Book Review: Greenspan’s Bubbles: The Age of Ignorance at the Federal Reserve by William A. Fleckenstein with Frederick Sheehan

Book Review: Greenspan’s Bubbles: The Age of Ignorance at the Federal Reserve by William A. Fleckenstein with Frederick Sheehan. McGraw Hill ● 2008 ● 194 pages ● $21.95

Have you lost your job, house, or retirement nest egg? Does your Social Security check buy less than you thought it would? Do the economic stresses currently pervading the atmosphere give you insomnia, impotence, and alopecia? According to money manager and investment columnist William Fleckenstein (“with,” whatever that means, Frederick Sheehan), the nation’s financial woes are due to the bumblings of Alan Greenspan, the slow-witted former chairman of the Federal Reserve. Greenspan, they claim, single-handedly caused the tech bubble of the late 1990s and the current subprime mortgage debacle. The dimwit did so by forcing interest rates too low for too long because he believed too fervently in the productivity advances of the so-called “new economy,” particularly the revolution in cheap networked computing. “Easy Al” also signaled Wall Street firms that they should go hog wild because the infamous “Greenspan put” would save them if they stumbled. Fannie Mae, Freddie Mac, Bear Stearns, Lehman Brothers, Merrill Lynch, and others were happy to oblige, running up huge profits before going quietly into that dark night, sticking the American taxpayer with their “final expenses.”

There is an element of truth to all this. The real world in real time is a confusing and complex place and the data and models available to central bankers are limited, lagged, and often deeply flawed, so nobody should expect perfection. Stabilizing financial markets to prevent decreases in output and employment comes at the dear cost of increasing moral hazard and risk-taking. Greenspan exaggerated the risks of a Y2K meltdown and failed to detect, much less stop, the irrationality at the heart of the dotcom and housing bubbles. As one would expect, his recently published memoirs are skewed in his favor.

Fleckenstein and Sheehan’s book is perhaps even more skewed, however, though of course in the opposite direction. Much exaggeration and sensationalism pervade the book, which contains nothing that anyone familiar with Fleckenstein’s columns, which are quoted as some length in the book, will be surprised by. The tone throughout is such that neutral observers will suspect that personal animus was a major motivation for the book’s creation. The authors claim that “the evidence speaks for itself” (p. 187), yet they felt compelled to interject editorially, often several times, in every Greenspan passage they quote. In addition to being distracting, the intrusions sometimes display the authors’ rush to judgment. For example, when Greenspan says “we are getting increasing evidence that we are probably expensing items that really should be capitalized,” they interject “That is, they should be treated as an asset, not as an expense [p. 34, their emphasis].” In fact, Greenspan was arguing for a change in accounting standards (depreciating software like a capital expenditure) rather than restructuring balance sheets. In another embarrassing editorial insertion, the authors reveal their ignorance of the nature and importance of network externalities (p. 97). Elsewhere, they quote Greenspan out of context to make it appear that “he was flying by the seat of his pants” (p. 109), as if their book were a segment on some late night fake news program. Greenspan was certainly imperfect but he was far from the feckless moron they portray.

Greenspan’s Bubbles is simply too thin to adequately address twenty years of U.S. monetary history. (I read it cover to cover on the Acela between New Haven and Philadelphia.) The endnotes are few (only 21) and of little help to readers interested in substantiating the book’s most important claims, which is ironic given that the authors chastise Greenspan on the same grounds (p. 136). Bold assertions appear to be based on nothing more than FOMC transcripts, not interviews, beige books, or any number of other potentially illuminating source materials. The authors rightly point out that financial history is too often neglected but then ignore it themselves, save for short and hackneyed allusions to the Tulip Mania and the South Sea Bubble. They know that interest rates are important to their story but fail to make the critical distinction between nominal and real (inflation-adjusted) rates. To make the most recent housing bubble appear of unprecedented proportions, they display a graph of nominal median U.S. house prices since 1972 (p. 172) instead of showing the percentage increases (or graphing the data on a log scale).
The book’s biggest flaw, though, is its failure to come to grips with the Fed’s power, or rather lack of it. Throughout, Fleckenstein and Sheehan argue that Greenspan could have controlled the financial system and indeed the entire economy if only he had possessed the prescience to, a claim that Greenspan himself repeatedly rejected. Fed chairmen, I submit, are more akin to a cowboy trying to stay atop a raging bull than a rider on a steeplechase horse. Markets, especially modern financial markets, are powerful forces. Central bankers can certainly influence them but they cannot control them in any significant way for long. Instead of blaming Greenspan for the nation’s economic ills, we might instead view him as yet another failed central planner. Despite the book’s subtitle, the Fed’s pre-Greenspan record is far from admirable. It performed poorly, especially in the 1930s and the 1970s, though not as badly as Soviet and Chinese planners sometimes did. What America needs is to reevaluate its fiscal, monetary, and regulatory systems and more generally to reexamine the ways in which government interacts with the economy. What it does not need are more diatribes.*

