#37 A breeding ground for the GFC: from Volcker to Bernanke
Brief notes on economic and financial history: Episode I
Today we inaugurate these short notes on economic and financial history. From the first economists in Ancient Greek to the FTX filing for bankruptcy. Every little story might have a place here from time to time.
Our free-market economy has a regulated price on interests, hence a regulated price of money, and hence the price of time. Central bankers seek price stability, as it was by default a good thing. Today we look at the tenures of Volcker, Greenspan, and Bernanke as heads of the Fed, and see how their policies led us to the greatest financial crisis since the 29 crash.
We have not targeted those things which we ought to have targeted, and we have targeted those things which we ought not to have targeted, and there is no health in the economy. Mervyn King. Former Bank of England Governor
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After the collapse of the Bretton Woods system in 1971, the economy was left once again in the hands of central engineers. However, these central bankers, unlike real engineers, play with infinite parameters they do not control and therefore, cannot understand.
Popular wisdom states that deflation is evil, regardless of the reasons for it. This stupidity is almost axiomatic. A high level of inflation is not desired. There is no need to convince any of this. Everyone quickly notices the consequences. Yet, magically, they have us "convinced" that a moderate level of inflation, around 2%, is positive and desired. That way, economists and PhDs can play with their fancy models and determine the policies needed to achieve their objectives. Should interest rates be left negative? Let's do it.
However, the 2% target is actually a fairly recent thing - even if it seems like it has always been that way. In fact, it was only added after the Great Financial Crisis.
Today we are looking precisely at the breeding ground before it. And for that we take space. In a world that tries to explain reality with yesterday's actions, we prefer to take a distance and understand the general context with a broad outlook.
The warrior against inflation: Paul Volcker
By the end of the 1970s, inflation was out of control. Furthermore, it was coupled with weak economic growth. The USA was experiencing stagflation. In August 1979, President Carter appointed Paul Volcker, a lanky former Treasury official, commercial banker, and ultimately president of the New York Fed, to head the Federal Reserve - by all accounts an independent institution where the President of the executive power appoints its Chairman. This time, however, Carter chose the right man for the job. The party had gone on too long and it was time to turn out the lights.
Volcker aimed to crush inflation by slowing the growth of the money supply, what he called practical monetarism, as opposed to Milton Friedman, and he didn't care how high interest rates rose to achieve his goal. Under Volcker, the Fed funds rate rose from 10 percent to nearly 19 percent in December 1980, and averaged more than 16 percent over the next year. The commercial bank prime rate peaked at 21.5 percent. Long-term Treasury bonds were issued at a yield of 15 percent, the highest coupon ever paid by the U.S. government.
Public opinion, as always short-sighted and unable to see beyond their noses, was outraged when Volcker's monetary tightening strangled the U.S. economy and drove the unemployment level into double digits. It was Volcker's fault, not those who had brought them to that situation. The Fed chairman was provided with personal security after several threats from different sectors of society: house builders, car dealers, etc. Bad investments made during bubble periods turn into capital misallocation and hence, extraordinary losses when the tide goes out. In those moments, the real responsible for those bad decisions, sponsored by a political power with siren songs, have to blame someone for what happened. It happens all the time. The Fed was accused of "cold-bloodedly murdering millions of small businesses" and ending "the American dream of home ownership." But Volcker stood by and finished his job. By the end of the 1981-82 recession, the battle against inflation was won.
Easy-money for Wall Street: Alan Greenspan
Five years later, Volcker was replaced by Alan Greenspan, a successful business economist with connections to the Republican Party. Greenspan was neither a career civil servant nor an academic economist. He had once been a member of Ayn Rand's Collective. A worshipper of Atlas Shrugged. He even wrote an article that upheld the Gold Standard and blamed the Federal Reserve for the 1929 crash.
Despite his libertarian background, Greenspan turned out to be a highly interventionist central banker. During his tenure as chairman of the Federal Reserve, monetary policy was frequently changed to give the financial markets what they wanted. For this, Greenspan earned abundant praise, eventually becoming a totemic figure to Wall Street, a monetary shaman whose indecipherable incantations had the power to keep markets aloft. Hailed as the "best central banker in history", his real achievement was to inflate a series of asset price bubbles and protect speculators from the worst consequences.
A couple of months after assuming his post, in October 1987, Greenspan faced the worst stock market collapse since 1929. He responded by cutting the Fed funds rate and flooding Wall Street with liquidity - current central bankers have learned well the playbook. The stock market recovered. Shortly thereafter, the Fed stopped trying to influence bank loan growth to focus directly on interest rates. Henceforth, monetary policy would remain focused on short-term inflation, while other financial imbalances - reflected in current account deficits, credit growth and underwriting standards, private sector leverage and asset price bubbles - elicited no response beyond the occasional attempt to pressure the market into a correction.
