The Greenspan Fed by Mutimba

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									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
   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

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 -
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

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

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

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

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


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

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

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

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

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.

April 8th, 2008 in Culture, Economics, Ethics, European Union, Financial
Markets, Politics | Permalink

3 Responses to ‚The Greenspan Fed: a tragedy of errors‛

  1. […] intellectually bankrupt, so this option may not be open to him.‛
     Meanwhile, Dean Baker and William Buiter also criticize Greenspan’s

     Posted by: Economics Blog : Secondary Sources: Greenspan Roundup,
     Builders' Breaks, Turning Point | April 8th, 2008 at 4:36 pm | Report
     this comment

  2. Can we get the FT to request Volcker to write an op ed piece on what he
     thinks about the Greenspan Fed, given that we will have to wait some
     years before Bernanke opines on the Greenspan Fed.

     Posted by: NM | April 9th, 2008 at 5:00 am | Report this comment

  3. Dear Willem Buiter,
     Your Greenspan article is extremely clear, as is your style, and I agree
     with all of it. I would add, however, one name o your list of baddies:
     that of David Mullins, former long time Harvard Business School
     professor, former vice president of the New York Fed and one of the
     partners of LTCM. His presence in the latter institution is perhaps part
     of the explanation why the Fed took such an interest in the rescue of
     LTCM and of the modalities of that rescue. It was also perhaps his
     presence at LTCM that made that institution a ‚left hand of God‛ for
     some central banks which wanted to support the prices of their
     countries’ public debt in the markets.
     I would also add that a good part of the explanation of the Greenspan-
     Bernanke put is in the absolute need Anglo-American styled retirement
     systems, based on pensions organised around the capitalization concept,
     and heavily invested in common stocks ( and now, lamentably , even in
semi-toxic derivatives) have to see the Stock Exchange go up
permanently. This was noted in Lamfalussy’s beautifully clear
‚European financial systems‛ as early as 1970. Institutional
investors’ heavy involvement with common stock, he said, required that
the Dow Jones could only go up. If it went down for any length of time,
this would spell disaster for millions of retirees, whose pensions
depended on pension funds that had to pay out huge sums every month as
the political economy aspects of this feature of Anglo Saxon capitalism
cannot be emphasized too strongly. A huge number of American voters
depend on the stock exchange’s performance for their monthly pension
checks staying within the boundaries of daily survival. They have the
habit of voting at presidential and congressional elections. A Fed’s
Chairman’s first duty to his president, who has appointed him, is to
keep the SP 500 going up, especially in election years.
Perhaps cognitive science does not need to be tapped, as much as old
fashioned electioneering techniques, or the ‚politics of money‛ as
they now call it in the US departments of political science.

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