Robert E. Wright is Clinical Associate Professor of Economics at New York University’s Stern School of Business and the author of 10 books on financial and economic history, including most recently One Nation Under Debt: Hamilton, Jefferson, and the History of What We Owe (2008).

*For an excellent study of U.S. monetary history and policy, see Robert L. Hetzel, The Monetary Policy of the Federal Reserve: A History (New York: Cambridge, 2008). It's a tough slog, but this is serious stuff that demands serious treatment.

Yoda on the Subprime Mortgage Crisis

For too long interest rates too low, the Federal Reserve did keep.

In myriad ways, home ownership the government did encourage.

Sign up everyone and anyone for a mortgage, originators had incentives to.

Their heads up their butts regulators had. Hmmmmmm.

Ever higher, housing prices rose.

To buy people began, with borrowed money, to sell again only. Herh herh herh.

To go up forever seemingly everyone expected housing prices.

But to be it was not. Herh herh herh.

Prices plummeted, with negative equity burdening over-leveraged borrowers. Hmmmmmm.

Reigned supreme the dark side did.

Defaults soared and banks teetered as billions of federation credits vanished.

With Hope for Homeowners the government responded, and with TARP, direct bailouts, contrived mergers, and a doubling of the Fed's balance sheet. Yeesssssss.

But the stock market still tanked and credit spreads remained wider than the Millennium Falcon, they did.

Bring what the future will, I know not. Hmmmmmm.

Jedi, I am, not a fortune teller.

---
Created with the aid of Learn to Talk Like Yoda.

Coming soon, a Battlestar Galactica version.

Never coming, a Klingon version.

Why we laugh at misfortune.

Declare Shenanigans!

My brother has a bailout plan too. He thinks we should declare shenanigans. Those of you who don't know what this means can click here and get schooled. If you want a more technical definition, click here.

How would one declare shenanigans against the financial crisis? Start by telling the government to stop distorting just about every major economic decision we make, from saving for retirement to buying a house to safeguarding our income, physical assets, and health. Then tell entrenched managers that they are no longer going to be able to run publicly traded corporations for their own enrichment. Then start the game over from scratch and for goodness sake stay vigilant this time. Check out public policy blogs instead of surfing for eye candy. Ask questions instead of FLAMING. But most importantly, read my books (and those of similar scholars) instead of wasting time watching TV!

;-)

The Economist and the Wright Rescue Plan

The Economist this week (25 October 2008) claimed that the U.S. national debt is at 38% of GDP (page 40, column 2). I'm still scratching my head over that one. Apparently it thinks U.S. GDP is like $30 trillion or the national debt is only about $5 trillion. No wonder it won't review my book. (It also unfairly ripped Abington, Pa. a few weeks ago.)

More importantly, The Economist also reported (p. 92) that "a growing number of economists, and now the Bush administration, believe that the credit crunch also has to be addressed at its source -- in America's housing market, where prices have fallen almost one-fifth from their preak, and foreclosures have soared." Perhaps there is still hope for the Wright Rescue Plan! Unfortunately, the magazine again ignores my work, though it mentioned plans by Feldstein, Zingales, Hubbard, and Mayer. It recommends Zingales' plan, which entails forced loan renegotations, but notes, correctly, that such a policy could "well lead to a higher cost of credit in the future." No kidding! No other scheme that I have yet seen has hit upon the key insight of the Wright Rescue Plan, that if lenders can mortgage foreclosed property mortgage backed securities can be priced and balance sheet uncertainty will end. And that will be the beginning of the end of the crisis.

