Myths of the Greenspan Era

Myths of the Greenspan Era

Barry Ritholtz
01/31/06 – 11:08 AM EST


The 18-plus-year tenure of Federal Reserve Chairman Alan Greenspan finally comes to an end today. The buildup to his retirement has become the largest love-fest since Woodstock.

I won’t review any of the accolades or criticisms that have become so ubiquitous the past few months. Instead, we are going to take a different tack. Rather than merely adding to the pile of the bon mots, let’s discuss the many myths that have developed during Greenspan era:

Myth 1: Greenspan Whipped Inflation

This is by far the most pervasive fallacy of the era. It has added to the Maestro’s legend — undeservedly so, in my opinion. This is probably the myth that’s easiest to disprove.

Numerous factors have led to low inflation over the past few decades; none of them have much to do with Greenspan.

To understand where you are, you must consider how you got here. And when it comes to whipping inflation, it all begins with Chairman Paul Volcker.

As the chart of long-term interest rates reveals, inflation was spiking in the late 1970s. The oil embargo of the early ’70s started an inflationary spiral that threatened the entire economy. Growth was anemic, and Japan was a growing threat to the industrial heartland. A post-Watergate and post-Vietnam malaise hung over everything. It was not a particularly joyous period in the U.S. When Volcker was appointed Fed chairman, inflation was in the double digits, and growth was stagnant. That combination came to be known as “stagflation.”

Fed Chair Volcker aggressively changed the way the Fed attacked inflation. He forced some unpleasant but necessary monetary medicine down the gullet of the American economy.

No helicopter drops for Volcker: The first thing he did was idle the Treasury Department’s printing press. By limiting the growth of money supply — and abandoning interest rate targeting — he made it clear that no matter how painful in the short term, he was going to get runaway prices under control. Inflation, which had peaked at 13.5% in 1981, was down to 3.2% by 1983. The U.S. has been enjoying the fruits of his labor ever since.

Whip Inflation Then
Volcker did it before Greenspan arrived
Source: Ritholtz Capital

Myth 2: Greenspan’s Flexibile Approach Met All Challenges

Flexible? Hardly. The Greenspan’s response to nearly every economic challenge has been the same: inject more liquidity into the system. That’s why money supply has risen so dramatically over the past 18 years. (Why the Fed is no longer reporting M3 is beyond my comprehension, so save your emails.) It’s also why rates are down to unnaturally low levels.

To be considered flexible, one would think you need more than a single trick in your bag of economic magic. Where Greenspan has shown a large degree of “flexibility” has been in his skillful political maneuvering. That has been an enormous asset to the Fed.

Consider how he handled the Long Term Capital Management blowup: Gathering the major Wall Street banks together, he strong-armed them into rescuing the derivative-laden hedge fund before it became a full-blown disaster.

This was less the act of an economist and more the workings of a master politician. Sure, all the firms involved made a lot of money from the rescue operation — but they put lots of capital at risk, and did so when the outcome was far from certain.

Myth 3: The Plunge Protection Team

The concept of the so-called Plunge Protection Team (PPT) comes from President Reagan’s executive order #12,631 (March 18, 1988) for the formation of “The Working Group on Financial Markets.”

The stated goal of the order was to “enhance the integrity, efficiency, orderliness, and competitiveness of our Nation’s financial markets” as well as “maintaining investor confidence.” It’s a short hop from that mission statement to the creation of a PPT.

The markets themselves contributed to the conspiracy. During the 1987 crash, traders claimed that equities “mysteriously” managed to stop their stomach-churning collapse. The most common explanation has been that large purchases of index futures stemmed the bloodletting.

While others have laid this myth to rest previously (for example, John Mauldin’s discussion here), the best way to resolve this fallacy is to look at the market during the month of the correction.

Plunge Protection?
The chart from October 1987 says otherwise
Click here for larger image.

