The Man Who Knew Better

Alan Greenspan served as chairman of the Board of Governors of the Federal Reserve System, the most powerful financial position in the world, for eighteen and a half years, from early August 1987 through the end of January 2006. The second-longest-serving Fed chairman, his tenure largely coincided with a period sometimes called the “great moderation,” when economic growth was relatively steady, inflation low, recessions short and mild, and serious crises defused without debilitating downturns.

Under Greenspan’s leadership the Fed had an important and well-publicized part in containing threats to the financial system and economy such as the stock market crash of 1987, the junk bond collapse a few years later, the Asian crisis of 1997 with the deep fall in the value of Asian currencies, Russia’s default in 1998, and the bursting of the tech-stock bubble at the beginning of the new millennium. Although it may have received more credit than it was due, the Fed’s successes earned Greenspan widespread adulation, including the Financial Times anointing him “guardian angel of the financial markets” and Time saying he was chairman of “the Committee to Save the World.”

But despite—or because of—his achievements, Greenspan and the economy were eventually brought down by his continued failure to contain financial bubbles, sharp rises in market prices that were not reflected in underlying values. That a sustained period of stability and success in limiting potential dangers would engender complacency and hubris among both policymakers and investors is hardly surprising. Even so, Greenspan’s overconfidence is deeply troubling, for he, like the economist Hyman Minsky, was well aware of the dangers posed by financial bubbles that develop during periods of great stability.¹ Sebastian Mallaby’s new biography, The Man Who Knew, ultimately aims to assess how seriously this one great failure undermines Greenspan’s legacy.

Now ninety, Greenspan grew up in Washington Heights, a largely immigrant neighborhood in northern Manhattan where he lived with his mother and her parents in their small apartment. He attended George Washington High School, two years behind Henry Kissinger.

Greenspan was uninterested in college. Musically talented, after graduating high school in 1943 he enrolled at Juilliard to study the saxophone and clarinet but lasted less than a year. Because a spot on one of his lungs exempted him from military service, he was able to tour for a year with Henry Jerome’s dance band before enrolling at the NYU School of Commerce, Accounts, and Finance. At NYU he was taught by Geoffrey Moore, a researcher associated with the National Bureau of Economic Research, an organization whose programs focused on finely measuring the economy’s performance and its cycles. It was an approach that appealed to Greenspan, who had been fascinated with railroad schedules and baseball statistics when he was a boy. Analyzing detailed economic data such as the volume of freight shipments or help-wanted advertising became central to his approach to economics.

In the early 1950s Greenspan struck up a long relationship with Ayn Rand, a writer and cult figure who celebrated extreme individualism and uninhibited capitalism. Introduced by his soon-to-be ex-wife of less than a year, “The Undertaker,” as the Randians called him because he always dressed in dark suits, soon became an important figure in Rand’s circle. Greenspan told Mallaby his flirtation with Rand was “a phase he had to go through.” But in the 1960s he avidly sought her approval, writing a letter to The New York Times contesting Granville Hicks’s review of Rand’s novel Atlas Shrugged, the first time he had written publicly about an issue not involving economics. His association with Rand also led to the start of his political career through his introduction to Martin Anderson, a fellow Randian and an adviser to Nixon and later Reagan.

His relationship with Rand appears to have meant a great deal to her. In the early 1980s Greenspan chaired a federal commission to reform Social Security, which recommended small tweaks to the system rather than the radical changes that Rand favored, preferably privatizing or doing away with the program entirely. She was furious, and at dinner with him at the University Club soon after she loudly castigated him for compromising his libertarian principles. Rand died on March 6, 1982, just weeks after her dinner with Greenspan, who had become an increasingly prominent acolyte.

By that time Greenspan was well on his way toward achieving the power and influence he more and more sought, discarding en route many of his early views and beliefs, including his support for a gold-based currency and much of the strict libertarian creed on which he had agreed with Rand. In 1971 he overlooked Nixon’s overt racism and anti-Semitism in helping to pressure Fed Chairman Arthur Burns to stop raising interest rates in order to improve Nixon’s chances of reelection. Before resigning in August 1974 Nixon nominated Greenspan to chair the President’s Council of Economic Advisers. He was confirmed that September, with Rand in attendance, and served until January 1977.

Perhaps most consequentially, Greenspan modified his concerns about financial bubbles—affecting stock prices among much else—that dated at least to the 1950s and were discussed in a paper he delivered to the American Statistical Association in December 1959. His presentation explored the connections between finance and the “real” economy, not a common concern of economists at that time. He focused specifically on what we now call the “wealth effect”: how increases in stock prices and other asset values increase spending by corporations and consumers, while decreases in asset values, as in the Great Depression, reduce spending, worsening the economy’s fall. Thus, the collapse of demand after the crash, he emphasized, “was not simply an issue of people losing confidence—they were actually significantly poorer.”

