Tuesday, July 29, 2014

C’mon Alan! Bubbles Are Caused By Central Bankers, Not “Human Nature”

By David Stockman

Alan Greenspan just cannot give up the ghost. During his baleful 18-year reign, the Fed was turned into a serial bubble machine—and thereby became a clear and present danger to honest free market capitalism and an enemy of the 99% who do not benefit from the Wall Street casino and the vast inflation of financial assets which it has enabled.  His legacy is a toxically financialized economy that has extracted huge windfall rents from main street, and left it burdened with overwhelming debts and sharply reduced capacity for gains in real living standards and breadwinner jobs.

Yet after all this time Greenspan still insists on
blaming the people for the economic and financial havoc that he engendered from his perch in the Eccles Building. Indeed, posturing himself as some kind of latter day monetary Calvinist, he made it crystal clear in yesterday’s interview that the blame cannot be placed at his feet where it belongs:

I have come to the conclusion that bubbles, as I noted, are a function of human nature.
C’mon. The historical record makes absolutely clear that Greenspan panicked time and again when speculation reached a fevered peak in financial markets. Instead of allowing the free market to cleanse itself and liquidate reckless gamblers employing too much debt and too many risky trades, he flooded Wall Street with liquidity and jawboned the speculators into propping up the casino.  Within months of his August 1987 arrival, for example, he panicked on Black Monday and not only inappropriately flooded with liquidity a Wall Street that was rife with rotten speculation and a toxic product called “portfolio insurance”, but also intervened directly to garrote the markets attempt at self-correction.

In that context he sent his henchman, Gerald Corrigan who was head of the New York Fed, down to Wall Street to break arms and bust heads in an effort to insure that firms continued to trade with each other and extend credit where their own risk control managers appropriately wanted to cancel credit lines to insolvent counter-parties.  Then and there, the Greenspan “put” was born, and the stock market was en route to becoming a Fed-driven casino rather than an honest venue for real price discovery. Indeed, the entire Greenspan-Corrigan mission in the wake of Black Monday was to force Wall Street firms and banks into price “undiscovery”.

Incidentally, in yesterday’s interview Greenspan belatedly confessed that he had caused Goldman Sachs to “undiscover” that Continental Illinois was a bad credit risk, and that, instead of demanding payment, they needed to see it Corrigan’s way. Not surprisingly, Corrigan went on to become a Goldman partner in charge of hand-holding the New York Fed’s open market desk, which is to say, an exemplar of how crony capitalism is done.

Goldman was contemplating withholding a $700 million payment to Continental Illinois Bank in Chicago scheduled for the Wednesday morning following the crash. In retrospect, had they withheld that payment, the crisis would have been far more disabling. Few remember that crisis because nothing happened as a consequence.
Well, that’s just the point. Free markets correct their own excesses when two-way trading is permitted to run its course. At the time of Greenspan’s first panic, the financial markets were laboring under the pressure of Washington’s huge debt emissions owing to the giant Reagan deficits. In that context, interest rates wanted to soar in order to reflect the “crowding out” effect of Uncle Sam’s massive borrowing—a path that would have laid the stock market speculators low for years to come. And it would have also generated a fiscal clean-up package in Washington that would have nipped in the bud the lamentable Reagan era myth that “deficits don’t matter”.

In short, owing to his Black Monday panic Greenspan let both the Wall Street gamblers and the Washington spenders off-the-hook, and launched the nation on the road toward the debt and speculation-riven crony capitalism that prevails today. So the claim that “nothing happened as a consequence” could not be farther from the truth. What happened was the onset of a historic calamity—that is, the official repudiation of free markets, fiscal rectitude and sound money.

And there was more. As is also well known, on the next morning (Tuesday), the futures market in Chicago and stock exchanges in New York came to a dead stop and were heading for another cleansing free-fall, when suddenly massive buy orders came in from Fortune 500 companies to buy their own stock.  That didn’t happen by accident. Ayn Rand’s former disciple was busy at work over-riding the free market and jaw-booning CEO’s into their first great foray into stock buybacks—-a speculative pursuit which has now become an institutionalized disease in the C-suites.

In the years that followed the same pattern ensued at each point the markets attempted to rectify themselves. That includes 1994 when the bond market and mortgage back securities market went into a cleansing tailspin, but instead of allowing the money market rates to rise to market clearing levels, the Greenspan Fed panicked and capped the rise at just 300 basis points. That is, at a fraction of what Volcker had permitted and far below what was needed to arrest the incipient financial bubble that was already then underway.
Likewise, during the 1998 Russian and LTCM crisis, Greenspan panicked once again and slashed interest rates to save speculators in Russian securities and domestic hedge funds, and jawboned Wall Street into bailing out LTCM. Needless to say, the latter was a reckless gambling den that had been leveraged 100:1 by the very same Wall Street firms that Greenspan organized into a mafia-like cartel designed to prevent the free market from working its will, and to spare the offending Wall Street firms from taking their lumps.

