RF Fall v23 10/30/06 2:17 PM Page 2

FEDERALRESERVE Initiation by Fire BY CHARLES GERENA

Alan Greenspan alking down the marble about what he thought appropriate hallways of the Eccles targets for monetary policy should be, faced a stock WBuilding, Ben Bernanke Greenspan noted that the Fed’s pri- follows in the footsteps of the previ- mary goal is to “set an environment in market crash just ous Chairman of the Federal Reserve which steady long-term maximum Board of Governors, Alan Greenspan. economic growth is feasible in our two months after Bernanke’s legendary predecessor is a economy.” In meeting that goal, the becoming Fed tough act to follow, but it’s easy to for- Fed needed to be very careful not to get that Greenspan had big shoes to “allow the inflation genie out of the Chairman in August fill when he stepped into the bottle, because that will clearly under- Chairman role in August 1987. cut that goal.” 1987. His response Paul Volcker, with his 6-foot-7-inch A week after taking office, stature and forceful personality, Greenspan immediately acted against would reverberate earned the respect of central bankers inflationary pressures. But his offen- over the next three and financial markets around the sive would be put on hold after Black world. From 1979 to 1987, Volcker took Monday, Oct. 19, 1987. The Dow Jones years, and beyond aim at the double-digit price growth Industrial Average plummeted 508 plaguing the U.S. economy and points, or 23 percent. Greenspan’s wringed out excess dollars from the response would be a precursor to how money supply, even if such actions had the Fed would deal with a crisis of con- short-run recessionary consequences. fidence in financial markets. It would His determination secured the pub- also stir debate over how monetary lic’s confidence that the Fed would policy should be conducted during a protect price stability, helping to crisis and how much discretion a Fed reverse inflation expectations that had Chairman should have in general. built up during the 1960s and ’70s. Like Volcker, Greenspan focused Into the Valley on inflation. He expressed this posi- The macroeconomic conditions that tion several times during his July 1987 Greenspan inherited from Volcker Senate confirmation hearing. In a were less volatile than what Volcker response to one senator’s question faced when he became Fed Chairman in 1979. Year-to-year changes in the Consumer Price Index had reached a high of 11.3 percent after wildly fluctu- ating during the 1970s, while Fed credibility at keeping inflation stable had reached a low. Over the next few years, Volcker worked to reduce the amount of money and credit available and rebuild confidence in the Fed’s inflation-fighting resolve, which even- President Ronald Reagan, right, watches as tually reduced people’s expectations Vice President George Bush, of future price increases. left, swears in Alan By 1987, the annual rate of inflation Greenspan as the new had fallen to 3.6 percent. It was up to Chairman of the Federal Greenspan to maintain the Fed’s Reserve Board during restored credibility and use it to a ceremony at the White House on Aug. 11, 1987. manage inflation expectations. PHOTOGRAPHY: APPHOTOGRAPHY: IMAGES