After the savings and loan crisis at the beginning of the decade, when more than a thousand U.S. mortgage banks failed, the Federal Reserve funds rate fell below 3%, its lowest level in many years and about half the rate of - nominal - GDP growth. Greenspan wanted to help Wall Street: cheap short-term lending allowed banks and hedge funds to profit by "riding the yield curve." The rebound in US productivity in the mid-1990s suggested that the natural rate of interest was rising. At the same time, prices of imported goods were falling and inflation remained low. If the interest rate follows the return on capital, US rates should have risen in parallel. But this did not happen. Instead, short-term interest rates remained below the growth rate of the U.S. economy for most of the period from early 1992 to the end of the decade.
Low inflation gave Greenspan the freedom to apply the monetary balm in times of financial distress. In late September 1998, the Federal Reserve funds rate was cut by 25 basis points following the near bankruptcy of Long Term Capital Management - managed by Nobel Prizes in Economics and with a dedicated book awaiting in my library. Markets responded warmly to the advent of what was called the "Greenspan put," an unwritten contract with Wall Street that committed the Fed to intervene to stem market declines. Between October 1997 and its peak two and a half years later, the Nasdaq did an x3. But the bubble, like all past bubbles, and those yet to come, ended up bursting where it was least expected.
The theorist, then saviour, and recent Nobel Prize: Ben Bernanke
In 2002, Ben Bernanke joined the Fed from Princeton, where he had headed the economics department. Bernanke brought intellectual ballast to Greenspan's practice of ignoring asset price bubbles. Since bubbles were impossible to identify in real-time, Bernanke said, monetary policy should not act preemptively against them, but deal with their consequences. However, Bernanke was a strong advocate of acting, this time preemptively, against deflation. In November 2002, he suggested that the Fed could stop a fall in prices under any circumstances. Worst case, it could drop "helicopter money" into the hands of the American public. In the spring of 2003, the Fed funds rate was lowered to 1%, where it remained for more than a year. For the next five years, the Fed funds rate remained well below the country's economic growth rate. The era of easy money had truly begun.
In a repeat of the Fed's conduct under Ben Strong's leadership in the mid-1920s, Fed policymakers paid scant attention to rapid credit growth or declining credit quality. No attempt was made to stop the housing bubbles that were popping up around the country. As Greenspan neared retirement in early 2006, he belatedly acknowledged that some regional housing markets appeared "frothy", and reflected that previous eras of stability had ended unhappily. Governor Bernanke remained a faithful believer, and a few months earlier had told Congress that rising U.S. home prices "largely reflect sound economic fundamentals".
The fundamentals are beside the point. The record shows that the Fed had used its considerable powers to boost the housing market. At a congressional hearing in November 2002, Greenspan noted that the Fed's low-interest rate policy had boosted home sales and construction. At an FOMC meeting on March 14, 2004, Governor Donald Kohn admitted that accommodative policy was distorting asset prices:
"Most of this distortion is deliberate and a desirable effect of the policy stance. We have tried to lower interest rates below long-term equilibrium rates and boost asset prices to stimulate demand."
What happened next is well known to all and, perhaps, the subject of a new note - specially after I read Bernanke’s book on how he saved us all. It is worth mentioning, however, the level of heroism given to Bernanke by mainstream economics. One of the main responsible for what happened is now a Nobel Prize laureate.
“Bernanke’s Fed has evaded suffering any consequences for its intellectual incompetence’ in the lead up to the crisis. Instead of being hounded from office, Bernanke was credited with saving the world from another Great Depression and anointed Time magazine’s ‘Person of the Year’ in 2009. His exercise in denial meant that the Fed learned little from the crisis. Besides the odd tweak, monetary policymakers saw no need to change their flawed models. If low interest rates hadn’t caused the crisis, there would be no problem in taking them even lower in future.”
Philip Mirowski. Historian and philosopher of economic thought at the University of Notre Dame, Indiana.
Time periods with artificially low-interest rates lead inexorably to the misallocation of capital. The consequences are not immediately apparent. The low-interest rates between 2002 and 2004 were the breeding ground for the great financial crisis in 2008, as they were before in the 1920s for the 29 crash or the bubble in the 2000s. Since 2009, we have lived through the longest period in history under unreal free money - free time conditions. May God have mercy.
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References
Chancellor, E. (2022). The Price of Time: the real story of interest. Atlantic Monthly Press. NY
Federal Reserve Bank of St. Louis. Link
#37 A breeding ground for the GFC: from Volcker to Bernanke
As some1 should menction, history rhymes, but is never the same tone.
great take, thank you!