Conventional wisdom has it that the Federal Reserve played a pivotal role in the Great Recession (2007-2009) by its easy money policies, which inflated the housing bubble that then burst, precipitating a cascade of crashing stock and bond markets, ultimately resulting in a severe contraction and massive job losses across the whole of the economic system. Conventional wisdom points in the right direction when it pins the blame for the crash on the Fed, but gets its causative agent wrong. It wasn’t easy money that caused the crash. It was the cult of personality that arose around its chairman, Alan Greenspan. When he left the chairmanship in early 2007, the stage was set for a spectacular fall.
The first hints of trouble in the housing market came in mid-2007, just after Ben Bernanke took the Federal Reserve Board’s helm, when a pair of Bear Stearns hedge funds specializing in subprime mortgage collateralized debt obligations failed (Bear Stearns was a deeply admired investment bank before the crash, which later also failed and was absorbed into the hydra-headed monster, JP Morgan Chase). Soon enough, the whole of the subprime mortgage slice of the housing market pie was deemed suspect, and failure after failure of similar instruments followed. The contagion quickly spread to every corner of the financial markets, though even at its peak, subprime mortgage lending was only a small fraction (about 10% in total) of the whole housing market. Why should it have happened that overleveraging and poor risk management in one area of the market brought the whole house, so to speak, down? Was it really the case that the margins upon which investment banks were operating were so slim that any moderately sized loss in a relatively remote sector could wipe out enough capital that it would bring the whole of investment banking to the precipice of financial Armageddon in such a manner as to imperil the whole of the economic system?
In May of 2007, when it became clear that trouble was brewing in the subprime mortgage market, the recently installed (February of 2007) Chairman of the Federal Reserve Board, Ben Bernanke, had this to say, in a speech titled “The Subprime Mortgage Market” given at a conference on banking held at the Federal Reserve Bank of Chicago:
All that said, given the fundamental factors in place that should support the demand for housing, we believe the effect of the troubles in the subprime sector on the broader housing market will likely be limited, and we do not expect significant spillovers from the subprime market to the rest of the economy or to the financial system.
Bernanke should have pulled an Obama, and said it was all Greenspan’s fault. Which, of course, it was. But not in the way that is commonly thought. To be sure, Greenspan caused the financial meltdown precipitated by the subprime mortgage market crisis, but not because of his easy money policies, dating from about 2001, to which most people attribute the cause. The easy money helped, but the real currency Greenspan traded in was confidence.
Confidence is the currency of realm in financial markets. At minimum, traders must be confident that freely entered contractual obligations will be enforced, and if need be, at the point of a bayonet. That part was easy, what with American military and political hegemony reaching unto nearly every corner of the globe, but that part was not really within Greenspan’s purview. Greenspan built on the confidence arising from American hegemony and leveraged it into a much broader and deeper sense of infallibility. He instilled in markets the confidence that with him at the helm, the Fed was the ultimate underwriter of risk. He was a con artist, inducing the markets to feverish and risky activity by implicitly covering their losses. The confidence in Greenspan came to be known as the Greenspan Put. I prefer to call it the Great Put, because the Great Put led directly to the Great Recession.
The con started in 1987, shortly after Greenspan took office, when he got involved in soothing stock market jitters after a one-day plunge which occurred primarily because of poorly quantified risk models. The decline, still the largest single day decline in the Dow in percentage terms, exceeded anything seen since the Great Depression. Greenspan’s involvement, while not large, set the tone for all that would follow. The ’87 crash involved all sectors of the market, and Greenspan’s actions were directed at ameliorating systemic risk. The Dow finished the year in positive territory. The notion that the Greenspan Fed would operate to save individual firms from their own folly didn’t really gain purchase until a relatively insignificant hedge fund, LTCM, failed in 1998 due to some bad bets it made on the Russian currency and bond markets. After LTCM, the party was on. The Fed, who had once been considered stern market disciplinarians willing to step in and facilitate rescues only when market failures threatened the economic system, and then, only enough to ameliorate financial system fallout to the real economy, had essentially coupled financial system failures, even if the systemic failure only extended to one firm, to the economic system. In a twist to the old saying in the fifties that anything good for GM was good for America, the Greenspan Fed stood for the belief that anything that was bad for the financial markets, was bad for America. Financial market speculators could now play without worrying over the Fed’s dour view of their activities. With Greenspan at the helm, there finally was a Fed who believed in the intrinsic goodness of capital markets. Players could double or triple down on risk so long as they understood that the Fed believed in what they were doing, such as with LTCM, which had as its principals several heavy hitters in the financial markets, including among them two economists who had won a Nobel prize for their derivatives pricing theory. Later, Greenspan spent the first part of the 2000’s showering housing market financial innovators with praise, recommending Adjustable Rate Mortgages, characteristic of subprime transactions, as a perfect vehicle for banks to lend to borrowers who couldn’t otherwise qualify to purchase a house.