This may seem an obvious outcome; but such “feedback loops” connecting finance and the economy make it essential, he argued, that central banks take account of asset prices and the effects their policies might have on these prices. In the 1920s the Fed did neither. Nor in fact did Greenspan when he had the chance more than seventy years later. Sharply foreshadowing the critical issues—and failures—of his own years at the Fed, Greenspan’s 1959 paper noted that during the 1920s the Fed not only fostered the stock market bubble through its loose policies and “talk of a new era of stability,” but ignored the extent to which it had done so. And yet again under Greenspan the Fed did not take account of its own effects.

Fittingly, Greenspan considers Paul Volcker, his immediate predecessor and in many ways his polar opposite, “the most important [Fed] Chairman ever.” Appointed in August 1979, Volcker tamed the inflationary spiral that had plagued the 1970s. The major power of the Fed is to raise or lower interest rates, and to stop inflation Volcker raised interest rates to up to 20 percent. Two recessions followed and Volcker endured criticism for causing both. Even liberal economists such as Nobel Laureate James Tobin admired his courage under the circumstances. Tobin wrote in 1994, “I hope that history will give Paul and his colleagues the praise they deserve not only for fighting the war against inflation but also for knowing when to stop, when to declare victory.”²

Mallaby, however, is of two minds about the “legend of Paul Volcker.” First he admits that “by dint of iron-willed persistence, Volcker turned the inflationary 1970s into the disinflationary 1980s.” But does it diminish his achievement, as Mallaby suggests, that Volcker became the Fed chair “at a moment when Americans craved bold leadership”? He did what was necessary, instituting painful policies that Greenspan and most others would probably have avoided. And in cleaning up the inflationary mess of the 1970s he set the stage for the Greenspan years, a period in which globalization and technological change strongly boosted the world economy and reduced the risks of serious inflation.

During Greenspan’s time in office, risks were more likely to be posed by asset bubbles—huge rises in the values of assets that were not to be explained by their actual worth—than by inflation. This placed a greater burden on maintaining financial stability and on appropriate regulation, both of which were becoming more difficult to impose as financial instruments such as derivatives became more complex. For someone like Greenspan who was always opposed to regulation, the fact that it was harder to exercise was yet another mark against it. As a frustrated representative from upstate New York asked him during 1998 testimony, “How many more failures do you think we’d have to have, Mr. Chairman, before you might think that some regulation in this area”—i.e., derivatives—“might be appropriate?” Cavalierly Greenspan replied, “This is a risky business and I would expect a lot of failures to occur.”

A relatively well-known example of Greenspan’s aversion to regulation involves the call in the late 1990s for the regulation of derivatives by the federal administrator Brooksley Born (this is the subject of the Frontline documentary The Warning, which first aired in 2009 and is available on YouTube). A former lawyer, Born headed the Commodity Futures Trading Commission (CFTC), a government agency that regulated derivatives such as soybean futures, contracts tied to the prices of soybeans at specified future times. These instruments allow farmers, for example, to hedge, or offset, the risk that soybean prices will fall by harvest time. By selling their crop today for delivery near the harvest, they can transfer that risk to those, generally speculators, willing to buy soybeans for future delivery.³

The CFTC regulated derivatives that were traded on exchanges, and Born wanted also to regulate derivatives that weren’t traded on exchanges, the fastest-growing and riskiest segment of the market. Unlike regulated derivatives, for which the exchange required that participants make partial payments on their trades and guaranteed that trades would be honored, the market for “over-the-counter” derivatives was a free-for-all with participating banks making up rules as they went along. As Born emphasized in the documentary, nobody even knew how extensively these derivatives were being used.

According to Mallaby, Clinton’s Treasury Secretary Robert Rubin was initially sympathetic to Born’s concerns—although the Frontline documentary, which Mallaby doesn’t mention, shows Rubin fully allied with Greenspan. Greenspan was vehemently opposed to Born’s case and her proposal never had a chance. Regulation offended Greenspan’s belief that markets were self-correcting. And it didn’t help that Born was a smart, aggressive woman heading a relatively obscure agency who knew more about derivatives than Greenspan did and was troubled that Greenspan was very slow to take account of her proposals. She was not a member of the club. Greenspan also may have been defending his turf as regulator of many of the banks participating in the over-the-counter derivatives market.

Although Mallaby agrees with many others that the Fed’s failure to address the risks of unregulated derivatives significantly contributed to the economic crisis of 2007, he also blames Born for not accepting some of the compromises to her proposals that were put forward. And he treats Edward Gramlich, the Fed governor in charge of housing-related issues, in a similar “blame the messenger” manner. In 2000 Gramlich became concerned about the spread of unsecured mortgage lending and broached the issue with Greenspan but did not pursue it because, he told The Wall Street Journal just before the crisis, “he [Greenspan] was opposed to it.”⁴

Despite Greenspan’s clear dismissal, Mallaby criticizes Gramlich for not following through on reforms the powerful chairman was not interested in. He considers it a prime example of critics failing to “connect the dots between abusive lending and systemic risk.” But he entirely omits that Gramlich actually wrote, in 2007, a book warning of the coming mortgage crisis entitled Subprime Mortgages: America’s Latest Boom and Bust. (It was reviewed in these pages by the Harvard economist Benjamin Friedman.)⁵

That a biographer of Greenspan could suggest that Gramlich was too reticent on the crucial subjects of mortgages and not mention his book on them seems oddly neglectful. Not only are Mallaby’s assessments unfair to Gramlich (who died in 2007); they also deflect responsibility, in the case of derivatives, from Greenspan—and Rubin and his deputy Lawrence Summers—for not pursuing concerns that such experts as Gramlich clearly perceived.

