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Saturday, December 22, 2007

The Terribly Mixed Record of Alan Greenspan

Up top is a historical graph of Prime Rate for much of the tenure of Alan Greenspan as head of the Federal Reserve. Alan Greenspan is nearly universally revered as a many of genius and strength, and his tenure is nearly universally lauded as a great one for the Federal Reserve.
I worked as both a stock broker and a mortgage broker during two pivotal periods of Federal Reserve action, and I firmly believe that once history is written on his tenure, it will be a lot more mixed than its current perception.
First, there is no question that Greenspan handled the Fed with great flexibility and adaptability and somehow managed to keep the economy moving along at a breathtakingly brisk pace without ever causing the sort of inflation that follows such growth. The nineties were an unbelievable time. When President Clinton got into office, the cell phone and the internet were rarities, and when he left, they were common place. Rarely does technology ever take such a short time to seep into the public consciousness. The television, the radio, and the automobile all took generations before they become commonplace.
This sort of growth of technology and by extension the economic growth that follows is frankly unprecedented. It is not to be understated what a wonderful job Greenspan did in navigating such a hot economy so that the heat never turned against it. By deftly cutting and raising interest rates at just the right time, in just the right amounts, he never let the economy get too hot, and also never let interest rates cool it too much. For this he will forever be lauded.
My problems with his tenure start at the end of Clinton's time in office. By the end of the nineties, internet stocks were frankly out of control. Paper thin companies which barely registered any revenue and were deep in red were worth more than well established brick and mortars like Sears, GM, and KMart, as a common place.
There were rumors among so called well placed sources that this was very troubling to the Chairman. It was more troubling than the normal bit of troubling economic date or trend. There were more rumors among more so called high placed sources that this was so troubling that the Chairman felt it was his duty to pop the so called internet bubble. Only the Chairman knows the truth, however this much is true. What he did starting at the end of 1999 and ending in 2001, was in and of itself very troubling, and its motivations are besides the point.
Starting at the end of 1999, when he unexpectedly first starting raising, the so called internet bubble burst. By the end of 2000, roughly three trillion dollars was lost in paper profits in the stock market. No one should argue that the popping of the internet bubble was also the pre cursor of the recession that followed, which officially started in mid 2001. What is very troubling is that in two years, Greenspan first raised rates dramatically and then immediately dropped the very same rate just as dramatically. In other words, whatever problem he thought he was fixing by raising the Prime Rate, he created an equally big problem that he then had to fix by lowering it.
The official explanation for the reasoning behind the initial increase in the Prime Rate was that he feared inflation on the horizon. This maybe so though the numbers at the time didn't seem that frightening. According to this chart, inflation was on the rise though, at least in my opinio, hardly at a level that warranted a rate increase. It matters not at this point. Whatever Greenspan did or didn't see, he rushed to head off inflation and caused a recession.
There are only two explanations for his motives. The first explanation is that he misread the tea leaves and was too aggressive in heading off inflation and caused the opposite, a recession. In that case, he was incompetent. The other more nefarious reason is that inflation worries were just a trojan horse for his real fear, the internet bubble. In that case, he showed unprecedented hubris since popping internet bubbles is not among the many lists of responsibilities of the Federal Reserve Chairman.
Either way, if the Chairman raises rates furiously for over a year and as a result then needs to drop the rates just as furiously, it is safe to say they didn't act appropriately in managing rates.
By the end of 2001, the recession was perpetuated not only by 9/11, but by the plethora of accounting scandals headed up by Enron. Chairman Greenspan continued to lower rates to absolutely no avail all the way deep into 2002. He lowered rates so much that eventually the Federal Funds Rate (three points below prime and the rate at which banks borrow from the fed) dropped below one percent. At that point, he could lower it no longer since it really couldn't go any lower.
As we shake out the current mortgage crisis, I below the ridiculously low Federal Funds rate will wind up being a not so insignificant factor in triggering the mess we are in now. By having this rate at such a ridiculous low level, it was too much of a stimulant for banks not to borrow, and borrow, and borrow, and borrow. At the time, the only sector that was performing was the housing sector, and so a large majority of the borrowed funds wound up in the housing sector, much of which by way of mortgages. That said, the borrowed money didn't have enough of an audience in the traditional mortgage market, and so these banks created new loans that would attract borrowers who traditionally wouldn't qualify. This fed on itself and just as the internet bubble burst so came along the housing bubble, and the rest is history.
Obviously, there was no way that Greenspan could possibly foresee how irresponsibly the banks would lend in the mortgage market, however what he could foresee was the law of unintended consequences. It was simply irresponsible to drive interest rates so low because at those levels there was simply too much money available. He may not have predicted that banks would lend irresponsibly in the mortgage market, but he should have predicted that at those levels the money would be used irresponsibly in some capacity.
So, while we laud Greenspan for the oracle and savior that he was, we should all remember his not so insignificant role in the two most important financial situations of our time as well. For, if we do, we will see that his record is not the shining beacon that some make it out to be.


Glen said...

Great post. I know this may sound a little over-simplified, but I honestly believe that Greenspan was just too old when he left. I agree that he lowered the rate too much after the dot-com bubble bursting, but I don't think he should completely be blamed for the housing correction, and it is a correction by the way, not a crisis.

I still think the good outweighs the bad with Greenspan. Since Volcker and himself became chairman, inflation has never really been a problem.

I think the current Fed should cool it though and stop these rate cuts.

mike volpe said...

I don't think anyone will ever know if he was too old. It is certainly possible. I agree that he isn't the only one to be blamed, in fact, I have written a piece about where the blame. Here is the piece...

He is absolutely NOT the only one to be held responsible. In fact, such a crisis by nature has plenty of responsibility. As a mortgage broker, I know this all too well since many want to pin all the blame on folks like me. We have our responsibility and so do others and Greenspan is included.

The reason that I wrote the piece is because he is looked at by many in mythical terms and I don't think that is fair.

Dave Schuler said...

Great post, Mike. One thing. You wrote:

The nineties were an unbelievable time. When President Clinton got into office, the cell phone and the internet were rarities, and when he left, they were common place. Rarely does technology ever take such a short time to seep into the public consciousness.

Something few seem to recall is that the explosion of technology into the public consciousness taht you refer to took place after 12 years of substantial investment by companies in technology (between 1983 and 1995) without seeing much in the way of return on the investment. Complaints about this are a staple of the business journals of the late 1980's and early 90's.