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Home , Alan Greenspan, Greenspan put, Paul Volcker, Real estate bubble, Stock market bubble

Greenspan’s Bubbles

The Age of Ignorance at the

by William A. Fleckenstein with Frederick Sheehan McGraw-Hill © 2008 208 pages

Focus Take-Aways

Leadership & Management • Before he became chair of the Federal Reserve, was chair of the Strategy president’s Council of Economic Advisers. Sales & Marketing • While there, he had a very bad record as a forecaster of interest rates. Human Resources • As a consultant to Jr., the notorious savings and manipulator, IT, Production & Logistics Greenspan lobbied for deregulation of the industry. Career Development • Nevertheless, as Fed chair, he became one of the most powerful regulators in the Small Business U.S. financial system. Economics & Politics Industries • He is at least partially responsible for encouraging two bubbles: the technology Intercultural Management bubble and the bubble. Concepts & Trends • He ignored or refused to see evidence of these bubbles developing. • His remedy for the bubble created the . • Greenspan debased the U.S. currency, creating turmoil in the U.S. financial system. • He seems incapable of admitting his errors and was not a “maestro.” • The U.S. will be paying for Alan Greenspan’s errors for a time to come.

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What You Will Learn In this Abstract, you will learn: 1) How Alan Greenspan’s career in finance evolved; 2) How he equivocated prior to his appointment to chair the Federal Reserve; 3) What Greenspan did as Fed chair; and 4) Why Greenspan’s legacy is a costly catastrophe.

Recommendation This book states the argument of those who oppose Alan Greenspan, the former chair of the U.S. Federal Reserve. William A. Fleckenstein and Frederick Sheehan, who sometimes seem to go a bit over the top in the intensity of their attacks, write that Greenspan, despite his reputation, was no “maestro.” Instead, they report he was a poor manager with a habit of either deception or self-delusion. The authors support their argument by drawing heavily on extensive quotations from Greenspan’s testimony before Congress and on minutes of the Federal Reserve Open Market Committee meetings. Although getAbstract might wish for less fervor in this presentation, it forwards this book to policy makers, executives and others who wish to understand the downside of Greenspan’s policies and how he may have contributed to the U.S. economy’s current dilemma.

Abstract

“Greenspan cut Maestro Greenspan? rates enough Alan Greenspan was an economic consultant before and after he served as chair of while he was still the president’s Council of Economic Advisers (CEA) from 1974 through 1977. When sanguine about the President appointed Greenspan as chair of the Board of Governors of economy to get it the Federal Reserve in 1987, the nominee faced tough questions from Senator William growing again. Yet he didn’t recognize Proxmire, who noted that Greenspan had built a terrible record at predicting interest the recovery rates during his tenure as chairman of the CEA. Greenspan replied, “That is not my – just as he missed recollection of the way the forecast went.” So Proxmire read his predictions aloud. the economic Greenspan replied, “Well, if they’re written down, those are the numbers.” contraction.” In fact, Greenspan’s career before he became Fed chair was full of blunders and even, arguably, ethically questionable conduct. Greenspan’s forecasts as chair of the CEA were not simply wrong; in retrospect, they seem colored by his tendency to say what was politically expedient. During the 1980s, Greenspan worked hard on behalf of Charles Keating Jr., a notorious savings-and-loan (S&L) looter. In a letter Greenspan wrote to the “Greenspan apparently had Principal Supervisory Agent for the Federal Home Loan of San Francisco, he praised little interest in Keating’s management of Lincoln Savings and Loan, saying he had shown “outstanding nipping problems success in making sound and profitable investments.” A few years later, regulators seized in the bud, that institution and Keating’s name became forever linked to S&L fraud. preferring instead to clean up Greenspan’s tenure at the helm of the Fed was consistent with his earlier actions. He whatever mess he presided over a regime of easy money that had dire consequences for the financial left behind with the same actions system in the U.S. and, indeed, the entire world. Low interest rates on bank certificates that started of deposit and on bonds led people to the stock market in search of higher returns. One the problem.” consequence of this was the equity market bubble of the . After the bubble burst, Greenspan continued to open the money spigots, and the flood of liquidity went into the housing market, creating the biggest real estate bubble in American history. Meanwhile,

