Sidelights to 1994

By Frederick J. Sheehan

Some odds & ends, tangential to "Is It 1994 Again?"

LURING THE UNSOPHISTICATED into the stock market was considered a risk by Federal Reserve Chairman Alan Greenspan in 1994. So much so, that protecting the individual investor was a mandate of the Fed. (The Fed advertises and then omits new mandates faster than spring fashions. My favorite is the brainstorm of former Fed governor Frederic Mishkin in 2007: "The modern science of monetary policy proceeds under the assumption that the central bank’s purpose is to maximize the well-being of households in the economy; the objective function specifies exactly what should be maximized.") On May 27, 1994, Greenspan told the Senate Banking Committee it was for this very reason that he – his FOMC – had started raising rates in February, 1994: "Lured by consistently high returns in capital markets, people exhibited increasingly a willingness to take on market risk by extending the maturity of their investments." The People had shifted assets out of bank deposits and the like. The avuncular Fed chairman, by raising rates, was shepherding his sheep: "[S]ome of those buying the funds perhaps did not fully appreciate the exposure of their new investments to the usual fluctuations in bond and stock prices."

Given this acknowledgement, the Fed later violated its Investor Protection Mandate when it did not raise margin requirements: a means to reduce credit to the stock market, but, as much so, a warning of forbearance to those who do "not fully appreciate the exposure of their new investments." The Federal Reserve has absolute authority to raise margin requirements at any time. The Dow rose from 3,757 on May 27, 1994 to over 11,000 in early 2000; the Nasdaq from 733 to over 5,000. During these manic years, households served as sacrificial lambs to finance an economy that was funded by rising stock and bond prices.

In comparison, Ben Bernanke’s Fed has explicitly stated its objective to artificially raise stock prices. Brian Sack, Manager of the System Open Market Account for the Fed (he runs the Fed’s applicable trading operations) told a group of bond managers on October 4, 2010: "Nevertheless, balance sheet policy can… [add] to household wealth by keeping asset prices higher than they otherwise would be."

Bond managers were thus enlightened, but this announcement eluded the average American. Rigging prices was not universally applauded within the Fed. In a speech on November 8, 2010, Richard Fisher, president of the Federal Reserve Bank of Dallas, warned: "The rich and the quick are certainly able to exploit these circumstances to get richer. I have no problem with market operators making money; I did so myself in my previous life as a funds manager…. But I take no comfort, and see considerable risk, in conducting monetary policy that has the consequence of transferring income from the poor and the worker and the saver to the rich."

In a speech on April 8, 2011, in Dallas, the former investment manager said: "[B]y taking interest rates to zero and making money cheap and abundant so as to reliquefy the economy, those who invested the most conservatively – tucking their savings away in the safest of vehicles, like CDs, money market funds, and Treasury bills and notes – saw the income earned on their hard-earned savings dramatically reduced."

SETTING INTERST RATES TOO LOW and encouraging credit to grow too fast in the 1990s, the Federal Reserve has attempted to cover that policy error with more of the same, by controlling more markets. After nearly two decades of laying greater deceptions on earlier deceptions, only an economist could think the greater they contort nature the closer we approach perfection.

Aldous Huxley (Brave New World) wrote in 1937: "[E]conomic planning inevitably leads to more economic planning, for the simple reason that the situation is so complex that planners cannot fail to make mistakes. Mistakes have to be remedied by improvisation and rapid enforcement of new plans. It is probable these new plans will also contain mistakes, which must in turn be remedied by yet other plans. And so on. Now, where planning has come to be associated with an increase in power of the executive (and unfortunately this has been the case in all democratic countries), every fresh access of planning activity, necessitated by mistakes in earlier plans, takes the country yet another step towards dictatorship."

Huxley was not an economist but he could apply his mind to circumstances (foreseeing a war), probable government policies, and the consequences of those policies. Huxley was not advocating or ruing the future. He wrote as an observer. When it was noted that Huxley had become disillusioned, Max Beerbohm (I think) replied – paraphrasing from memory now: "Aldous cannot be disillusioned. He’s never had an illusion."

This is in contrast to Ben Bernanke – or, whichever policymaker is under review – who lives entirely within his illusions. Simple Ben could not escape his abstractions even if he so desired.  Of course, he will never be inclined to reconstruct his thinking since it is the security of his illusions that permit him to sleep so well at night. (As was put to me: "If you think Bernanke is losing any sleep over all this, you’re wrong.")