By now, therefore, the “Greenspan put” was deeply implanted in the casino. That became fully evident when the market soared in 1999 after Greenspan’s late 1998 panicked rescue of the speculators. The Wall Street gamblers now understood that shorting over-bought markets was dangerous and that buying the dips was the route to fabulous riches for fast money traders. The era of one-way markets had thus been launched.
Yet by that point Greenspan had been crowned the “Maestro”, causing him to throw any remaining semblance of sound money and respect for market price discovery to the winds. Even as the NASDAQ and dotcom stocks soared to insane heights in the spring of 2000, Greenspan told a congressional committee that there was no evident financial bubble and that the Fed could not prevent one if there were. A noxious lies was thereby born.

And then it got worse after the dotcom crash. Beginning on Christmas eve 2000 the Fed began to slash interest rates, and didn’t stop its meeting after meeting cuts until it had lowered the funds rate to an unprecedented 1% by the spring of 2003.  By then, of course, the housing bubble was already galloping toward its eventual destructive demise, but the Greenspan Fed was oblivious.

Even during the first bubble of the 1990s, the home mortgage market had been reasonably well-behaved and gross mortgage originations rarely exceeded $1 trillion annually until the end of the decade. But at the time that Greenspan made the final federal funds reduction to 1.0% in Q2 2003, the annualized run-rate of gross mortgage originations had soared to the outlandish sum of $5 trillion.

Indeed, the whole housing bubble finance mechanism of homeowners raiding their own ATM (i.e. equity in their homes) was underway, and a debt fueled boom in housing prices was entering its final lunatic phase.  But Greenspan saw no bubbles at all. Nor did he have a clue that a giant financial crisis owing to his destruction of honest financial markets was just around the corner when he exited the Eccles Building early 2006.

Notwithstanding this sorry history, Greenspan did the world a large favor in yesterday’s interview while trying to justify his Calvinistic blame of “human nature” for financial bubbles. He claimed that the Fed tried to stop a bubble when it tightened in 1994, but that effort failed—thereby proving, apparently, that central banks are no match for human nature.

Accordingly, bubbles needed to be allowed to run their course. Henceforth, the Fed would function as a clean-up brigade with a mission to flood the market with liquidity after the fact—that is, to operate the very kind of bubble finance policy that has now become deeply and destructively institutionalized.

 The Fed tried in 1994 to defuse a bubble with monetary policy alone. We called it a boom back then. The terminology has changed, but the phenomenon is the same. We increased the federal funds rate by 300 basis points, and we did indeed stop the nascent stock-market bubble expansion in its tracks. But after we stopped patting ourselves on the back for creating a successful soft landing, it became clear that we hadn’t snuffed the bubble out at all. I have always assumed that the ability of the economy to withstand the 300-basis-point tightening revised the market’s view of the sustainability of the boom and increased the equilibrium level of the Dow Jones Industrial Average. The dot-com boom resumed.
When bubbles emerge, they take on a life of their own. It is very difficult to stop them, short of a debilitating crunch in the marketplace. The Volcker Fed confronted and defused the huge inflation surge of 1979 but had to confront a sharp economic contraction. Short of that, bubbles have to run their course. Bubbles are functions of unchangeable human nature….

No better indictment of monetary central planning and money market interest rate pegging could be delivered. Greenspan institutionalized macroeconomic management through rigid control of the funds rate and  by an intolerance for money market movements of more than 25 basis points. In the process, “price discovery” was supplanted by “price administration”.

More importantly, the single most important price in all of capitalism—-the price of hot money on Wall Street—-was shackled. The carry trades were soon off the races because cheap and predictable overnight funding costs are the mothers milk of financial speculation.

Once upon a time, Wall Street would cure its own excesses when the “call money” rate soared by hundreds of basis points during a single day, and rates sometimes reached deep into double digits when speculation got overheated. Yet it was that vital market-clearing mechanism, that instrument of financial market self-correction, which Greenspan now admits he destroyed in 1994 when he capped the funds rate rise at 300 basis points.And then he became puzzled as to why just a short time later the mania reignited.

It goes without saying, of course, that the free-market/sound money Greenspan of the days before he became head of the monetary politburo in Washington would not have been puzzled at all.

David Stockman was the Director of the Office of Management and Budget during part of the Reagan Administration, from 1981 to 1985. He is the author of The Great Deformation: The Corruption of Capitaism in America and The Triumph of Politics: Why the Reagan Revolution Failed.

 The above originally appeared at David Stockman's Contra Corner and is reprinted with permission. 

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