Greenspan’s Bubbles © Copyright 2008 getAbstract 2 of 5 Greenspan ignored the fact that were getting more and more deeply involved in exotic, difficult-to-understand securities markets, such as mortgage-backed securities. “Greenspan delivered his notorious Stock Market Bubbles ‘irrational Bubbles are uncommon and relatively easy to recognize. During in the exuberance’ speech Netherlands in the 17th century, everyone seemed to be making a killing in tulip bulbs, one on December 5, of which might cost six times the average annual income. Then, quite suddenly, the bubble 1996, but nothing he said before popped. No one wanted tulip bulbs anymore and many people faced financial ruin. or after indicates that he actually Similarly, the of the Roaring 20s was exhilarating while it lasted, took his own until it crashed and sent the world into the . Central bankers had nothing message to heart.” to do with the tulip bubble, but a lot to do with the Roaring 20s, and Greenspan’s Fed outdid even the Fed of the jazz age. Demographics, technology, round-the-clock market coverage on cable television and artful by U.S. all played their part in the speculative mania of the 1990s. However, the stock market bubble couldn’t have happened without Greenspan. He kept the money flowing with low interest rates.

“The equity bubble The Fed first began loosening money in 1989 and continued the trend until 1992, collapsed and overstimulating the financial markets. Interest rates stayed at about 3% until 1994, when Greenspan drove the Fed boosted them slightly. Greenspan claimed before a meeting of the Federal Open interest rates down Market Committee (FOMC) that the rate increase had taken the air out of what might to one percent in the wake of that have become an equity market bubble. Then, in Senate testimony in the summer of 1994, collapse. That gave Greenspan explained that even though the economy had been doing well, he was worried rise to the real about how the rate increase would affect the financial markets. In 1995, Greenspan’s Fed estate bubble.” began to cut interest rates again.

Fiddling with Greenspan labored under the delusion that the stock market was rising because American productivity was breaking growth records. He interpreted the surging stock not as a bubble but rather as a sign that rational in an efficient market were responding “Greenspan, through his to new information about productivity. He thought that standard inflation statistics irresponsible overstated real inflation, and that with the right kind of accounting for investments in , technology, stock prices would look more reasonable. had fomented massive Indeed, statisticians were doing some interesting fiddling with inflation numbers in that drove Internet the mid-1990s. The Senate Finance Committee appointed the Boskin Commission to stock prices to such examine the consumer index (CPI). However, the findings of the Commission high levels that they were completely were to some extent determined by its purpose, which was to reduce the government’s incomprehensible.” estimate of inflation rates and thereby reduce the amount of money the government had to spend on entitlement programs that adjusted for inflation. It achieved its objective using these three tactics: 1. It stopped using geometric calculations of period-to-period CPI changes and started using arithmetic calculations. “Many people 2. It used price increases in substitute goods in calculations; increases in beef prices would learn the might thereby be cushioned by decreases in chicken prices. hard way that speculating was 3. It used “hedonic adjustments,” which suggest that if the price of a commodity rises, fun while it worked, quality improvements rather than inflation account for at least some of the increase. yet disastrous when it didn’t.” The downward adjustment of the inflation rate had pernicious consequences, not the least of which was enabling the Fed chair to claim that inflation was not a problem.

Greenspan’s Bubbles © Copyright 2008 getAbstract 3 of 5 The “” At the end of the 1990s, financial crises in Southeast Asia and Russia caused problems “Greenspan for a massive and somewhat mysterious fund: Long Term Capital Management. focused on the falloff in demand Its collapse threatened the stability of global financial markets and sent the stock that occurred due market tumbling. However, the market had gone up more than 20% in the first half of to overcapacity. the year, and its fall only amounted to giving back that gain. Nonetheless, the Fed cut He failed to interest rates. Within two weeks the market began to move up. Greenspan sent signals utter one word about the bubble that he might be planning to cut rates again. This was irresponsibility of historically which had caused unprecedented proportions. It amounted to assuring speculators that he would not let the overcapacity the market fall. to begin with.” The business media christened this tactic the “Greenspan put.” A “put ” protects investors from market downturns by giving them the right to sell a stock at a certain price by a certain date. Similarly, the Greenspan put protected investors who took risks that caused the market to go down, because Greenspan would lower interest rates to revive it – and save their shirts. Speculators went wild. The bubble in technology , especially new Internet stocks, swelled. Initial public offerings skyrocketed. Greenspan “The Maestro thought these were the market’s rational responses to solid, diligent analysis of earnings maneuvered to rewrite the history and growth prospects. of the stock market bubble … in an The Bubble Pops effort to absolve himself and the In May 1999, former Fed Chair told an audience, “The fate of the world Fed of any bubble- economy is now totally dependent on the growth of the U.S. economy, which is dependent related blame.” on the stock market, whose growth is dependent on about 50 stocks, half of which have never reported any earnings.” Volcker saw the bubble.

