Review: Greenspan’s Bubbles, by William A. Fleckenstein with Frederick Sheehan

New York: McGraw-Hill, 2008. 208 pp. $21.95 (cloth).

In 1954, the Board of Governors of the Federal Reserve System issued the third edition of “The Federal Reserve System, Purposes and Functions,” in which they stated:

The basic function of the Federal Reserve System is to make possible a flow of credit and money that will foster orderly economic growth and a stable dollar. An efficient monetary mechanism is indispensable to the steady development of the nation’s resources and a rising standard of living (p. 1).

In Greenspan’s Bubbles: The Age of Ignorance at the Federal Reserve, William Fleckenstein, the president of a Seattle-based money management firm, sets out to show that under Alan Greenspan’s supervision the Federal Reserve System has been anything but a stabilizing influence on America’s economy—especially in recent years. In the book’s first chapter, “How Wrong Can One Man Be?” Fleckenstein quotes a prediction by Greenspan in the January 7, 1973, New York Times: “[I]t is very rare that you can be as unqualifiedly bullish as you can be now.” Then, he points out that four days later “the Dow Jones Industrial Average peaked at 1051 and then declined by 46 percent over the next two years as the country endured the worst recession since the Great Depression” (p. 10). By tracing the Fed’s actions in detail from the 1970s through late 2007—discussing along the way the 1973–74 recession, the market crash of 1987, the savings and loan crisis of the 1980s and 1990s, the Y2K fear, and the demise of Long Term Capital Management (a large hedge fund)—Fleckenstein demonstrates that the Fed chairman’s analytical and predictive capabilities improved little over the years, and that his poor decision-making greatly contributed to both the 2000 stock bubble and the 2007 housing/credit bubble.

Greenspan erred by continually picking an interest rate that was too low, then he solved the turmoil that resulted from that decision with another period of interest rates that were again too low. The result was that, during his reign, the United States experienced a bubble in stocks and then in real estate. These two massive bubbles emerged within 10 years of each other. Prior to Greenspan’s arrival at the Fed, excluding the brief mania for commodities and precious metals from late 1979 to early 1980, the country had been bubble-free for over 50 years (p. 3).

To demonstrate that Greenspan’s faulty decision-making wreaked havoc on the American economy, Fleckenstein presents a trail of documentation that includes excerpts from the Federal Reserve Open Market Committee (FOMC) meetings, Greenspan’s testimony before Congress, Greenspan’s press statements, Fleckenstein’s own contemporaneous columns, and comments from other market and financial experts. Combining this documentation with several charts showing interest rate fluctuations and stock market action, Fleckenstein contrasts Greenspan’s words with corresponding actions and reactions in the economy and the markets in order to arrive at the truth.

Fleckenstein traces the 2000 stock bubble back to an FOMC meeting in August 1995, at which Greenspan suggested that the Consumer Price Index (CPI) was understating productivity and thus overstating the inflation rate. Partly on the basis of this suggestion, the Senate Finance Committee made three changes to the way the CPI is calculated. One of these changes, made in order to eliminate the problem of “understating productivity,” was the adoption of Hedonic Adjustment: “[I]f a product went up in price but improved in quality, then the increase in price needed to be reduced by the amount of dollars that captured how much the object had been improved” (p. 40).

The result of adopting Greenspan-supported Hedonic Adjustment was the shifting of the CPI away from an objective measure of money actually spent, and toward a subjective measure of improvement. When a product price declines but its quality improves, the hedonically manipulated price for the CPI goes even lower. This happened in the case of computer power in the late 1990s.

For instance, for the year 1998, although only $95.1 billion was actually spent on business computers, the BLS [Bureau of Labor Statistics] concluded that after hedonic adjustment it was as though business had spent $351.8 billion, which by itself increased real GDP by over 2 percent. In short, the statistical techniques championed by the [Senate-appointed] Boskin Commission are a cheat (pp. 41–42).

Driven by hedonics, analysts and investors found new ways to value stocks. By the end of 1996, after two years of interest rate easing by the Fed, the stock market had risen 60 percent, and would continue rising until 1999. At the March 25, 1997, FOMC meeting, Greenspan discussed how wonderful the economy was, with no acknowledgment of the growing bubble in the stock market:

[T]hough the interest rate hike at this meeting to 5.5 percent was the first one in over two years, it was to be the last one for 15 months (and it would be followed by three rate cuts). . . . The Standard & Poor’s (S&P) 500 gained about 31 percent in 1997, putting the cumulative gain from the early days of bubble talk in 1994 to almost 110 percent. . . . The truly extraordinary gains and delusional behavior were still to come (p. 45).

The policy at the Fed had evolved into an eagerness to lower interest rates and a reluctance to raise them.

Rampant speculation and runaway stock prices dominated the second half of the 1990s. Yet late in that cycle, in a May 6, 1999, speech to the Federal Reserve Bank of Chicago, Greenspan opined, with an approving nod, that stock analysts were arriving at projections of improved productivity and earnings growth: “The macroeconomic data to date certainly suggest little evidence of a slowdown in productivity growth” (p. 67). Meanwhile, former Fed chairman Paul Volcker expressed his doubts in a commencement address at American University on May 14, 1999: “The fate of the world economy is now totally dependent on the growth of the U.S. economy, which is dependent on the stock market, whose growth is dependent on about 50 stocks, half of which have never reported any earnings” (p. 67).

