Greenspan fiddled while the economy burned

William D. Rutherford

HOW DID Alan Greenspan rise to become one of the most powerful men in America? How did he survive two decades as Federal Reserve Board chairman when practically every, president who reappointed him really wanted to replace him? How did the man who engineered the collapse of the greatest economy in history--ushering in the longest market decline since the Great Depression, costing 2,500,000 people their jobs, and destroying wealth equal to seven times the gross national product of China--keep his position, let alone achieve such a lofty status?

It is time for a reevaluation of the Greenspan myth. Even the chairman himself thinks so. In a number of recent speeches, he has displayed a new humility, admitting mistakes, and raising the question of whether the Federal Reserve trader his watch has served us well. With his 20-year reign as monetary czar coming to an end, Greenspan has shown an increased interest in his legacy. We should, too.

Greenspan was born on the upper west side of New York City. His parents' marriage ended in divorce and he was raised by his mother while living with her parents. Greenspan remained very close to his mother. Not so with Herbert, his father, a self-educated stock market analyst. Herbert Greenspan published a book in 1936 called The Recovery Ahead; in 1937, the market collapsed. Herbert made a gift of the book to his eight-year-old son with the following inscription: "May this my initial effort with a constant thought of you branch out into an endless chain of similar efforts so that at your maturity you may look back and endeavor to interpret the reasoning behind these logical forecasts and begin a life work of your own." Perhaps that gift set Greenspan on the course of economic study; perhaps it "also set the stage for "Fed speak."

After learning to play the saxophone and traveling with a be-bop band, Greenspan returned to academic pursuits, studying economics under Arthur Bums at New York University. He became an acolyte of writer Ayn Rand. Later. he formed Townsend-Greenspan and Co., an economic consulting firm.

Greenspan rose through the ranks of government agencies, He chaired the National Commission on Social Security Reform from 1981-83. where he authored a plan to raise Social Security taxes dramatically on working people and companies. He served as chairman of the Council of Economic Advisors under Pres. Gerald Ford. On Aug. 11, 1987, he was appointed by Pres. Ronald Reagan to be chairman of the Federal Reserve Board.

None of those around him thought he was destined for greatness. His former wife said she did not see it coming. He was viewed by some as "Woody Allen with math skills." Nevertheless, Greenspan is poised to become the longest serving Federal Reserve chairman in history. He arguably is the second most powerful man in the U.S. and certainly one of the most influential in the world.

Along the way, he presided over--and some say caused--several market calamities. In some instances, he did not appreciate the problems around him or what lay ahead; in other instances, he did not take sufficient action to head off trouble.

His history at the Fed begins with the Crash of 1987. which followed backroom dealings where he succeeded in getting the discount rate increased after having been rebuffed by the Federal Open Market Committee. At his first meeting with the FOMC. Greenspan insisted that inflation was a threat, but the committee disagreed. Not to be denied, he engineered a discount rare increase through the Board of Governors with a bare quorum while two members were out of town and with a vacancy on the Board. The market reacted negatively. Fear set in quickly, and, within days, a wave of unprecedented selling hit the market. Suddenly, U.S. stocks were in free-fall. It got so bad that IBM and other stocks stopped trading because all orders were to sell.

On Oct 19, 1987. a day that would become known as Black Monday, the Dow dropped 22.6%. the first time it ever had fallen more than 20%. An amount greater than the gross national product of France disappeared from the Exchange value in less than 24 hours. Greenspan had been chairman for 72 days.

Black Monday

In 1989, Greenspan told the FOMC that he felt the economy was "more balanced" than any he ever had seen. Nevertheless, within two weeks, he asked for--and received--two interest rate increases. These had a domino effect on the market. First, the junk bond market nose-dived. By October, the Dow had its biggest one-day drop since Black Monday. The performance of the junk bond market led to the collapse of the nation's Savings and Loan associations. (The S&L debacle eventually cost taxpayers over $150,000,000,000.)