CONGRESS DECIDED THIS DERIVATIVE STUFF, whatever it was, had gone far enough. The House Banking Committee held hearings in the spring of 1994. It called witnesses. George Soros testified on April 14, 1994. He was already famous, which gave him credibility. (Soros was also a superb investment manager, but it is fame and not skill that impresses Congress and Americans, in general.) He told the Congressmen: "There are so many [derivatives], and some of them are so esoteric, that the risks involved may not be properly understood even by the most sophisticated investors, and I’m supposed to be one of them."

After the Congressional study was completed, Alan Greenspan dismissed it. Brooksley Born should have read the newspaper summary. She might have understood that the study was for show and Alan Greenspan, as well as other regulators, were more interested in protecting bank profits than the financial system.

"Derivatives Get a Key Supporter," by Saul Hansell, New York Times, May 26, 1994:

"Strongly disagreeing with a new Congressional study, the chairman of the Federal Reserve Board, Alan Greenspan, said today there was "negligible" risk that the rapidly growing market for financial derivatives might someday require a taxpayer bailout.

"In testimony before a House subcommittee, Mr. Greenspan and other senior financial regulators said there was no need for new legislation to supervise derivatives.

"Derivatives are highly profitable products offered by banks and brokerage firms to corporations and investors…. Several large companies recently reported losses from unusual derivative transactions that combined normal hedging of risks with speculative bets on interest rates."

Note that Greenspan reminded the House Banking Committee the derivatives they might regulate were "highly profitable products offered by banks and brokerage firms." Brooksley Born did not stand a change of regulating derivatives with Greenspan and Congress running a protection service for the top growth industry in America.

Another slant: Congress decided Alan Greenspan knew more about derivatives than did George Soros.

ALAN GREENSPAN’S SO-CALLED AUTOBIOGRAPHY, The Age of Turbulence, has been described as a vital historical document. As a study of American finance in 1994, the book is negligent.

Greenspan reports (The Age of Turbulence) that he made an extraordinary contribution to central banking in 1994. All past Fed efforts to manage the "inevitable downturn" (after the growth phase of the business cycle) by "tightening rates at the first sign of inflation" had failed. This (past) approach "had never averted a recession." The Greenspan Fed opted for "a more radical approach: moving gently and preemptively before inflation even appeared." In Greenspan’s words: "For decades, analysts had wondered whether the dynamics of the business cycle ruled out the possibility of a ‘soft landing’ for the economy – a cyclical slowdown without the job losses and uncertainty of a recession."

Whether any of the former central banker’s claims to such evolutionary thinking and success should be regarded as such can be decided elsewhere. Greenspan’s synopsis is of importance for what he does not say. The Age of Turbulence never mentions the 1994 markets. Therefore, we do not read that the FOMC believed it was already too late in raising rates at the December 1993 meeting. (Larry Lindsay: "[W]e all agree that the 3 percent [funds] rate is unsustainable. We all know it is too late.") This sits uncomfortably beside Greenspan’s Age of Turbulence claim of a "radical approach: moving gently and preemptively before inflation even appeared."

Given that Greenspan never discusses the markets of 1994, we do not read of Greenspan’s self-proclaimed ability to pop a bubble in 1994 (some of which is quoted in "Is It 1994 Again?" He made the declaration five times at FOMC meetings in 1994 and 1995.) He cannot mention this (in conjunction with his character) since, in 1999, he would wave the white flag and state it was impossible to identify a bubble in advance

As for the author’s accomplishment, as construed in The Age of Turbulence: Was his fascinating and nerve-wracking "radical approach," which, if true, is worthy of a permanent display in the central banking hall-of-fame, actually a diversion from a more candid admission – that the 1994 rate hikes were largely driven by fear of asset bubbles?

The discussion of 1994 in The Age of Turbulence does not include the words "derivatives," "Orange County," or "Procter & Gamble." The consequences of Inverse IO CMOs must be learned elsewhere. Instead, the chairman closes the year in his hometown, canceling a dinner reservation at his favorite restaurant, Le Perigord on East Fifty-second Street, called away as he was by Bob Rubin to make more hall-of-fame decisions regarding the next "foreign financial crisis."

Did anybody really read his book?

Frederick Sheehan writes a blog at www.aucontrarian.com