The case against Alan Greenspan

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As Alan Greenspan nears retirement, it is time to assess his legacy. Does the Fed chairman deserve his reputation as one of the great central bankers? Frank Partnoy argues that he is in fact the beneficiary of virtuous circumstances, has rarely been in control of events, and has often made the wrong call – notably in his attitude towards credit derivatives.

THERE ARE PLENTY of nice things one might say about Alan Greenspan. He is smart, savvy and well connected and he is a charming and gracious dinner guest. He certainly has political staying power. During nearly two decades as chairman of the Federal Reserve he has been one of the world's most powerful and influential figures.

Indeed, as Greenspan prepares to retire, commentators are lining up to praise him and his work. The dominant view is that he was a kind of mystic saviour – like the diminutive Yoda of Star Wars fame – who could foretell the future and understand the forces that would lead to prosperity and peace. During the upcoming months, many commentators will uncritically applaud Greenspan's record, often with good reason, for there is much to praise.

But now that the Greenspan era is ending, it is time to view the man through something other than thick rose-coloured glasses. Was the relationship between his actions and relatively low unemployment, low inflation and high growth merely correlation rather than causation? Put another way, would just about any qualified Fed chair have made the same or similar moves to those Greenspan made? Did the world become more prosperous because of Greenspan, or did Greenspan become more popular because of prosperity?

A strong case can be made against the notion of Alan Greenspan as economic saviour. Instead, many people believe he has lost his grip on the markets, and he has admitted as much on occasion, saying he has been wrong about growth estimates and wrong at times in setting interest rates. Most recently, Greenspan labelled low long-term interest rates a "conundrum", and waffled about the costs and benefits of credit derivatives.

His spoken words remain opaque; it has been several years since he conjured up a master phrase, such as "irrational exuberance" or "infectious greed", to suggest that he understands the challenges facing modern financial markets. Asset price bubbles and financial innovation continue to confound him because they do not fit his preconceived notions of how markets work.

Perhaps most importantly, Greenspan is losing respect among his most important constituencies: central bankers and sophisticated market participants. Many believe Greenspan should have left the Fed a long time ago.

It is worth taking a closer look at how and why so many people came to revere this man and why they might be wrong. To understand Alan Greenspan, it is necessary to focus not only on what he has done but also on who he is. And it is impossible to get a picture of who he is without knowing a bit about his past.


Strict libertarianism

Alan Greenspan's childhood is summarized in an incomprehensible quote from his father Herbert, an economic pundit who published a book called Recovery Ahead! in 1936. In this book, Herbert Greenspan argued that if the government spent more money, the country could escape the Great Depression. He was an ardent supporter of Democratic president Franklin D Roosevelt's New Deal.

He proudly gave his eight-year-old son a copy of the book, with the following words scrawled in longhand inside the cover page: "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 like work of your own. Your Dad."

Even if young Alan understood what his father meant, the last thing he wanted to do was undertake "similar efforts" or "like work". (Alan would emulate his father's mangled prose soon enough.) Alan's parents were divorced and he didn't want to be like his father, a stockbroker, political activist and policy wonk whom Alan saw only infrequently. Instead, Alan dreamed of becoming a famous jazz musician.

Alan's academic record was undistinguished, and he focused more on learning to play the clarinet than on his studies. He was admitted to the music college now known as the Juilliard School but dropped out to play bebop with a touring big band. However, Alan's music career fizzled out and he quickly realized he was more like his father than he had hoped. As Bob Woodward described in his book Maestro: "While other musicians drank, smoked dope and stayed up all night, [Alan] read economics and business books and eventually became the band's book-keeper." Apparently, the fruit did not fall far from the tree.

Alan completed a first degree in economics at New York University but then dropped out again, this time from a PhD programme in economics. (Few people realize that he never completed a dissertation.) Biographers have described him as both emulating and resisting his father during this time. Alan lacked the drive and aptitude to become a world-class economist, but he was an adept networker and was generally well liked. In 1953, aged 27, he founded a consulting firm, Townsend-Greenspan & Co, Inc, and cultivated relationships with writers, politicians and business people. He balked at his father's left-leaning political sensibilities, though, and instead became the opposite: what he called a "strict libertarian".

Alan fell in with the Objectivist movement, dominated by the writer Ayn Rand, that favoured free markets and opposed strong government. He wrote articles for Objectivist newsletters, and contributed several essays to Rand's book Capitalism: The Unknown Ideal. He was a strong advocate of the gold standard (an irony, given that his fame would derive from the Fed's role in fiat money). In 1957, 31-year-old Alan Greenspan wrote a letter to the editor of the New York Times book review section protesting about a hostile review of Rand's novel Atlas Shrugged. It was the first time his name appeared in that paper.