One S&L in particular made Americans pay dearly: Lincoln Savings and Loan. run by Charles Keating. In 1985. Greenspan had lobbied Washington on behalf of Keating. He wrote a letter to Federal regulators in which he stated that. under Keating's leadership, Lincoln Savings and Loan had become "... a financially strong institution that presents no foreseeable risk." In fact. at the time, Lincoln was engaged in massive fraud and its investments were nearly worthless. It has been reported that Greenspan was paid $12,000 to write Keating's letter of recommendation. In the end. the Federal takeover of Lincoln would cost $3,000,000,000. Keating was convicted in state and Federal courts of fraud. racketeering, and conspiracy.

In 1991, as the economy weakened and the time for his reappointment drew near, Greenspan pushed for lower interest rates. By June, 1991, Greenspan reported to Pres. George H.W. Bush that the economy was growing at a strong pace and that inflation was well contained. Ten days later, he was reappointed. Ironically, Greenspan never had been known for his forecasting skills. His firm, Townsend-Greenspan, had been dead last in its rankings of economic forecasts by the Federal Reserve; it had overstated inflation by as much as 2.5%. Sen. William Proxmire (D.-Wisc.) criticized Greenspan at his initial confirmation heating for his "dismal" forecasting record. True to form, within a short time after his statements to Pres. Bush, the economy took a nosedive. Bush, who had enjoyed approval ratings of over 90%, found himself in a struggle for reelection. Bush's advisors found Greenspan out of touch and "a day late and a dollar short" in his reaction to the economic downturn. Bush lost the election and later said of Greenspan, "I appointed him and he disappointed me."

On the night of the first Inaugural Address by the new president, Bill Clinton. Greenspan was found in the balcony seated between incoming First Lady Hillary Clinton and the vice president's wife. Tipper Gore. Clinton took office: the recession was over. In time. the Goldilocks Economy--not too hot, not too cold, just tight--began.

By 1994. Greenspan felt it was time to ruse interest rates, which had not been upped in almost five years, a fact which the Fed chairman found "almost unimaginable." The Dow was at about 4,000, which he postulated was too elevated, He lobbied for. and received, a rate increase. The day the new rate increase was announced, the market suffered its biggest loss in two years. Yet, he continued to raise rotes, causing one of the biggest bond market routs in years. Greenspan was satisfied. The round of lightening had headed off inflation--inflation which he claimed was "not yet seen in the data."

Clinton was furious. "What is wrong with prosperity?" he wondered aloud. How can "too many" people be working? Clinton had a successor in mind for Greenspan but the President's plans ultimately failed. Therefore, in spite of the slowing economy and because of a fractious Congress, in February, 1996, Clinton reappointed Greenspan to his third term. Shortly thereafter, Greenspan decided that an interest rate cut was in order, and a beleaguered Clinton cruised to reelection in November of 1996.

Asian contagion

In 1997, Greenspan reported to Congress that the U.S. economy was strong. That month, however, the Thai baht (currency) collapsed leading to the "Asian contagion." A ripple in Thailand became a tsunami in the U.S., severely punishing American markets. Nevertheless, in May, 1998, Greenspan reported to Clinton that we had "the best economy he had seen in 50 years." A few months later, Russia devalued the ruble and suspended payment on its debt. Global credit markets seized up. An investment firm in Connecticut called Long Term Credit stood to lose billions and international credit markets were poised on the brink of disaster.

Greenspan previously had assured Congress that there was no need to oversee funds like Long Term Capital Management; now Greenspan's own Federal Reserve staff concluded that, if LTCM failed, there was a significant potential for a once-in-a-lifetime capital market meltdown: A bailout was arranged, but it is reported that Greenspan was unhappy with the Fed's role in the solution. He felt that the probability that the world financial system would collapse was less than 50%, and the Fed should not have lent its name or offices to the bailout. Yet, even if the odds of a collapse were less than half, why would one with the power to prevent the collapse run the risk? The answer can provide an insight into Greenspan's thinking and his tolerance for others to be hurt.