Greenspan’s exuberance at the housing market and its financial innovations was not accidental. Greenspan was a staunch Objectivist, an acolyte of Ayn Rand who believed that markets unfettered by government interference could best allocate capital and risk through the pricing mechanism. He failed to see that as Chairman of the Federal Reserve, he controlled via government fiat both prices and risk allocation. There was no free market in the currency whose price and supply he controlled. If anything, the Fed used its monopoly power over the money supply to operate like a Soviet Politburo, dictating price levels for every last economic transaction. Even had the residential mortgage markets been mostly free from other government interference and oversight (they weren’t, but even if), they were still beholden to the Fed. The price of money determines the prices of financial assets, and the residential real estate market, i.e., houses purchased mainly with mortgages, was and is a financial market.
During the early 2000’s, in the wake of the tech stock bubble (which was also a product of Greenspan’s infusion of confidence that he ironically described as “irrational exuberance”) bursting and the relatively mild recession that followed, Greenspan kept decreasing the price of money. The Fed Funds rate hit 1% in 2003, a post-WWII low. On Greenspan’s cheap money and tacit risk indemnification, the housing market boomed. Ayn Rand had to have been rolling in her grave. The only Atlas who might have shrugged and let it all fail was not a self-reliant individualist like John Galt. He was the government’s own Great Wizard, the Economic Talisman for the ages; Mr. Greenspan himself.
Then, just as it was becoming apparent that Greenspan had engineered everything so precisely as to require perfection in outcomes, he retired. The markets almost immediately started sputtering and wheezing, no longer exuberantly confident that the Fed had their backs. That Bernanke let the two Bear Stearns hedge funds fail in 2007 shook systemic confidence. That he let Lehman Brothers fail in 2008 destroyed it. The rout was on. That Greenspan’s retirement directly preceded the onset of the Great Recession and financial crisis was not an accidental correlation. The markets believed in Greenspan’s ability to save them from their excesses. Bernanke was an unknown quantity who at first appeared ready to disavow Greenspan’s Great Put and let the capital markets return to being capitalists, instead of being dependent on the Federal Reserve to indemnify their stupidity.
Bernanke finally realized the error of his ways, and did as his predecessor surely would have, pumping the markets with liquidity and overpaying for crappy, nonperforming assets owned by practically any entity with some connection to financial markets. After several months of frenzied rescue, everything stabilized and gradually began recovering (except employment levels). And now, Bernanke has just about returned the confidence level of financial markets to its heady Greenspan peak, and it shows in capital markets of every kind. The stock markets hit new all-time highs virtually every day, barely even hiccupping at the recent government shutdown (they know the real government is far less important to their operation than the shadow government of central banking). The bond markets are back to issuing “covenant lite” loans that have far fewer protections against default than normal underwriting generally views as necessary—characteristic of the late stages (2006 and 2007) of the Greenspan bubble.
Even the housing market has become a favorite playground for hedge funds, just as it was before, if in a different manner this time. Institutional investors comprise up to a quarter of housing market activity today, as they did at the peak of the housing bubble, and comprise a far greater proportion than that in some locales. The difference now is that hedge funds are buying the houses outright instead of lending money to a homeowner, hoping to profit from the home’s rental value (which is actually not all that different than before—a homeowner without equity, as almost all subprime borrowers were, is effectively a renter). And the tech stock IPO frenzy of the late nineties has resurfaced, as barely profitable or profoundly unprofitable companies (e.g., Facebook and Twitter, respectively) float initial public offerings in the multi-billion dollar range. Basically every fundamentally unsupportable financial market characteristic attributable to Greenspan’s Fed is being or has been reengineered by Bernanke’s Fed.