2 Region Focus • Fall 2006 RF Fall v23 10/30/06 2:17 PM Page 3

It wasn’t going to be a cakewalk, the Council of Economic Advisers Bank presidents, the committee though. Oil prices nearly doubled during the Carter administration. agreed to lean toward tightening between 1986 and 1987, and the unem- While it honed Greenspan’s ability policy between August and its next ployment rate was falling. Neither to reach a consensus among people meeting on Sept. 22 if circumstances factor alone would have automatically of differing viewpoints, his political warranted it. This gave Greenspan a pushed up average price levels, since experience counted against him as window of opportunity to use his competitive pressures often prevent well. After serving as Richard Nixon’s authority in between FOMC meetings companies from passing along higher economic policy adviser during the to initiate small adjustments in the input costs, and there was only mixed 1968 presidential campaign, Greenspan federal funds rate, the interest that evidence of resurging inflation at the advised Gerald Ford as chairman of banks charge each other to lend time. Still, bond prices dropped and the president’s Council of Economic reserves. On Sept. 3, the rate moved up long-term interest rates on mortgages Advisers from 1974 to 1977. Later, he a quarter of a point to a range of 6.75 and other loans soared during the first joined President Reagan’s Economic percent to 7 percent. half of 1987. Policy Advisory Board in 1981 and The next day, Greenspan persuaded “There was some concern at the co-chaired his bipartisan commission his fellow members of the Board of time that the economy was over- on Social Security reform from 1981 Governors to raise the discount rate heated, and some fear that inflation to 1983. half of a point to 6 percent, the first [was] drifting back up and the progress Given these Republican ties, plus increase since April 1984. (In response, that Volcker had made in getting it the fact that six out of the seven mem- the funds rate rose again to 7.25 per- down would prove to be temporary,” bers of the Board of Governors would cent.) Changes in the discount rate — recalls Benjamin Friedman, a the interest that the Federal Harvard University economist who Reserve charges to lend reserves to has studied monetary and fiscal By 1987, the annual rate banks — served as an important sig- policy. nal to financial markets about the Meanwhile, fiscal policy wasn’t of inflation had fallen to Fed’s policy intentions because doing much to assuage inflation changes in the funds rate weren’t yet fears. Tax cuts and increased 3.6 percent. It was up to publicly announced. government spending produced Greenspan would soon prove his large federal budget deficits. Greenspan to maintain the mettle in another way. A month While Greenspan was widely later on Black Monday, Oct. 19, considered to be the best choice, it Fed’s restored credibility he would confront the central was a tough job to replace “Tall banker’s historical problem as the Paul.” Greenspan was an unknown and use it to manage provider of liquidity to the financial quantity as a monetary policymaker system facing a crisis. He would also in the eyes of central bankers and inflation expectations. demonstrate his willingness to financial market participants over- loosen the Fed’s grip on the money seas. While appointees to the supply to mitigate threats to the Board of Governors were usually be Reagan appointees, some people financial system. macroeconomists from the banking labeled Greenspan a political partisan and securities industries, his under- who wouldn’t have the gumption to After the Fall standing of the economy came from tighten monetary policy if necessary. “A stock market crash can patently his work as a corporate consultant and “Investors feared that Greenspan increase the credit risk involved in a director on the boards of manufac- would not be the aggressive inflation lending to certain borrowers,” turers like Alcoa and General Foods. fighter that Volcker had been and that Greenspan would recall in his February “He was a crackerjack domestic he might look the other way rather 1988 congressional testimony about nonfinancial economist, intimately than squelch inflationary pressures if the Oct. 19 crash. “But there can be … familiar with the data stream on the that meant slowing the economy an exaggerated market reaction as well, present and future prospects of the before the November 1988 presiden- based on little hard evidence, that industrial sector in America. But tial election,” McClain notes. builds on itself and ultimately affects [being Fed Chairman] was a financial Greenspan quickly disproved this borrowers whose creditworthiness has job, with both national and interna- perception when he took office on not been materially impaired by the tional dimensions, and he would have Aug. 11, 1987. At his first meeting of drop in equity values. This irrational some work to do to come up to speed,” the Federal Open Market Committee, component of the demand for liquidity wrote David McClain in his 1988 book which includes the Board of Gover- may reflect concerns that the crisis Apocalypse on Wall Street. McClain nors, the New York Fed president, and could affect the financial system or the served as senior staff economist for a rotating group of four other Reserve economy more generally.”