As the prosperity of the 1990s progressed, Greenspan's celebrity increased. The cable channel A&E called him the most fascinating person of 1999. Paeans to him were written. Friends from his early life, who never saw such celebrity coming, were surprised. Greenspan clearly relished his status. As one of the most powerful men in the world, he certainly could have been driven to the Fed meetings, but he chose to walk. Television networks chronicled these strolls. Commentators speculated on the future of rates based upon the size of his briefcase. Greenspan spoke in ambiguous terms, which allowed him an easy way out of any position because no one could understand what he was saying, giving rise to the term "Fed speak." It is said that he had to propose three times to Andrea Mitchell before she understood that he wanted to marry her.

Greenspan will be remembered for many things, but perhaps none more than a speech he gave on Dec. 5, 1996, at a reception in his honor at the American Enterprise Institute. It was over 4,000 words long. About halfway through, Greenspan did something that only two other Fed chairmen had done before: he addressed the market directly.

He asked, "How do we know when irrational exuberance has unduly escalated asset values?" His dramatic phrase was unprecedented. Greenspan's predecessor at the Council of Economic Advisors, Herbert Stein, observed it was a good thing the U.S. markets were closed. International markets, however, remained open and tumbled immediately. The Nikkei had its biggest loss of the year. The sell-off continued around the world. At the New York Stock Exchange opening the morning after his speech, the Dow was down 145 points. His comments cemented his status as an oracle. He began to have a clerk monitor his congressional testimony for market movements.

His comments further established his record as a terrible forecaster. In 1959, he had made similar comments to Fortune when he warned of "overexuberance." The market was up 43% the ensuing year. The day following his comments to the AEI, the Dow closed at 6,448. The Dow would continue to climb, not reaching its peak for four more years.

Greenspan and the Fed never have been able to appreciate fully the effects of productivity increases and advancing technology on those improvements. In the 1990s, the American economy (minus technology) grew at about the same rate as Germany's very slowly. The difference between the U.S. and the rest of the world was the effect of technology and the efficiencies it provided.

During the 1990s, old-economy companies General Electric, General Motors, Dupont, and Procter & Gamble shed over 400,000 jobs while businesses such as Microsoft, Dell, Cisco, and Oracle added nearly 140,000. The decade saw gross domestic product grow at an average annual rate of 3.5%. The Dow increased from 3,000 to over 10,000 and the Nasdaq from 500 to over 5,000. Consumer confidence reached an all-time high. The tide of tax dollars moved the U.S. budget into surplus. Unemployment fell below four percent and inflation remained low at 2-2.5% thanks largely to increased productivity. It was not until much later that the Fed began to understand the effect of technology and productivity, and later still until it admitted to errors. Because of these miscues, American workers paid a large price.

Though Greenspan was concerned about "irrational exuberance," he feared Y2K even more. In 1999, leading up to the year 2000 and the chaos Greenspan thought might ensue, the Fed poured large amounts of cash into the money supply. This fueled the hot market and the "Interact bubble." The bubble already was on the mind of the Federal Open Market Committee, according to the minutes of its June, 1999, meeting in Jackson Hole, Wyo. Raising margin rates on stock purchases was discussed, but discarded. Instead, the money supply was increased, adding fuel to the flames. That action has gone unexplained to this day.

If the economy was overheating, or inflation was prevalent, the Fed had several tools at its disposal. Greenspan mentioned inflation often as justification for raising rates, but since there were no signs of inflation, he was compelled to cite the "wealth effect" as his justification. The wealth effect, the result of so many people working and making money from the increased value of their assets, would cause inflation, he postulated. Therefore, interest rates had to be raised. And raised they were as the Fed went on an aggressive rate increase schedule in 2000.

