The Greenspan Gamble

The most notable thing about Treasury Secretary Hank Paulson’s proposed plan for restructuring financial regulation is the expansion of the Federal Reserve into a sort of “Super Fed.” This new Fed would have oversight of all financial markets and firms, including investment banks. It would be responsible for financial market stability and would be expected to spot and control “systemic risks.”

The Treasury has proposed a number of changes that will likely go nowhere. However, it appears to me that the “Super Fed” could actually happen. Many of the other changes require consolidation of regulatory agencies, and bureaucracies seldom go gently into that good night. They and their constituents will fight for survival and probably win. But the Fed expansion is likely to be seen as the solution the problem of risk that the housing bust has made apparent.

But wait. Isn’t this the same Fed whose 1 percent fed funds rate helped inflate the great Housing and Mortgage Bubble that is now popping? Didn’t this lead to massive losses, illiquidity, and panic? Wasn’t the bubble exactly the sort of systemic risk that the new, more powerful Fed is expected to effectively manage?

Full points for irony, but this “Super Fed” idea is actually consistent with what the Fed founders had in mind in 1913, when Congress passed the Federal Reserve Act. The great idea was to mitigate market panics.

Much has been made lately of the Fed’s extending discount window lending to Wall Street investment banks, rather than only to commercial, deposit-taking banks. But this is nothing new. In fact, the separation of banking into these two parts had not occurred in 1913. It came 20 years later with the passage of the Glass-Steagall Act.

In 1913, J.P. Morgan and Co. was still both an investment bank and a commercial bank. It did not split into Morgan the commercial bank and Morgan Stanley the investment bank until forced to in 1935.

Of course, today it is again both an investment bank and a commercial bank, after the repeal of the Glass-Steagall prohibition in 1999, and will be even more so with its pending acquisition of Bear Stearns, as arranged by the Fed. The Treasury proposal could simply produce a Fed that deals with the banking structures of the future.

As the Fed got organized in 1914, hopes were high for what it would accomplish. The Comptroller of the Currency expressed the view that with the new Federal Reserve, “financial and commercial crises or panics seem to be mathematically impossible.” A bold call!

As we know, it didn’t quite turn out that way–financial crises and panics have continued right up to the housing bubble and bust of our new 21st century. But hope for what the Fed might do springs eternal. The prestige and authority of the Fed has been on a long term ascent, in spite of the problems it could not prevent, or has aggravated, or even caused.

The history of the Fed has been marked by periods of severe economic and financial problems, after which its policies have come in for sharp attack as deflationary or inflationary blunders.

Bernard Shull, in his insightful history of the Fed’s evolution, discusses three of these instances: the “roller coaster” of inflation and deflation in 1919-21; the Great Depression with the collapse of the financial system, including the Fed’s 1937 “tragic mistake” of pushing the economy back into contraction; and the Great Inflation, then stagflation, of the 1970s.

Now with the current bubble become bust we have a fourth instance and resulting criticism, such as a recent statement by Columbia Professor Jeffrey Sachs: “The U.S. crisis was actually made by the Fed . . . one main culprit was none other than Alan Greenspan.”

A typical phase in the reaction to a bust is the search for the guilty, so we should not be surprised at the rhetoric of a “culprit.”

Shull observes that the Fed “has been winning battles since its establishment in 1914, regardless of the merits of its policies.”

Its position and power “ratcheted upward . . . in several distinct periods during which its policies were so profoundly disappointing.” It managed somehow to “[transcend] its failures.” Shull quotes an economist colleague who “disconsolately asked, ‘How is it that the Federal Reserve always wins?'” And perhaps it will once again.

A reason frequently given for financial market behavior in recent years is said to be the “Greenspan Put”–the belief that the Fed will bail out the market’s mistakes. I believe instead we should call it the “Greenspan Gamble.”

Here’s how that went: In the wake of the burst tech stock bubble, an impending recession from industrial overinvestment, and also the shock of the terrorist attacks, the Greenspan Gamble was purposefully to ignite a housing boom to offset industrial weakness and bridge the economy until, with the help of a falling dollar, industrial growth resumed.

It was a reasonable gamble and it almost worked–but the intended housing boom turned into a bubble, nourished by a great credit overextension. We now focus on the unintended costs: falling prices for houses, most people’s principal asset, the severe credit contraction, and illiquidity. But remember a year ago we were being treated to pontifications about the “global liquidity glut” which would insure robust markets for financial assets.