During this early, pre-political period in his life, Greenspan formed firm, unshakable views. The 1950s were a relatively simple time, and his philosophy was relatively simple, too: regulation bad, free enterprise good. His consulting work for companies such as Burlington Industries and Ryder Systems stressed straightforward analysis of large data sets. He supported his general conclusions with statistical minutiae, an approach he would try to follow as chairman of the Federal Reserve.

This history is important, not because Greenspan's views were objectionable or even incorrect but because they were so ardently held. He was more zealot than scholar, more advocate than analyst. And he remains so.

Consider a Greenspan quote from a 1996 speech to the American Bankers Association: "If banks were unregulated, they would take on any amount of risk they wished, and the market would rate their liabilities and price them accordingly." It sounds very much like the late 1950s, when his philosophical approach to markets was so clearly delineated. During the five decades after he formed these views, Greenspan barely budged.

A political animal

Richard Nixon gave Greenspan his
first foothold on the government ladder
During the 1960s, as America moved to the left, Greenspan held firm. He became close to conservative politicians and active in the Republican Party. He advised Richard Nixon's presidential campaign in 1967, and Nixon rewarded him a few years later by nominating him to replace Herbert Stein, an economist, as chairman of the president's Council of Economic Advisers.

In today's politically charged climate, Greenspan's nomination wouldn't have had a chance. Greenspan was a business-friendly, anti-government activist. Perhaps most important, he was not an economist. Senator William Proxmire questioned Greenspan's bias and his close ties to business interests, but the public didn't seem to care about conflicts of interest or the fact that he had never completed his PhD. Nixon's head economist would not be an economist at all.

Greenspan remained as chairman of the Council of Economic Advisers when Gerald Ford took over as president. He quickly sent Ford a 26-page memorandum blaming the nation's serious economic problems on runaway government spending and intervention in the economy. He argued for unregulated markets and limited government. At the time, the budget deficit was in the range of $20 billion, and Greenspan advocated an immediate spending cut of $20 billion.

Few people took Greenspan's radical proposal seriously; Ford's leading advisers called it "madness". Greenspan soon returned to his consultancy, with a strong political network and a reputation as a strict economic conservative. He spent the next decade as a lobbyist and consultant, and was named a director of numerous companies, including Alcoa, ADP, Capital Cities/ABC, General Foods, JPMorgan and Mobil. Greenspan also donated money to high-level Republicans, including the Senate campaign of conservative leader Jesse Helms.

By this time, administrators at New York University must have understood that Greenspan was becoming a powerful, wealthy man. They belatedly awarded him a PhD in economics, even though he still had not completed a dissertation.

This, in a nutshell, is the history of Alan Greenspan before he was nominated to chair the Federal Reserve. He was only nominally an economist and had little exposure to, and no experience in, central banking. He had deep connections in politics and business, and was a hard-line conservative who consistently favoured unregulated markets.

In short, he was a dependable advocate; what commentators today would call a "political hack". (A prime example was when Greenspan declared, on September 29 1974, on the television programme Meet the Press, that all antitrust laws should be abolished.) Greenspan had spent most of his career effectively as a lobbyist, using his contacts to help businesses deal with government, on both sides of the revolving private–public sector door.

As James Grant has documented in his superb book The Trouble with Prosperity, Greenspan was a careerist and an establishmentarian. Greenspan's experience with the savings and loan industry alone should have killed his shot at another government job. In 1984, just before the savings and loan crisis, Greenspan was hired to examine the financial statements of Lincoln Savings and Loan Association and its owner, Charles Keating. Greenspan concluded that Lincoln Savings was safe and sound, and he wrote a seven-page letter lobbying regulators to leave Lincoln Savings alone, arguing that the S&L "had transformed itself into a financially strong institution that presents no foreseeable risk to federal regulators".

Within a few years, Lincoln Savings collapsed, along with more than a dozen other S&Ls Greenspan had supported. Keating and others were convicted of crimes, and Greenspan admitted in on-the-record interviews: "I was wrong about Lincoln."

In today's politically charged climate, someone with this record, and these skeletons, both in and out of the closet, would never be nominated to chair the Federal Reserve. Such a person could not possibly be confirmed. Indeed, today's list of Greenspan's likely replacements includes only the most prestigious economists, all of whom have extensive private-sector and public-sector experience, pristine records and balanced views. But 1987 was a different era.