Moreover, the Fed began to drain the money supply at a particularly crucial time. The price of oil was increasing from $10 to $37 per barrel. Since oil contracts are priced in dollars, an increasing supply of oil was necessary just to service these contracts. The Fed, though, foolishly drained $37,000,000,000 from the money supply just as more dollars were needed. By the fall of 2000, capital markets were in disarray; capital spending stopped; and the economy and the stock market fell off a cliff.

Carly Fiorina, CEO of Hewlett-Packard, commented afterwards: "In December; it was just like someone turned off the lights." Sun Microsystems CEO Scott McNealy added, "We were going 110 miles an hour and then we weren't." John Chambers, CEO of Cisco, likened the debacle to a 500-year flood. Business and investor confidence, a precious commodity, was destroyed. Thus ended the Goldilocks Economy, the longest economic expansion in our nation's history. More jobs, more prosperity, more wealth: it had to be stopped.

Greenspan also kept his poor predictive record intact, for on March 6, 2000, at a conference in Boston in a speech entitled, "The Revolution in Information Technology," Greenspan described with wonder a new age of productivity and growth. He indicated that the strong capital-spending boom showed that business continued to find and make a wide array of productivity enhancing investments in technology. " And I see nothing ... to suggest that these opportunities will peter out anytime soon." Ninety-six hours later, the NASDAQ began the descent from which it has yet to recover.

At first, it was thought that the only people who were losers were the Internet kids with the propellers on their beanies, but as the collapse spread, it became apparent that it would affect nearly every American. Over the two and a half years following Greenspan's Boston speech, U.S. stocks would lose fully half of their value--more than 8.5 trillion dollars--roughly equal to seven times the GDP of China and 50% more than the GDP of Japan. Two and a half million people would lose their jobs. Retirement plans were shattered; businesses were shuttered; and college plans were destroyed. Even the Shriners would have to close several hospitals for crippled children because of their portfolio losses. Businesses with new products under development were shut--with projects and services in their development pipelines that probably never will see the light of day. The market declined for 32 consecutive months, nearly equaling the 34 months of the Great Depression. For the period of the decline, the Dow was down 37.8%; S&P, 49.1%; and Nasdaq, a crashing 77.9%. Notable blue chips such as AT&T dropped 76.6%; Ford, 76.7%; and Intel, a staggering 82.4%. The consequences were felt throughout Europe, Asia, and a number of emerging economies around the globe.

According to the minutes of its January, 2001, meeting, the Federal Reserve itself was shocked by the result of its actions. Greenspan, convinced of inflation and trapped in his data, drove the economy off a cliff while looking in his rear-view mirror. Then, like a general committing his reserves piecemeal to battle, he doled out small interest rate cuts as the economy gasped for help. The Fed, with its 500 economists, studied the aftereffects of the Japanese bubble and concluded that the Japanese central bank had reacted with interest rate cuts that were too little and too late. Yet, the Fed, under Greenspan, adopted that policy as its own.

Piecemeal solutions

The Fed continued its pattern of piecemeal interest rate cuts and slow monetary growth until Sept. 11, 2001, when it began a period of aggressive interest rate cuts. Even then, as if to show who was in charge, the Fed delayed until just before the opening bell of the Stock Exchange, five days after the terrorist attacks, to cut rates. The Dow was down 500 points that day. The economy fell into recession and the markets continued to decline for another year.

Nobel prize-winning economist Milton Friedman has taken the position that the Fed is "always wrong: "one-hundred and eighty degrees wrong." As Massachusetts Institute of Technology economist Rudy Dombusch once commented, "None of the postwar expansions died of old age, they were all murdered by the Fed." Or, as CNBC host Larry Kudlow stated, "The Fed ... completely lost their mind."

In December, 2002, a few months after being knighted by Queen Elizabeth, Greenspan, in a speech to the Economic Club of New York, reported that the economy was going through a "soft spot."