It has taken unprecedented measures to achieve this heady confidence level. The Fed Funds rate has been at zero since 2008 and is anticipated will stay there for the foreseeable future. The Fed is in the midst of its third round of quantitative easing—buying mortgages and Treasury bonds to the tune of $85 billion per month, which appears will also continue indefinitely, as anytime of late that the Fed even hints that it might reduce its extraordinary confidence-building measures, the markets simultaneously tank. None of the markets’ “investments” are any good without the Fed’s willingness to underwrite their risk of failure. The Great Put is back on.
Which brings us to January of 2014, when Ben Bernanke’s second term as the Federal Reserve Board Chairman will end, and he will step down, to be replaced by Janet Yellen. If the script plays out like before—though it should never be forgotten that history doesn’t repeat but sometimes rhymes—she too will face a crisis of confidence not long into her tenure. And if Bernanke doesn’t begin dialing back the bond purchases before January, she will, for a while, be practically incapable of doing so without rattling the tender psyches of market participants. If Bernanke does begin tapering before his tenure ends, the markets will likely have already begun to tremble and cower in the face of the harsh, cold reality that this latest era of free money and outsourced risk management might be drawing to a close. Yellen’s tenure would then begin with a bang. Confidence in the Fed is so highly leveraged about now that it would take only a small hit to the confidence equity to send the whole thing into a death spiral. And confidence in the Fed is profoundly dependent on the person who is its chairman. The markets believe they’ve made Bernanke their bitch. They will need to feel the same about the new Fed chairman in short order, else the house that Greenspan and Bernanke built will come tumbling down, perhaps for good this time. The first few months of Yellen’s tenure might be quite tumultuous.
As the Federal Reserve Chairman, Alan Greenspan rode an expanding economic system to rock-star, demigod status, in what has to be a first among central bank chairmen and economists. The expansion had little to do with Greenspan, but he didn’t seem to mind being given credit for it. There were two main factors at play propelling economic growth–the peace dividend accruing after victory in the Cold War, and advances in information technology.
People so believed in the magic of Greenspan’s wizardry that President Bush remarked off-handedly one time that if Greenspan died during his tenure, he’d have him embalmed in his chair so that he might still attend FRB meetings. People have what appears to be an innate need to attribute human agency to causes they don’t understand, and Greenspan filled the bill for explaining how it could be that everyone was seemingly getting richer without much working harder. The truth was that technological advances were making people more efficient, so they didn’t have to work as hard to produce the same output, but that they weren’t getting richer (except a precious few); instead they were sinking deeper into debt through financial innovations the technological advancements made possible.
Somewhere towards the latter third of Greenspan’s tenure, markets shifted their focus of risk analysis from economic fundamentals to musing on what the maestro might do next, explaining their loss of confidence when he departed. After a rough patch initially, the situation is the same under Bernanke. Financial markets have become an abstraction of the mind, devoid of concern for economic realities, except as economic realities might impact actions the Federal Reserve might take to influence them. Financial markets decline now at the slightest hint of improvements in the real economy, as improved economic conditions might mean less “stimulus” to be supplied them from the Fed. Greenspan’s strategy of trying to work economic magic through financial market manipulations, though still followed by his successor, is all but an exercise in futility now.
Janet Yellen will inherit a financial system drunk with liquidity, meandering along the edge of disaster, with an economic system that has extensively rationalized since the Crash. She might try, unsuccessfully, to coax the financial system off the ledge. Or she might just push. I’d go with the latter. Either way it happens, she’ll be blamed for the crack-up. But she could really make a name for herself if she would simply and succinctly and steadfastly ignore the caterwauling of the children in the markets when they lose all their marbles. Let the markets crash. Let the financial system fail. Let the banks go belly up. The financial system has become a liability to the economic system, a parasite instead of a critical source of capital for its growth. Let it fail. The economic system arose without it, and can do so again. Kill the Great Put and the market psychoses attributable to it might just go away too.
Whatever happens, the first quarter of 2014 is likely to be interesting. I thought the markets would be wound tight enough by December of 2012 to falter and fail again, in conjunction with worries over the presidential election. I was silly to think the markets really care who is president. They only care about the Fed chairman. And they’re getting a new one in January. Better buckle up.