Lost in a sea of derivatives

For president Ronald Reagan, Alan Greenspan was a plausible, if not obvious, choice to replace outgoing Fed chair Paul Volcker. Greenspan had led a board studying the social security programme during the Reagan administration (Greenspan recommended against reform and is thus at least partly responsible for the current social security quagmire), and Reagan rightly saw him as a tireless advocate of conservative economic policy. The economy was strong at the time, and the Fed was not as important or high profile as it is today. Moreover, the law dictated that whoever sat as chair of the Fed was required to implement policies to achieve sustainable economic growth and stable prices, meaning inflation in the range of 2% to 3%. Greenspan's political connections clinched the job, and he took over in August 1987.

Greenspan's term as chairman began quietly, with the Fed raising short-term rates by half a percentage point to 6% in September. But the quiet didn't last long.

Greenspan is often praised for his swift reaction to the stockmarket crash on October 9 1987, now known as Black Monday. But the truth is that as the market was falling more than 22% that day, Alan Greenspan was stuck on a plane, out of touch with the markets. He learned the details only after trading had closed. Instead, Gerald Corrigan, the 46-year-old president of the Federal Reserve Bank of New York, managed the immediate reaction to the crash.

Even after Greenspan's plane landed, Corrigan, a fully fledged economist, continued to pull the strings as the markets recovered. According to Woodward's book, Greenspan privately admitted that he thought the recovery had been a miracle. He said: "I don't know where it came from."

The next few years were less dramatic, and the Fed periodically raised rates until the beginning of 1989. Then, as rates stood at almost 10%, Greenspan settled on the plan that would cement his popularity. At his urging, the Fed embarked on a five-year path of steadily declining interest rates – 25 consecutive Fed rate cuts in all. Who wouldn't be popular after such reductions? Greenspan was hailed as a genius.

Unfortunately, Greenspan and his colleagues did not understand that during this period the financial markets were spinning out of control. Short-term borrowing had skyrocketed. Financial institutions were exploiting advances in financial innovation to help their clients make leveraged bets of unprecedented size. Unregulated markets in over-the-counter derivatives grew at an explosive pace, reaching $25 trillion of notional amount (they are more than 10 times that large today). This was the time when Procter & Gamble made and lost a bet that interest rates would remain low that was roughly the size of the entire outstanding issuance of 10-year US treasury bonds.

It also was the time when Orange Country treasurer Robert Citron made and lost a similar $20 billion bet by using complex structured notes. Hundreds of institutions, ranging from banks to local school districts, were using derivatives to gamble on interest rates, and most of them lost. Government-sponsored enterprises, such Fannie Mae and Freddie Mac, were making some of the biggest bets, with the implicit backing of the federal government.

Greenspan either didn't know about the astonishing increase in the amount of credit washing through the financial system or lacked the tools to understand it. Nor did he see any cause for alarm: consistent with his unwavering philosophy, derivatives markets were unregulated and therefore they must be good.

Even after learning the details about the derivatives scandals of the mid-1990s, Greenspan concluded in a 1997 speech at a Fed conference that "there appears to be no need for government regulation of off-exchange derivative transactions between institutional counterparties".

But even if Greenspan was right about regulation, he was wrong about the effect of this financial innovation on Fed policy. When the Fed finally raised rates in 1994, it sent shock waves through the system, in ways Greenspan and others would later admit they had

not understood. Derivatives counterparties lost billions of dollars; many went bankrupt. And yet Greenspan, seemingly oblivious to the new world of finance, continued not only to lobby for more rate increases, he also pressed for greater deregulation of derivatives. As rates increased throughout 1994, the financial carnage spread.

Out of touch

Meanwhile, Greenspan began to lose the respect of some his Fed colleagues. A few members of the Federal Open Market Committee said Greenspan was bullying and that the process of setting short-term interest rates was undemocratic. Others suggested that Greenspan had advocated cutting rates to curry favour before elections, in order to ensure his reappointment. For example, during 1991, the year before a presidential election, the FOMC lowered rates 10 times, from 7% to 4%.

Ronald Reagan: At the time, Greenspan
seemed an obvious appointment as Fed
chairman. In today's climate, he would
stand little chance of nomination
Colleagues were also sceptical about some of the new approaches to Fed policy that Greenspan had introduced. For example, he increased the number of data series tracked by Fed researchers to more than 14,000, and focused on two-dozen data series that some Fed insiders believed Greenspan did not understand. Former Fed governor Janet Yellen told BusinessWeek that one series "was so complex that it was beyond me".