Greenspan missed it. Just a few weeks after Volcker’s speech, Greenspan testified before Congress, saying “Bubbles generally are perceptible only after the fact. To spot a bubble in advance requires a judgment that hundreds of thousands of informed investors have it all wrong. Betting against markets is usually precarious at best.” But the so-called “However “informed investors” were acting in response to Greenspan’s policy of lowering rates to wild…the real estate market was, help the financial markets. it clearly wasn’t unruly enough In 2000, inevitably, the bubble popped. Minutes of FOMC meetings show that Greenspan for the Fed to pay was blind to the fact that the market had been racing up precisely because of his reckless attention to it.” monetary policy. The market crash ruined many naive speculators. Meanwhile, economic researchers began to take issue with Greenspan’s beloved productivity growth. One found that productivity had actually decreased during the late 1990s.

In addition, the supposedly astute analysts responsible for advising the “informed investors” were often thinking of their own benefit rather than the investment merits of the stocks they recommended. Although the public may have had an excuse for gullibly “Lenders kept swallowing these analysts’ palaver, Greenspan did not. He admitted to the FOMC that getting more aggressive and so analysts’ forecasts “are biased on the upside, as they are made by people who are getting did homebuyers; paid largely to project rise in earnings to sell stocks.” Still, he kept referring to the naturally, that… analysts’ reports as causes for optimism. kept housing prices climbing, which kept the whole The Real Estate Bubble game going.” When, at last, no one could deny that the “new economy” had been a mirage, Alan Greenspan eased money again and pumped up the biggest real estate bubble in American

Greenspan’s Bubbles © Copyright 2008 getAbstract 4 of 5 history. Contrary to what many think, the terrorist attacks of 9/11 did not cause the stock market rout and the ensuing economic weakness. The market had already been falling, and the popping of the stock market bubble had put the real economy under pressure. In December 2001, a meeting of the FOMC paid extra attention to mortgages. Greenspan said, “We are seeing this as very high sensitivity to long-term mortgage rates, for example in the extraction of that leads promptly to consumption expenditures.” “Greenspan bailed When he testified before Congress in early 2002, he avoided any reference to a bubble in out the world’s the stock market. Instead, he said that capital had been misallocated. He praised innovative largest equity bubble with the financial products, saying, “New financial products – including derivatives, asset-backed world’s largest real securities, collateralized loan obligations and collateralized mortgage obligations…have estate bubble.” contributed to the development of a far more flexible and efficient financial system.” He reiterated his enthusiasm for home equity as, “a significant source of funding for consumption and home modernization.” Greenspan was aware that the housing market was approaching what some considered bubble proportions by 2002. However, he said that a real estate bubble was unlikely, denying it just as he had denied the stock market bubble. So, instead of taking action to counter it, Greenspan worried about – a concern raised publicly by , who eventually succeeded Greenspan as Fed chair. Although Americans were experiencing higher prices for a wide range of goods and services, the Fed chair was worried about falling prices and was providing easy money to help keep them from falling too far.

The Housing Crash Crazy things were happening in the housing market. People were treating home equity lines of like credit cards. So-called “125s” allowed homeowners to take more equity out of their homes than they had actually earned. prices were rising, interest rates were low and speculation was rampant. In a speech, Greenspan told homeowners that they were too conservative. He recommended floating-rate loans at a time when interest rates were at historic lows. In 2005, he praised subprime mortgages and the financial innovations that made them possible. Former Fed Chair Paul Volcker seemed to be doing his best to point to the danger. However, “We will all Greenspan by now seemed chiefly concerned with polishing his image for the history books. be paying an enormous price for Four months before the end of his last term as Fed chair, Greenspan said that expecting the decisions Alan policy makers to notice bubbles was “not realistic.” He also claimed, disingenuously, that Greenspan made the Fed had tried to keep the stock market from overheating during the 1990s. as chairman of the Federal Reserve.” It was clear to less self-interested observers that Greenspan and his Fed had not only facilitated the bubbles but had also worked to make sure that speculators did not suffer as much as they deserved when the bubbles popped. Greenspan’s policies increased , but the housing bubble did not really pop until after Greenspan had left office. He had gone a long way toward debasing the U.S. dollar, but, of course, it would suffer much more in 2007. He had also created a precedent for the financial system to load up on risk and trust the Fed to bail it out. The consequences of his policies will continue to be severe.

About the Authors

William A. Fleckenstein is president of a money management firm in Seattle. Frederick Sheehan is former director of asset allocation services at a financial services company.

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