The Dow Jones Industrial Average had been over 2650 in the beginning of October 1987, and over 2500 a week before the crash. Back then, volume was a more modest affair, and the chart shows 20-million-share days as average. Volume started ticking up on Oct. 13 and built gradually the rest of that week toward 60 million on the Friday before the crash. By then, the Dow had fallen to near 2200. On “Black Monday,” the Dow plummeted to near 1600.

From over 2650 to about 1600 was a huge drop of nearly 40% in less than a month. That kind of peak-to-trough drop is not the sign of an invisible hand: It’s a massive, capitulatory distribution that exhausts sellers. A correction of that magnitude brought out bottom-fishers — fools and heroes alike. No Plunge Protection Team was necessary.

When the Nasdaq Composite collapsed in the year 2000, it dropped from over 5000 to nearly 3600 — before bouncing back toward 4500. That’s not an atypical bounce for such an oversold condition. If it was the work of the Plunge Protection Team, they are not very good: the Nasdaq subsequently hit 1100.

Incidentally, I was in grad school at the time of the 1987 crash, and snorted derisively when President Ronald Reagan called Black Monday “a correction.” The media had a field day with it. But it turned out that a correction was all it was. Consider this my belated mea culpa: The Gipper was right, I was wrong, and the bull market continued its ascent for another 13 years.

Myth 4: The Greenspan Put

Similar to the PPT, the concept of the “Greenspan put” is alive and well today. However, it has less resonance than it might have enjoyed during the 1990s. Perhaps that 78% plunge in the Nasdaq had something to do with that.

As of Big Al’s last day as chairman, the Nasdaq was still down well over 50% from its all-time peak. If there’s a “Greenspan put,” it’s doing a lousy job. Indeed, if that’s the kind of capital destruction that exists with the “put,” I’d hate to imagine what we’d have seen without it. (Yes, that’s sarcasm.)

The brutal post-2000 crash makes it hard to argue that the put is — or ever was — anything more than wishful thinking by a speculative public.

Myth 5: Greenspan as Economic Sage

At the risk of repeating myself, Greenspan’s track record belies the consensus view of his economic prowess. Consider this sample of the Maestro’s greatest misses:

  • July 20, 2004: Greenspan testified before Congress saying that rising energy prices “should prove short-lived.” Crude prices have risen appreciably since then.
  • Summer 2004: Greenspan’s advice to would-be homeowners: Consider adjustable-rate mortgages. Surprising advice, considering that fixed-rate loans were near half-century lows. Rates have subsequently increased.
  • May 2003: Greenspan made an amazingly bad call on natural gas when he warned of potential shortages; natural gas prices tumbled shortly thereafter.
  • Summer 2003: Fed concern about deflation led Greenspan to suggest the Fed stood ready to make open-market purchases of Treasuries to ensure rates stayed low. He even convinced the Treasury market into believing that rates would stay low for a long, long time. Bond buyers discovered (to the detriment of their holdings) that this statement was false.
  • October 1999: The Fed erroneously anticipates a Y2K-induced run on the banks, and it infuses liquidity. That surge in money supply effectively doubled the Nasdaq Composite from October 1999 to March 2000; I presume you recall how that ended.
  • 1996: “How do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions?” Markets proceeded to rally strongly for another four years.
  • Free Lunch = Indigestion

    One has to wonder why so many acolytes believe you can get something for nothing. Yet much of Greenspan’s aura and the myth-making surrounding it is based on the theory of the free lunch: easy money, and lots of it, via low rates, lots of money supply.

    Yet I recall the very first lesson in economics: “There is no free lunch.” That simple truism seems to have escaped much of the Greenspan fan club. There are costs associated with such accommodations, ones that have yet to be paid for. That’s why some time and distance may be necessary before we know the true measure of Greenspan’s legacy.

    In my opinion, the “Greenspan mystique” myth is as much a result of fortuitous timing as anything else: He started his gig as the Fed head honcho five years into the biggest bull market in history; 13 years later — well before the tech wreck and dotcom crash — his reputation had been cemented.

    It’s a Wall Street cliche, but it’s still the truth, certainly in Greenspan’s case: People still confuse a bull market with genius.

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