Given that Greenspan appeared to rely on a few simple rules in assessing interest rates, it wasn't clear what role these complex data series served. Greenspan advocated a shift away from relying on money-supply measures towards a single, simpler measure: the short-term real interest rate (essentially the short-term nominal rate minus expected inflation). He argued that the Fed's objective was straightforward: keep short-term real interest rates low.

The problem with relying on real interest rates is that inflationary expectations can't be measured, so an estimate requires a "seat of the pants" judgement. Moreover, inflationary expectations can change very quickly, and historical measures of inflation, such as the consumer price index, can be misleading. The Fed looked not only at the CPI, but also at other measures, including the prices of financial assets such as stocks. Greenspan's idea was to get a rough sense of inflationary expectations and then adjust nominal rates so that the short-term real interest rate remained between 1% and 2%.

Greenspan became frustrated when stock prices continued to rise quickly even after the Fed rate increases of 1994. He became convinced that the markets were overvalued, and in 1996 gave his infamous "irrational exuberance" speech. That phrase became well known but the prediction was dead wrong. The technology bubble did not burst until March 2000, and an investor who had followed Greenspan's advice would have been worse off than one who had simply remained in the market.

It is surprising that so many people regard Greenspan as a skilled economic forecaster. In reality, his track record is unusually poor. For example, in 1959, he told Fortune magazine he thought stocks were overvalued; the market went up 43% the following year. In 1973, he publicly announced that "it is very rare that you can be unqualifiedly bullish as you can be now"; the stockmarket had peaked two days earlier.

Before Greenspan became chair, the Fed ranked his consulting firm dead last in its list of economic forecasters. And in a speech on March 6 2000 – several years after his "irrational exuberance" query and just a few days before the technology bubble burst – Greenspan gave a speech entitled "The Revolution in Information Technology", in which he lauded the market for technology stocks, praised the "wide array of potential high-return, productivity-enhancing investments," and concluded that "I see nothing to suggest that these opportunities will peter out any time soon."

But at least Greenspan seemed engaged in issues surrounding the valuation of technology stocks. Throughout the Clinton years, he was strangely disconnected from most other major crises. When the Mexican peso was devalued in 1994, officials from the US Treasury, and particularly Robert Rubin, took the lead. (Greenspan's responsibilities were minor, including a phone call to Rush Limbaugh, the conservative radio talk-show host, to attempt to explain the reasoning behind the $40 billion "bailout" of Mexico that Limbaugh opposed.)

The same was true of the Asia crisis that followed the devaluation of the Thai currency in 1997. During the credit crunch of 1998, Greenspan remained on the sidelines, permitting the Fed to play a role in the attempted rescue of Long Term Capital Management, the hedge fund that held over $1 trillion of unravelling derivatives positions. Ironically, this was one of the few times Greenspan strayed from his free market philosophy; Ayn Rand and the Objectivists would have let LTCM fail without batting an eye.

His most serious mistake?

Greenspan's most recent and perhaps most serious mistakes have involved his comments on credit derivatives. Although he has changed positions on credit derivatives several times, and has criticized the high concentration and inadequate disclosure in the market, he has generally praised credit derivatives for their role in transferring credit risk away from banks.

Gerald Corrigan: While
Greenspan was stuck on a
plane, it was the New York
Fed chairman who took and
kept control of the Black
Monday crisis
From a banking perspective alone, credit derivatives have obviously been a boon. They have enabled banks to manage and shift risks and have created new streams of fee income. But credit risk is a hot potato, and when banks get rid of it, it is passed to someone else. The largest seller of credit default protection has been the insurance and pension sector. Greenspan has dismissed worries about credit-related losses at these institutions by suggesting that parties who assume credit risk using credit derivatives are better able to bear that risk than banks.

But the problem with shifting credit risk is not the ability of the insurance and pension sector to bear risk. Obviously, these are large institutions. Instead, the problem is that insurance companies and pension funds are not in a position to monitor borrowers. Banks uniquely occupy that position, and the great strength of banks as lenders in a market economy is their ability to police the extension of credit. They have relationships with borrowers, they have access, and they can keep tabs on key data, financial measures and personnel.

Credit default swaps distort global investment by shifting monitoring incentives away from banks to other parties that have no relationship with the borrower and who are less skilled and experienced in evaluating credit risk. As a result, capital is misallocated and borrowers take on too much risk, a problem generally known as moral hazard. Ironically, moral hazard has been one of Greenspan's sworn enemies for 50 years, particularly when parties take on undue risk because regulation encourages them to do so. That is precisely the case with credit derivatives, where legal rules such as capital requirements encourage banks to offload credit risks, while insurance and pension rules impose lower capital charges and require less disclosure.