Fall 2006 • Region Focus 3 RF Fall v23 10/30/06 2:17 PM Page 4

Greenspan compared this irra- To make sure the additional liquid- ing the stock market decline from tional flight to liquidity and safety ity in the banking system would affecting the banking system. For with a run on a bank that is fundamen- reach the securities industry, Fed many people, Black Monday was just a tally sound. Before the existence of officials assured many in the banking bad day on Wall Street. In contrast, deposit insurance, bankers attempted industry that, despite the turmoil, stock market crashes in March 1907 to calm jittery depositors by putting the economy remained fundamentally and October 1929 precipitated the cash in their front window. “In a sense, sound. E. Gerald Corrigan, president failure of financial institutions and led the Federal Reserve adopted a similar of the New York Fed, spent several to broader economic problems. strategy after Oct. 19” to counteract weeks calling Bankers Trust, Bank of Even as the Fed did whatever it market uncertainty, Greenspan noted. New York, and other large banks to could to prevent financial gridlock — Greenspan was en route to Dallas “encourage” them to lend to brokerage and, according to one report, contem- to speak at the American Bankers firms. Corrigan personally knew plated more serious intervention such Association’s annual convention when many of the biggest financial players as directly lending to brokerage firms the Dow began to plummet. Upon because the New York Fed conducted or guaranteeing payments between landing, he rushed to his hotel and the Federal Reserve’s open market them — Greenspan didn’t want to cre- held a conference call with Vice purchases. ate unrealistic perceptions of the Fed’s Chairman Manuel Johnson, who was He reminded bankers that it was power. in charge of crisis management, and their job to assess creditworthiness, “If you intervene too much, then senior Fed officials. They discussed not circle the wagons until the dust you create expectations that you’re the seriousness of the situation — the settled. Furthermore, it was in their controlling and shaping things,” says Dow’s decline was nearly twice as interest to keep the financial system Donald Kettl, a political science pro- sharp as the 12 percent drop during the functioning. Greenspan also talked fessor at the University of infamous crash of 1929, and financial with financial market officials to calm Pennsylvania and author of Leadership markets would likely be in panic mode them down. at the Fed. “Greenspan wasn’t sure that the next day. This combination of gentle persua- he could do that, and he wasn’t sure On Tuesday morning, the group sion and reassurance was essential in that the Fed should do that if it could.” reconvened and agreed to issue a one- the days following Black Monday. By Such views, if proved wrong, would sentence statement in Greenspan’s midday on Tuesday, dozens of stocks erode the Fed’s credibility and make it name before the markets opened: that didn’t attract any buyers stopped harder to influence market behavior in “The Federal Reserve, consistent with trading on the New York Stock the future. It would also create a moral its responsibilities as the nation’s Exchange, which was on the brink of hazard problem, whereupon investors central bank, affirmed today its readi- closing itself. Meanwhile, the Chicago factor Fed intervention into their risk ness to serve as a source of liquidity to Board of Trade and the Chicago assessments. support the economic and financial Mercantile Exchange halted trading in In addition to addressing the fear- system.” various futures contracts since there induced demand for liquidity, As Greenspan flew back to weren’t enough stocks trading to set a Greenspan saw the need to counter Washington — on a private jet sent price. Eventually, though, enough risks to the nation’s economic growth. by White House Chief of Staff confidence and impetus to act built up In his semiannual testimony to the Howard Baker — the Fed backed up to prompt someone to do something House Banking Committee on Feb. 23, that promise. That day and for the — several companies began repurchas- 1988, he noted that the sudden loss next two weeks, it made millions of ing their stock while a number of in financial wealth and subsequent dollars available to banks through its Wall Street firms bought $60 million erosion of business and consumer open market purchases. The purchases in futures contracts. That helped draw confidence threatened to reduce were significant and frequently made other buyers back into the stock spending. at an earlier time of the day than usual market, sending the Dow up 102 So Greenspan persuaded his fellow to assure markets that liquidity was points for the day. members of the FOMC to lower their available. (Later on, the Fed loaned The Fed closely monitored market target for the federal funds rate from reserves to banks through its discount developments for several days. 7.50 percent just before Oct. 19 to a window, which has historically served Greenspan set up a crisis management range of 6.75 percent to 6.88 percent as the “lender of last resort.”) As a center in his office with Johnson and by mid-November. Greenspan result, excess reserves — funds set other staffers who kept in touch with reduced the rate again to 6.5 percent in aside by banks above the amount Corrigan in New York, other Reserve between the FOMC’s meetings in required by the Fed and to clear debits Bank presidents around the country, January and February 1988. to their accounts — rose 61 percent and market players worldwide. The Fed’s accommodative mone- from $967 million on Oct. 21 to $1.6 Many credit these decisive actions tary policy for the five months billion on Nov. 4. for restoring confidence and prevent- following the October 1987 crash