Mortgage difficulties in 1830: Henry Van Der Lyn as Nostradamus

Reading through part of the Diary of Henry Van Der Lyn (New York Historical Society, Vol. 1, pps. 245-46) today, I was struck by the following entry, dated 1830. It isn't written in quatrains but it does reinforce Mark Twain's notion that history, if it doesn't repeat, at least rhymes:

There was a company chartered Last winter by the Legislature in N.Y. called the Trust Co[mpan]y which is now lending money all over the state, where ever they have applicants, at 7 percent on Bond & Mortgage. They have the lands of each applicant appraised & lend him 1/2 of the appraised value for a term of years. Interest payable every six months. This is a dangerous business both for the Company & the Applicants. Many persons will take larger sums of money than they otherwise would, merely because it [is] as easy to get a large as a small sum and will thus encumber their property by a claim they never can meet, when it is called for & will be disabled by the every encumbrance to obtain any new credit. They will thus live with[ou]t hope and their mortgaged farms will soon show all the ruin & waste attendant as an occupant who has no interest in keeping up the constant repairs necessary to maintain a farm in good condition. Others will endeavor to Mortgage their farms for all the money they can get & never intend to repay the money, making use of this scheme of borrowing in order to sell their farms to the company. Thus in the end a Number of farms will fall into the hands of the Co[mpan]y which they will not be able to rent for any cash rent, and which they will not be able to sell for 1/2 of the money they advanced. At this moment a great deal of money is (I may say a very unusual quantity) is loaned by the Banks at Utica & by this Trust Co[mpan]y on apparently very easy terms, but the time for repayment will soon come & a reaction on the very Banks, who are now so profuse is at hand, when many borrowers will be cramped & be ruined & property will have to change hands; and a general depression, confusion & scarcity of money, will inevitably follow. In short, the Co[mpan]y at N.Y. should not lend their money on the security of farms in the Country: & Persons here, should never, without the most despearate necessity encumber their farms by a Mortgage as they thereby at once lose their independence, their spirits & their Ambition.

Interest in the debt rises (on the debt too)

As the financial crisis drags on, people are beginning to pay attention to the national debt again. It has soared over $10 trillion, sparking a slew of stories about the national debt clock in New York City running out of digits. Soon, scientific notation may be necessary to express what we owe.

The silver lining is that the federal government is borrowing money very cheaply right now because investors see it as the safest thing going. The trouble is that it is all of short duration and will need to be refinanced in a few years, perhaps at much higher rates if we begin to feel the sting of inflation.

One Nation Under Debt has benefited a little from this resurgence of interest but let's face it, the book has not really received its just due yet in terms of reviews. I just found more evidence of the book's main thesis, that the non-predatory nature of the U.S. government after the ratification of the Constitution was the main reason for the country's economic success, which of course was a necessary precondition to debt repayment. The evidence bolsters the book's main counterfactual, the relative poverty of Canada, which labored under arbitrary, authoritarian rule until well into the 19th century. Its economy suffered accordingly as the following passage shows.

At the other side of the [St. Lawrence] river, which is here about two miles in breadth, we saw a rising village, called, I think, Ogdensburgh. I asked my host whether they held any intercourse with the yonder town? 'Yes,' said he, 'we smuggle across all their commodities, notwithstanding the extreme rigor of the revenue laws.' What, continued I, could they possess that you possess not; is not your climate as good, soil as fertile, and your skill in agriculture equal, if not superior to theirs? 'All that is true,' replied the loyal Scotchman, 'but the governments are not alike.' Then he began in the Highlands squawking, drawling tone, a long history of 'the enormous duties on tea, the total absence of internal improvements &c. in the Canadas.' -- Jeremiah O'Callaghan, Usury, Funds, and Banks (Burlington, Vt.: For the Author, 1834), 20.

Government Ownership of Banks

I see that the federal government is now considering taking equity positions in banks.

This is not as crazy or unprecedented as it may sound.

The federal government owned shares in both the first Bank of the United States (1791-1811) and the second Bank of the United States (1816-1836). There is a nice article about this in the William and Mary Quarterly by Carl Lane.

Early state governments owned considerable amounts of state bank stock, some of which it purchased and some of which it received as a sort of tax or quid pro quo for granting an act of incorporation.

The benefit of stock ownership was that it provided the government with a nice revenue stream.

The cost of stock ownership was the conflict of interest it created. Pennsylvania and New York, for example, were stingy with new bank charters because they did not want to hurt the value of their stock portfolio or decrease their dividends by allowing competitors to enter. That, of course, hurt both depositors and borrowers.

By the 1830s/40s, national and state governments began to divest their bank and other corporate stocks because of such conflicts of interest.

On net, therefore, I think it would be better simply to adopt my plan (see below), or similar ones recently proffered by Glenn Hubbard, Robert Shiller, or Martin Feldstein. (McCain's plan is too vague to evaluate but note its similarities to mine.)

Another thing we might think of doing is walling off safe institutions -- those with minimal exposure to derivatives -- behind very strong government guarantees and letting the rest crash and burn. The billions could then be spent on unemployment and re-education benefits and we could end this nasty moral hazard problem once and for all.