If these rules did not exist, much of the incentive to use credit derivatives would disappear, and the markets would be freer, safer and more efficient. In other words, credit derivatives might help banks, but they are creating hidden dangers elsewhere in the financial system. In a speech in May 2005, Greenspan said that although the Fed lacked the data to draw conclusions about what he called "non-bank risk-takers", he assumed that these non-banks would better bear credit risk because they are unregulated. That assumption was wrong.

Shame on Alan Greenspan for not understanding this.

Greenspan's philosophical bias in favour of unregulated markets, honed as a child, has not permitted him to recognize what could be an impending disaster in the derivatives markets, or to find a pithy phrase that might crystallize his views. The best he has mustered is an announcement that he is no longer "entirely sanguine with respect to the risks associated with derivatives". Some commentators believe Greenspan has serious concerns about both hedge funds and banks, particularly JPMorgan Chase, but he has not clearly expressed those concerns.

There are reasons to be afraid. JPMorgan now holds a notional amount of more than $1 trillion in credit derivatives positions. This year, the bank reported that 97% of its derivatives assets and liabilities were valued based on "internal models with significant observable market parameters". It also said the majority of its remaining derivatives positions were valued based on "internal models with significant unobservable market parameters". A decade ago, several financial institutions, including Askin Capital Management, used such internal models and collapsed instantaneously when they discovered the models were wrong. With respect to JPMorgan, the problem is not merely disclosure: the bank has already said very clearly that it is a house of cards. The problem is that no one, including Alan Greenspan, seems to care.

A politician, not an economist

In sum, the case against Alan Greenspan boils down to this: he has stuck stubbornly to the narrow-minded view that unregulated markets are always preferable to government involvement. This view has prevented him from seeing subtle changes in modern financial markets or adopting a more nuanced view of how markets often need ground rules in order to operate efficiently. Because his background was primarily as a consultant, lobbyist and politician – not as an economist – he was unable to conduct an effective dialogue with other members of the Fed who were economists.

Throughout Bill Clinton's administration,
Greenspan seemed strangely
disconnected from most major
financial crises
What he lacked in technical understanding he was forced to make up in political savvy; fortunately for Greenspan, he accumulated huge sums of political capital from the effects of sustained rate cuts, particularly during the 1990s. Finally, Greenspan – perhaps unsurprisingly – has not been capable of explaining the rationale for Fed actions. This is one reason why the public has seized on his occasionally lucid phrase. If a person can't explain what he means in clear language, he probably doesn't understand what he is saying.

Greenspan is frequently as incomprehensible as his father's longhand inscription from 60 years ago. There is a story told that when he gave what he thought was a proposal of marriage to journalist Andrea Mitchell at a Washington, DC, restaurant, Mitchell didn't understand what he was saying, and only agreed to marry him weeks later when he was more explicit, finally asking about wedding plans. That view of Greenspan, as an endearing bumbler unable to express himself clearly with words, is a charitable one. The more nefarious view is that Greenspan has been deliberately vague – Greenspan

labels it "constructive ambiguity". According to Bob Woodward, at times Greenspan actively wanted to confuse the press and admitted it, saying at one point: "I'll just say a little bit this way and a little bit that way, and I'll completely confuse them so there'll be no story."

One final thought: what is one to make of Alan Greenspan's decision to step down now, a decision that seems as unclear as any of his speeches? When president Clinton said: "I bet he'll stay there until they carry him out," he was only partly joking. Greenspan obviously loved the position of Fed chair, and has consistently been reluctant to give up his spot. Of course, an obvious reason to leave would be to spend more time with his family and friends. He certainly has worked long and hard enough to deserve retirement. But another possibility is that he still believes he can foretell the future, and he doesn't like it. He might see that there is no way to fix the problem he created by cutting rates too far too fast.

As recently as August 26, at a Fed symposium honouring him, Greenspan spoke in typically impenetrable prose; nevertheless most people got the message: soon stocks, bonds and housing prices will plummet and the global economy will enter free-fall. When that happens, blame the new guy, he intimated. That is the Greenspan legacy.

Frank Partnoy is one of the world's leading scholars in law and finance. He is a professor of law at the University of San Diego. He is the author of two extensively reviewed, cited, and translated books about financial markets: Infectious Greed: How Deceit and Risk Corrupted the Financial Markets (Henry Holt, Profile Books, 2003); and F.I.A.S.C.O.: Blood in the Water on Wall Street (W.W. Norton, Profile Books, 1997).