regulatorily insolvent and placed into receivership.

Maverecon: Willem Buiter

Willem Buiter's blog ran until December 2009. This blog is no longer active but it remains open as an archive.

Professor of European Political Economy, London School of Economics and Political Science; former chief economist of the EBRD, former external member of the MPC; adviser to international organisations, governments, central banks and private financial institutions.

Willem Buiter's website

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