The Wright Rescue Plan

Last Friday (see below), I posted some ideas about how to rescue the economy from recession. I alerted numerous individuals about the plan by email and also sought media attention for it, thus far to no avail (that I know of, anyway). During the course of email and blog comment discussions, it became clear to me that some readers had not grasped the plan's most important features. In this post, I will be more specific.

The heart of the plan is to give homeowners (including financial institutions that come to own homes via foreclosure) the option of refinancing with the Federal government at 7 percent for up to 50 years. The 7 percent will ensure that most Americans will not opt for the Federal refinance (re-fi) because most already have mortgages at a lower APR. The 50 years is to help lower the monthly payments of homeowners who got in over their heads.

The government will pay off the existing principal balance on the mortgage with Treasury bonds. Right now, the government can borrow at low yields. It is the only large economic agent at present that can with great certainty generate a positive spread between its assets (7% mortgages) and its liabilities (2-3% Treasury bonds).

The plan should provide immediate relief to the financial sector because it will effectively remove uncertainty about the value of mortgage-backed securities (and hence credit default swaps, etc.). Either:
a) borrowers will continue to pay their existing mortgages
or
b) borrowers will re-fi with the Federal government, thus removing the risk of their default from the financial system
or
c) borrowers will default, in which case the lenders can re-fi, which will replace the "toxic" asset on their balance sheet with a safe and liquid one (Treasuries).

With the uncertainty gone, the credit markets can again function and mortgage backed securities will rise in value and will begin trading again, ending the cycle of write downs that has caused the recent bankruptcies.

The Wright Rescue Plan is also much more politically astute than the administration plan because it offers aid to homeowners first. While the total amount of aid needed cannot be known with certainty, the plan is clearly not a "bailout" because the government will almost certainly profit from it (at least at today's gross spreads). The sums already appropriated to the Hope for Homeowners program may very well suffice. Finally, and I can not stress this point enough, the plan could be implemented without creating a new federal bureaucracy. The Treasury and IRS already know how much people earn, whether they have existing mortgages, and so forth. They also have the power to garner wages and track people across state lines, so defaults on the re-fi's should be low. If the government comes to own some homes through default, it alone can afford to hold them until the market turns or to re-purpose them. As noted in various posts below, governments have successfully run mortgage programs in the past.

The Philadelphia Fed's Money in Motion Exhibit and the Subprime Mortgage Crisis

Thanks to the Jewish holiday, I had the opportunity to take 5 children, including 3 of my own (yes, Alexander Hamilton Was Wright too) to spend the day in Philly. After the obligatory Duck tour, we checked out the Philly Fed's Money in Motion Exhibit. As a guest museum curator myself (for the Museum of American Finance), I appreciated the exhibits in a new way and the kids had a blast. (I suspect they think, wrongly of course, that they can reassemble the shredded money the Philly Fed hands out upon each visitor's exit. Hey, what else are you going to do with the stuff?)

The exhibit "Supervision Mission" was particularly fascinating and provides unintended insights on the subprime mortgage crisis. The exhibit is a computerized game where the visitor starts off as a trainee. After mastering a basic multiple choice test, the trainee becomes a loan officer who has to make decisions about whether or not to lend to various fictional applicants. It was great fun for the kids and even for me, until I started to get the "wrong" answers, invariably because I turned down loans that my electronic boss thought were "good business for the bank." One applicant wanted a $1 million loan on terms that would have had her repaying some $50,000 per month on expected income of like $20,000 per month. She had other collateral of $2 million but the collateral was not income earning. I turned the sucker down only to be chastised for it!

I managed to get promoted (I think everyone does, eventually) to the final level, investment manager. Here, again, my decisions (60% domestic loans, 15% foreign, 15% Treasuries, 10% cash) were chastised as too conservative. Apparently, they wanted primary reserves of less than 5 and secondary of less than 10.

If this is the sort of supervision the Fed gives its banks I have only two words to say:
No wonder!

Cause of, and Cure for, Hard Times (New York: 1818)

I'm writing a variety of things right now, including a book called Fubarnomics and a book chapter on corporate capitalism. To help with both, I pulled an old pamphlet out of my collection -- Cause of, and Cure for, Hard Times (New York: 1818) -- and was struck by the similarities with our financial struggles today. I received a photocopy of the pamphlet the hard way, via ILL, about a dozen years ago but if readers are interested it is on Google books and also available for purchase in a 2008 edition on Amazon.