On top of this accelerating mania, the Fed decided that the possibility of a big Y2K glitch justified an explosion of the monetary base, and, during the last ten weeks of 1999, it expanded this base at an annualized rate of 44 percent. This action was like pouring gasoline on a fire already burning too brightly—and the Fed poured more when it opted not to raise margin rates. Fleckenstein outlines happened next:

The stock market bubble, which had exhausted itself in early March, was taking no prisoners as it slid. The Nasdaq peaked at 5048 on March 10, 2000 . . . and stood at 3164 on May 23, 2000. By that point in time, the index was down . . . a staggering 47 percent from the highs. A great deal of damage was done in those 10 weeks (p. 100).

By the end of the year, the Nasdaq had dissolved about $2.5 trillion of market capitalization. In January of 2001, Greenspan cut interest rates by 0.5 percent to 6 percent and, as Fleckenstein notes: “[H]e would continue to cut rates at every [FOMC] meeting that entire year. That’s not all; Greenspan made three surprise rate cuts outside of the scheduled meetings, for a grand total of eleven rate cuts for 2001” (p. 120). By the end of 2001, interest rates were down to 1.75 percent. But the rate cuts could not reverse the market’s fall: By September 10, the Nasdaq was down another 34 percent for the year.

The terrorist attacks of September 11, 2001, temporarily diverted attention from the economic meltdown already underway, but also aggravated the situation. In 2002, the Nasdaq dropped another 32 percent. Meanwhile the low interest rates, combined with other political and financial factors, began to inflate the next bubble: real estate.

From 1991 through 1995, the growth of total mortgage debt outstanding averaged just 3.7 percent. That growth rate accelerated . . . to average 6.2 percent for 1996 and 1997. By 1998 it was . . . 9.5 percent. . . . By the end of 2000, total mortgage debt outstanding stood at approximately $6.8 trillion, 50 percent higher than it had been at the end of 1995. . . . Though the stock market was delivering red ink, the real estate market was not (p. 129).

In addition to low interest rates, Fleckenstein reviews the now-familiar panoply of events and conditions that contributed to inflating the real estate bubble: the illusions of wealth from the stock bubble, the “creative” financing, the bad underwriting, the fraudulent loan documentation, the lax loan standards, the pressuring of real estate appraisals, the speculation by homeowners, the sundry creative financial instruments, and so forth. (He fails to mention the legal requirements and political pressures that existed for the purpose of putting unqualified applicants into homes.) Fleckenstein notes Greenspan’s positive attitude at the time toward developments in housing, such as the new mortgage instruments targeted at the subprime market.

In June 2003, Greenspan lowered rates, for the thirteenth time in a row—this time to 1 percent, where he held them for nearly a year. Fleckenstein argues that interest rates were driven too low and that holding them there for so long invited disaster: “The housing market was quickly becoming a game of hot potato, and the only ones who seemed to care was anyone left holding the hot potato—a mortgage about to default” (pp. 153–54).

In early 2004, Greenspan gave a speech about household debt in which he suggested that adjustable rate mortgages (ARMs) could be a better deal for homeowners than traditional fixed-rate mortgages.

Greenspan was extolling the virtues of floating rate mortgages when interest rates were at the lowest level they had been in over 50 years. . . . In the two years that followed that statement, Greenspan more than quadrupled interest rates in a series of 17 hikes, from 1 percent to 4.5 percent (p. 156).

Those who followed Greenspan’s advice by acquiring ARMs soon faced escalating payments when he raised interest rates, while those with fixed-rate mortgages saw no such impact.

Subprime mortgages began to explode in 2004. In 1997, they accounted for less than 3 percent of all mortgages; between 2004 and 2006, they accounted for 20 percent. Meanwhile, the developing real estate bubble was morphing into a credit bubble as buyers leveraged their real estate higher and higher. By the end of 2007, when Greenspan’s Bubbles went to press, this credit bubble began to deflate, with financial institutions asking for bailouts and the entire economy grinding down to a much slower pace.

Fleckenstein makes a convincing case that Greenspan’s policies were instrumental in creating the financial crises of the past decade. By his account, the Fed chairman was oblivious to economic reality, often pursuing courses of action long after their destructiveness should have been apparent to him.

Greenspan’s major shortcoming—and critical flaw—was not his mistakes but his refusal to admit them. Thus, he never learned from his errors in judgment, repeating them time and again over the course of 19 years (p. 187).

Fleckenstein neither asks nor answers an important question: Was the damage wrought upon the economy by the Federal Reserve Bank merely the result of bad (in this case, Greenspan’s) leadership, or is the Fed as such incapable of fostering the “orderly economic growth and a stable dollar” that is its stated function? But Greenspan’s Bubbles ably demonstrates that recent financial crises were at least in part fueled by Fed policies, and provides strong evidence that when the government attempts to solve alleged problems by manipulating the market, it creates real problems.

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