4 Region Focus • Fall 2006 RF Fall v23 10/30/06 2:17 PM Page 5

helped keep short-term interest rates Harvard’s Benjamin Friedman But a series of six rate increases from spiking as they had done in pre- agrees that the Fed tends to overreact occurred in 1999 and 2000, partly to vious financial crises. However, it also to a financial crisis, but that’s better pull liquidity back out of the economy “led to higher real economic growth in than doing nothing, which is the mis- and partly to address concerns about 1988 and 1989 than most experts had take the Fed made after the 1929 crash. inflation that dated back to the mid- forecast,” noted William Niskanen, He offers the analogy of putting out a 1990s. This tightening may have who served on President Reagan’s fire in a room. “You spray a lot of water helped trip the 2001 recession. Council of Economic Advisers and is on it [and] the next morning you’ve Greenspan’s approach to dealing now chairman of the Cato Institute, got some waterlogged furniture to deal with financial crises has raised a in a recent paper on the Greenspan with. … That doesn’t mean the smart number of important questions. era. This forced the Fed to take deci- thing to do would have been to stand How responsive should the Fed be sive steps to remove excess liquidity back and watch the room burn.” when faced with such a crisis — and from the economy and “deflate this how quickly should it revert to pre- demand bubble.” Greenspan’s Legacy crisis form? Also, how much leeway The federal funds rate increased The Fed’s response to the October should the Fed Chairman be given to nine times between March 1988 and 1987 crash would presage how it would “fine-tune” policy? March 1989, moving more than three cope with other threats to U.S. finan- This last question is not only percentage points to 9.75 percent. But cial markets. A series of events added relevant to how the Fed puts out it took some time to have the intended new stresses to financial markets 10 financial fires, it also gets to the effect — the annual inflation rate years after the crash. First, foreign heart of the Fed’s day-to-day policy- inched upward from 3.6 percent in investors fled currency and equity making. The Fed’s effectiveness 1987 to 5.4 percent in 1990 before markets in East Asian countries in depends on its ability to communicate receding to 4.2 percent a year later. mid-1997. Then, Russia defaulted on its intentions and manage inflation The Fed’s success came at a heavy its domestic debt and stopped making expectations. price. Tighter monetary policy, coin- payments on its foreign debt in August Some would say that Greenspan ciding with a reluctance to lend 1998. The International Monetary mastered the art of managing among some banks and anxiety over Fund chose not to help the country expectations. It first came into play Iraq’s invasion of Kuwait and the like it helped Thailand and other during the stock market crash and United States’ military intervention, countries. would help instill sufficient contributed to a recession that lasted Again, U.S. monetary policy focused confidence in the Fed’s inflation- from July 1990 to March 1991. on preventing these stresses from caus- fighting prowess to reduce volatility There is little doubt among macro- ing bigger problems — the Fed lowered in prices and economic output during economists that the yearlong string of the funds rate from 5.5 percent to Greenspan’s 18 years as Fed Chairman. increases in the funds rate was neces- 4.75 percent during the fall of 1998. This is the legacy Greenspan has sary to keep inflation in check. But “Easier money helped sustain the U.S. left Ben Bernanke. He and other some would argue that such correc- expansion — and prevent a global FOMC members will take a hard look tive action wouldn’t have been slump,” wrote Washington Post colum- at setting an explicit inflation target. required if the Fed hadn’t kept mone- nist Robert Samuelson this past In the meantime, they will continue tary policy so loose for so long after February in an editorial about to use economic data and their best the crash. Greenspan’s legacy. judgment to keep prices stable. RF

R EADINGS

Beckner, Steven K. Back From the Brink: The Greenspan Years. McClain, David. Apocalypse on Wall Street. Homewood, Ill.: New York: Wiley, 1996. Dow Jones-Irwin, 1988. Friedman, Benjamin M. “The Greenspan Era: Discretion, Rather Neely, Christopher J. “The Federal Reserve Responds to Crises: than Rules.” American Economic Review, May 2006, September 11th Was Not the First.” Federal Reserve Bank of vol. 96, no.2, pp. 174-177. St. Louis Review, March/April 2004, vol. 86, no. 2, pp. 27-42. Goodfriend, Marvin. “The Phases of U.S. Monetary Policy: Niskanen, William A. “An Unconventional Perspective on the 1987 to 2001.” Federal Reserve Bank of Richmond Economic Greenspan Record.” Cato Journal, Spring/Summer 2006, vol. 26, Quarterly, Fall 2002, vol. 88, no. 4, pp. 1-17. no. 2, pp. 333-335.

Greenspan, Alan. “Risk and Uncertainty in Monetary Policy.” Solomon, Steven. The Confidence Game: How Unelected Central American Economic Review, May 2004, vol. 94, no. 2, pp. 33-40. Bankers Are Governing the Changed Global Economy. New York: Simon & Schuster, 1995.

Fall 2006 • Region Focus 5