The 2000s were not kind to Greenspan, as he curried favor with the more powerful even when he knew they were wrong—for example, in providing important support for the Bush tax cuts—and adopted monetary policies that encouraged the buildup of the housing bubble. He told the markets when he started raising interest rates that the Fed would be doing so only at a “measured pace.” In fact he never tried raising rates more aggressively to choke off the housing bubble. But after the crash he claimed to those still listening that he was powerless to prevent it from happening.

Greenspan blamed his supposed impotence on the Chinese, a convenient scapegoat frequently invoked by our current president. They were, he claimed, buying US bonds in quantities that prevented rates from rising rapidly enough to cool the bubble. More generally, he attributed his failure to his libertarian worldview—his consistent belief that the markets would police themselves since it was in everybody’s interest to do so—as if that claim would somehow absolve him of direct responsibility.

The decade of the 2000s began badly with the collapse of the tech-stock bubble and a relatively mild recession that was followed by a slow recovery, the same pattern that occurred during the 1990–1991 recession. Unlike earlier recessions that generally were caused by the Fed raising interest rates to cool overheated economies, these were caused by collapsing asset values—stocks and real estate, respectively—that decimated the net worth and thus the spending of businesses, families, and individuals, much as Greenspan’s 1959 paper observed of the 1920s. In Fed-induced recessions, the economy tended to bounce back quickly once the central bank reversed course and began lowering interest rates, creating a V-shaped trajectory. But recessions took longer to correct when based on serious losses in balance sheets that carried, for example, many billions of dollars in subprime mortgages and securities based on them. As a result such recoveries tended to be slow and drawn out.

Greenspan can be credited with some insights. He had a prophetic sense in the mid-1990s that productivity was rising even though it was not yet evident in the data. But Greenspan proved incapable of fully adapting to the changes occurring in the economy. Mallaby makes it clear that he never really incorporated the behavior of asset values, whether of stocks or real estate, into his monetary policymaking.

He seemed more inclined to accept new academic theories suggesting that central banks adopt “targets” for the rate of inflation they’d like to achieve. It was thought that they’d be more successful in doing so if the Fed and other central banks provided the markets with “forward guidance” about their objectives and likely policies. One of the advocates of the new approach was Ben Bernanke, who served as a member of the Fed Board from 2002 until June 2005 when he became chairman of Bush’s Council of Economic Advisers. He succeeded Greenspan as Fed chair in February 2006 and was an important force in helping to prevent the economy’s collapse from being even worse.

In theory, forward guidance is thought to make market adjustments to Fed policy smoother and less disruptive, but to announce in a bubbly real estate environment that the Fed would be raising interest rates very gradually was likely to foster complacency and exacerbate speculation—and it did. The combination of forward guidance and gradual increases in interest rates proved lethal, as was dramatically shown by the financial crisis of 2007–2008.

Mallaby’s summation is both confusing and disappointing, leaning heavily on the unconvincing notion that Greenspan was an observer, not a doer. He argues that although Greenspan “understood the frailty in finance, he underestimated the cost in doing little about it.” This is a distinction that makes no clear sense. For how can one understand financial fragility without appreciating the damage it might cause?

Perhaps, as Mallaby suggests, Greenspan was ambivalent about using monetary policy to deflate the housing bubble and chose a weak middle ground between acting forcefully and not doing anything. He also seems to have vastly underestimated the consequences of his regulatory neglect and the extent to which the banking and financial system was infected with financially weak real estate–related derivatives. And banks were woefully undercapitalized, a situation that Fed regulators allowed to happen. It was almost as if Greenspan’s luck had run out and his severe blind spots were exposed.

Most puzzling is Mallaby’s apparent dismissal of Greenspan’s failures; he believes that it would not have made a difference if Greenspan had done the right things. “If Greenspan had demanded a bolder response to the challenges of leverage, megabanks, and derivatives,” he asks, “would he have made a real difference?” It’s a good question but, amazingly after almost seven hundred pages of biographical detail, Mallaby’s “best guess” is that The Man Who Knew would not.

If Mallaby is right that Greenspan could not have made a difference in preventing or mitigating the crisis beginning in 2007, one can also ask serious questions about his importance to the successes that were so celebrated. But if he is wrong, as seems clear from the record, then to the extent that Greenspan’s failures were in part a result of his ideological perspective, as Mallaby documents and Greenspan admitted in hindsight, those failures illustrate how ideology can interfere with good judgment.