None of this was necessary. First of all, one of the beauties of the U.S. economy is that it is self-correcting. Given time, the markets would have wrong out the excesses in the system. The economy did not have to be bludgeoned. The Fed had other more subtle tools at its disposal, if they were needed at all. Greenspan seems to have conceded these points. In a speech given Jan. 3, 2004, to the American Economic Association in San Diego, he took pains to justify Fed policies over his tenure. Practicing uncharacteristic humility, he said that making monetary policy is an "especially humbling activity," that "uncertainty characterized virtually every meeting" of the FOMC, and the committee made decisions "we came to regret." He mentioned that "forecasting was elevated to an even more prominent place in policy deliberations." Russian apparatchiks tried to run their economy from data points and failed. Greenspan relied on historic economic data for his roadmap, and put faith in models he now concedes cannot capture the complexity of that economy and probably never will. These comments are eerily reminiscent of those of former Secretary of Defense Robert McNamara in The Fog of War. When speaking of America's Vietnam experience, he conceded, "We made some mistakes."

In spite of his many costly gaffes, Greenspan consistently has survived presidents who did not want him. George W. Bush held his renomination hostage until it became an embarrassment, although the President remarked that Greenspan had done a "superb" job. Of course, this was the same appellation that he had applied to Secretary of Defense Donald Rumsfeld after the Iraqi prison scandal, and CIA Director George Tenet as he was being pressured to resign. Reenergized by his renomination, Greenspan came out speaking aggressively about the need for interest rate increases. Of course, any rate increases at this late date will not have an effect until after the election. The reader can speculate on what deal was struck between two of the most powerful men in America.

Now that Greenspan has been reappointed, it is time to begin the analysis of the his legacy. Is he an icon? Is he to be revered, as the Senate Finance Committee did at his renomination hearing? Or is it time to see if the emperor is wearing any clothes? I submit that when we look to see who shot the Goldilocks Economy, we do not have to look far. He is hiding in plain sight.

Meanwhile, what is to be done regarding the Fed? Reform is long overdue. Here are some suggestions:

* First, Congress should not be so deferential to the Federal Reserve Board and its chairman. They are apointees; they were not elected. As the watchdogs of our welfare, elected officials should be more aggressive in holding the Fed accountable for its job performance. If the Fed is management, Congress is the board of directors and American citizens are the shareholders. In spite of the devastation to the economy and working Americans, hardly a voice has been raised in Congress to question (and criticize) what happened and why.

* The Fed and its chairman should communicate in plain English. Greenspan practices "constructive ambiguity." The European Central Bank, on the other hand, holds a press conference after its rate decisions to explain its action.

* The term of office of the Federal Reserve Chairman should be shortened. When one person holds an office for so long with so little accountability, it is a recipe for trouble. Americans learned this with J. Edgar Hoover in the FBI. A long-term chairman becomes so powerful that he always gets his way. Just about all of the FOMC votes are unanimous, or nearly so. In the words of Gen. George S. Patton, "When everyone is thinking the same, no one is thinking very much."

* There should be a mandatory retirement age. Greenspan will be 80 if he finishes out his latest four-year term. Can he slay in touch with the developments in the economy? Has he? Does he care? The chairmen of the Federal Reserve Banks, on the other hand, must retire at 65.

* The structure of the Fed should be reformed. When the current Federal Reserve System was established in 1913, it was reflective of the economy then. While there are two branches in Missouri, there is just one west of Kansas City. A Federal Reserve Board that is more reflective of the real economy of the U.S. could give a more balanced approach to economic policy. Keep in mind that, if California stood alone as a separate economy, it would be the fifth largest in the world.

The economy is not just statistics. It represents, in very real terms, lives and fortunes of millions of individuals and families. It is obvious the kind of damage inept policies can cause. If the legislative and executive branches of government really are interested in avoiding the mistakes of the past, these policy recommendations would be a good place to start.

William D. Rutherford is president of Rutherford Investment Management LLC and author of Who Shot Goldilocks? How Alan Greenspan Did In Our Jobs, Savings and Retirement Plans.

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