Sebastian Mallaby on Alan Greenspan, the Man Who Knew Matthew Klein

Alphachatterbox: Sebastian Mallaby on Alan Greenspan, The Man Who Knew Matthew Klein: Sebastian, thanks for coming. I want to start towards the end of the narrative. Let’s place ourselves in 2002. I want you to give us a sense of the world that Greenspan was operating in, the choices that he made, the choices that maybe he could have made differently, and whether or not that could have actually led to a different outcome than we had in terms of the bubble and the financial crisis. Sebastian Mallaby: The background to 2002 was obviously 9/11. The attack on the United States shocked people so much that what was already following the collapse of the NASDAQ bubble -- falling inflation and falling growth -- fell off the cliff. Inflation expectations as measured by the Michigan survey fell to a record low right after 9/11. So in this context the Fed became extremely preoccupied by the danger of Japan, of a deflationary-type trap. And the Fed responded by cutting interest rates aggressively. They believed in the notion that you shouldn’t keep your powder dry because if you keep it dry and you save up those interest rate cuts, growth will slow so much that it won’t work anymore. They were in terror of the zero lower bound. People forget this today of course, we think of the zero lower bound debate as being a modern one following from 2008, but it was very much in people’s minds in 2002. So that was what Greenspan faced. What he did was he cut rates aggressively down to 1% in 2003, and hoped that monetary stimulus would get the system out of the shock of both the NASDAQ bubble collapsing and the 9/11 confidence shock. MK: So looking back with the benefit of hindsight, I feel like a lot of the narrative of Greenspan focuses on -- or at least the modern narrative of Greenspan -- focuses on the idea that the crisis and the bust as something he should have seen coming. The title of your book suggests that in fact knowing or being aware is very much a theme of Greenspan. It’s easy to underrate him. So to what extent were the policies in this whole pre-crisis period -- both on the monetary and the regulatory side -- things that, looking back, Greenspan should have done a lot differently? I ask because a lot of people, looking back, they say “well because of all the other global forces that we talk about, the global savings glut, the shortage of safe assets, the commodity boom, whatever, there wasn’t anything that could have been done differently.” 00:05:53 SM: Well you’re right, the title of the book is The Man Who Knew and that is because I do think that he knew that finance could be very unstable. He was particularly aware of this in the 2000s when, in the transcripts, as you know well, he was discussing financial instability quite openly with his colleagues. 1 So what he decided to do about that was to essentially take a couple of shots at it through regulation but to ignore it on the monetary side, on the interest rate side. On the regulatory side what he did was, first of all, he did try to pass effective regulation on crazy, subprime mortgages. There were certain insurance products that were being bundled into the subprime mortgages that were clearly abusive. And in late 2001 the Fed adopted new rules to limit those. Greenspan also went out and testified -- with the backing of the White House -- in favour of limiting the size of Fannie and Freddie because he saw them as the central source of systemic risk at the time. And what happened was that neither of these regulatory efforts came to anything. The new mortgage rules were adopted but they were easily circumvented by the industry which just tweaked the products and carried on as if nothing had happened. The Fannie and Freddie push for regulation for limits on portfolio size was beaten back by a barrage of TV ads that the mortgage giants put up to warn members of Congress that if they sided with Greenspan they would be facing a tough re-election. So Greenspan tried because he knew there was potentially trouble. He tried with regulation and that failed. He did not try with interest rates, and that’s where I think he was at fault, because knowing now that regulation was not going to work -- and I think he frankly knew it as well; he was trying, but he was too realistic to assume that regulation would really prevent excess leverage -- he didn’t take the next step which was “okay, so regulation won’t work, so we’d better use interest rates.” 00:08:02 MK: That’s interesting because of course that’s essentially the opposite of the conventional wisdom now, that although the Fed was fine on the monetary front that it was on regulation that it should have done more and chose not to. And it’s interesting because you’re basically saying it’s the exact reverse: they really tried on regulation, that didn’t work, and so in the absence of this, more monetary tightening would have been appropriate. SM: Yes, in the five years when I was researching the book I would say to people “I’m writing a book about Alan Greenspan” and the typical thing would be “Fantastic monetary policy! Just look, inflation came down and it was very low variance; it was on target in the 2000s, perfect interest rates. But on the regulatory side, boy did he mess up.” That’s the standard line and, exactly as you say, I have the opposite view, which is that, on regulation, he tried. Regulation, frankly, is never very easy to implement, particularly in the United States, where you have this massively fragmented regulatory structure with all this alphabet soup of agencies. So when, for example, on subprime mortgages, Greenspan and the Fed passed new rules the supervision of the non-bank mortgage originators who had to obey those rules that was being done by the FTC which doesn’t actually have boots on the ground to go and supervise. So I think he tried on regulation and it was never going to work, so I don’t share the standard criticism of Greenspan on that. But the flipside of that is if you don’t use regulation you’d better use monetary policy. 00:09:29 2 MK: So the counterpoint of this, which I think is something you were implying in your initial answer, is that the economy at the time was very weak. Inflation was so slow people worried about hitting zero bound. It was an extremely rough jobless recovery. Would it have been possible, realistically -- and I’m talking about Fed independence, which is in the law but in practice how that plays out is a tough question -- how realistic would it have been to imagine Greenspan marshalling the [Federal Open Market] committee to pursue a meaningfully tighter policy back then? SM: Well, in my view 2002 is the wrong year to peg that dilemma. So I think in 2002 in the one year or so after 9/11 it was reasonable to be fearful of the Japanese trap. After all the real estate bubble we now know peaked in 2006, early 2007. So 2002 was pretty early, and I think it was fine at the time to run very loose policy for 2002/2003. By the time you get to 2003 and into 2004, then the argument changes. You’ve escaped the deflation threat and Japan is not happening. Inflation in 2003 in the second half was below target it was around 1.5% or so, but by 2004 it was picking up again. That’s the point where I think Greenspan should have had a different monetary policy, and I think he could clearly have done it. Not for nothing was he called the “maestro.” He had complete control over the FOMC, the interest rates setting committee. And if he had wanted to he could have raised interest rates faster and also he could have done it with less forward guidance. I think that’s a crucial part of this discussion. It’s one thing to hold the policy rate, the short-term rate, low. It’s another thing to guide people about longer-term rates because that just incentivises leverage. 00:11:21 MK: I want to get into this more because it’s interesting that Greenspan’s defence -- not just his defence, but the defence a lot of people make of the way monetary policy was conducted in this period -- was that they did raise rates in 2004. They raised rates relatively quickly, but long rates didn’t move. You could argue that this was a fault of forward guidance, or the fault of excess savings from other countries, or what have you. But that is a claim that people make, which is the Fed did try and it just didn’t work. You could say there’s an analogy there to the regulatory moves preventing particularly abusive mortgage products, which just didn’t work. What is your take on that? SM: If I remember correctly, around the middle of 2004 the Fed began to tighten. It tightened by 25 basis points per meeting and this was extremely clearly telegraphed. Everybody in the markets understood, because of the Fed’s language, that it would be 25 basis points per meeting and not more.

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