The ultimate failure of the Greenspan Gamble notwithstanding, the Fed will continue to be extremely useful in helping ameliorate busts and financial panics, just as it was intended to do in 1913. Its usefulness to the government insures its continued influence and authority, which may very possibly include acquiring wider jurisdiction as the “Super Fed.”

But it is foolish to think that the Fed (or “Super Fed”) can foresee all future problems or prevent future bubbles and busts. It is even foolish to think that the Fed will consistently make correct forecasts of the results of its own actions.

After all, everybody, no matter how clever and diligent, no matter how many economists and computers one employs, makes mistakes when it comes to predicting the future.

Originally publish by AEI and reproduced here with the author’s permission

5 Responses to "The Greenspan Gamble"

  1. DC   May 23, 2008 at 1:23 pm

    Latest from Peter Schiff, Poorly concealed behind contrived government statistics, the signs of America’s falling standard of living are everywhere; all one has to do is look. We are unloading SUVs for less desirable compacts, and are paying more to fly on crowded planes (where we pay to check luggage and dine only on what we bring onboard). The collective belt tightening is simply the down payment on the Government’s massive bailout of Wall Street investment banks and mortgage lenders. As the Fed creates money to buy bad mortgages and other shaky securities held by banks and brokerage firms, the value of the savings and wages of everyone on Main Street will continue to fall. As a result, the costs of products previously taken for granted have begun to bite.

  2. Guest   May 23, 2008 at 3:05 pm

    Interesting article, in that it poses the question of the “private” Fed in terms of a logical discussion. This seems to be the established consensus as it continues to mimic other “logical discussions” on the topic of the Fed. Those that may not be quite as interested in a “logical discussion” about the Fed, its founding, etc., etc., can only sit and point to a history of manipulation, deceit, failed monetary policy and closed door deals that have all served to undermined the American economy and the investments of citizens. Such short term, biased and duplicitous behavior has led us to the very edge of a collapse unthought-of previously.Greenspan’s glad handing of “Supply Side Theory” and his ever-present debt mentality is only outdone be a willingness to then do whatever necessary to save face. I am afraid that, like the proponents of a “Flat Earth Theory” of the past, this folly which is nectar for the drones of unrestrained Capitalism, will provide historians much to write about. Needless to say, with stewardship comes fiduciary responsibility, without that the fox sneaks into the hen house!

  3. OuterBeltway   May 24, 2008 at 6:29 am

    Greenspan wasn’t just compensating for 9-11, or the loss of the manufacturing base. It wasn’t a patch for a single moment, or a momentary problem. Instead, it was an attempt to eke out one more business cycle from an economy with deep structural flaws. The problems are well-known. We are a consumptive economy; we consume more than we produce. Most of what we consume is ultimately based on cheap energy, and energy isn’t going to be cheap again for a while, maybe decades. Greenspan along with our entire babbling class of so-called economists are busy tinkering at the edges, trying to regulate or de-regulate the structure of last century’s economy.Our economy needs to be re-built from the ground up. We need completely new distribution/transportation, education and manufacturing systems which are powered by the sun, fully utilize automation, and use and/or develop our human potential to its fullest. We need our nation’s intellect and financial resources allocated to those sectors, and we need it done now.OuterBeltway

  4. Guest   May 24, 2008 at 9:06 pm

    "Greenspan wasn’t just compensating for 9-11, or the loss of the manufacturing base."@ OuterBeltway on 2008-05-24 06:29:23Interesting comment.The foundational question is: Was it a conspiracy or just crasse ignorance that drove the "elite" onwards and allowed the Bankers and the Financial Industry to destroy the Global Economy and the USA. The answer is the latter which makes the case that man is Moral Hazard and cannot be trusted a priori. This fact is the foundation upon which a new global economic system must be built, given the point that no man or group be given the power to control and or manipulate the real economy while at the same time, men must be permitted to achieve their dreams and to reach for the sky.Theft of public funds takes no intellectual power at all so these "Bankers" (financial industry heroes) are just "whankers" who deserve no respect despite the huge sums of money they have acquired.The FedRes has become a SIV of toxic waste; it can be done away with and big banks must be discouraged at all costs. Documents of exchange must flow freely throughout the whole economy and no be allowed to be hoarded and leveraged by Banks and just organizations.PeterJB

  5. Anonymous   May 25, 2008 at 3:18 am

    PeterJB – c’mon global economy is doing great. It has never been doing better. Just ask the BRICs.