I
In late July 1998, Alan Greenspan delivered his semi-annual report on monetary policy to the Senate Banking Committee. Since his previous report, in February, the Fed had kept the federal funds rate steady, at 5.5 percent. In fact, the rate had been the same since March 1997, and it hadn’t shifted by more than 0.25 percent for three years. This do-nothing policy, which was sometimes referred to as “watchful waiting,” had accompanied an unprecedented economic expansion, but it had also facilitated a speculative boom that even Greenspan, with his laissez-faire inclinations, now found disturbing. On June 10, 1998, Goldman Sachs issued stock in Inktomi, a Silicon Valley search engine. Inktomi operated in a crowded market, and during the past two years its losses had outstripped its revenues. On its first day of trading, the stock doubled. The following day, Amazon.com announced plans to sell CDs as well as books. Its stock, which earlier in the month had been trading at $40, raced to $100; a few weeks later, it hit $140. Investors’ appetite for Internet stocks seemed to have no bounds. On July 17, Broadcast.com, a Dallas start-up that posted audio and video feeds on its Web site, went public in an IPO managed by Morgan Stanley. Broadcast.com didn’t have any of its own programming, and its site was free. For revenues, it relied on advertising and corporate video conferencing. In 1997, the firm had lost $6.5 million on revenues of $6.9 million. After being issued at $18, Broadcast.com’s stock closed at 62 3/4. This was a first-day gain of 250 percent, the biggest IPO “pop” yet.
Even on Wall Street, these events caused astonishment. It was one thing for professional investors to dabble in risky stocks, but the most aggressive speculators now appeared to be regular Americans. The New York Times reported that, on the streets of Manhattan, UPS drivers and taxi drivers were trading technology stocks on laptop computers and portable quotation machines. CNBC claimed its audience had increased by 75 percent in a year. The speculative mania was starting to spiral out of control. Only Greenspan had the capacity to restrain it, but his eyes were fixed on the ongoing financial upheaval in Asia. The Asian crisis began in Thailand in 1996, when the Thai government devalued the Baht, and it quickly spread to Hong Kong, Indonesia, South Korea, Malaysia, Singapore, and Taiwan. Most of these countries entered deep recessions. In the middle of 1998, Greenspan was worried that a rise in U.S. interest rates might lead to renewed chaos in Asia, which could spill over into Japan, the world’s second largest economy, and, from there, to the United States. The Asian crisis had placed Greenspan in an awkward position. After sitting on the fence for a couple of years in the debate about whether there was a speculative bubble, he had now concluded that what was happening on Wall Street did, indeed, represent a bubble, at least in part. But he still didn’t accept that it was the Fed’s duty to burst the bubble, and his concerns about Asia reinforced this reluctance.
Some of the nation’s most famous economists were calling on Greenspan to change course. “I think there is a good deal of comparison between the market in 1929 and the market today,” Milton Friedman, the University of Chicago Nobel laureate, told The New Yorker. “I think both of them are bubbles. Whether the magnitudes are the same I don’t have any idea. If anything, I suspect there is more of a bubble in today’s market than there was in 1929.”1 Paul Samuelson, of MIT, who has also been to Stockholm, was equally blunt. “I define a bubble as a situation in which the level of stock prices is high because of a self-fulfilling prophecy in which people believe the market is going to go up,” he said in July. “On that basis, I think there has been an element of bubble in the market for at least two years, possibly longer.” By refusing to raise interest rates, Samuelson argued, Greenspan had “painted himself into a corner. He’s now dealing with the physics of avalanches.”2
Inside the Fed, Greenspan was coming under pressure from his previously quiescent colleagues. At an FOMC meeting in May 1998, there was a lively debate about whether the rise in the stock market was affecting behavior elsewhere in the economy. “Some members expressed concern that the widespread perception of reduced risk or complacency that had bolstered equity prices beyond levels that seemed justified by fundamentals were beginning to be felt in a variety of other markets as well, including commercial and residential properties, business ventures, and land,” the official minutes recorded.3 Two FOMC members—Jerry Jordan, president of the Federal Reserve Bank of Cleveland, and William Poole, president of the Federal Reserve Bank of St. Louis—voted to raise interest rates immediately. Jordan and Poole were both monetarists who believed that the recent rapid growth in the money supply was a signal of higher inflation on the way. Greenspan argued against any immediate action. The FOMC backed him by ten votes to two, but, as recorded in the official minutes, “a number of members indicated that the decision was a close call for them.”4
Between May and July, the pace of economic growth had moderated a little, but the stock market had continued to rise. Wall Street was watching Greenspan’s appearance on Capitol Hill closely for signs of what the Fed would do next. After being introduced by Al D’Amato, the chairman of the Banking Committee, Greenspan delivered a detailed presentation on the “cross-currents” affecting the economic outlook. The economy was growing too strongly, he said, but there was a reasonable chance that it would slow down of its own accord. “Failing that, firming actions on the part of the Federal Reserve may be necessary to ensure a track of expansion that is capable of being sustained.” At the same time, Greenspan continued, “We need to be aware that monetary policy tightening actions in the U.S. could have outsized effects on very sensitive financial markets in Asia.”5 This was typical Greenspan: hinting at higher interest rates, but hedging his bets. The following day, the Fed chairman appeared before the House Banking Committee, where he was asked about the possibility of a stock market crash. “History tells us that there will be a correction of some significant dimension,” he replied. “What it doesn’t help you on very much is when.”6
Despite the studied ambiguity of Greenspan’s remarks, Wall Street decided that higher interest rates were finally on the way. The Dow fell three days in a row, slipping back below 9,000. A week later, it slumped 299 points in one session. The run-up in Internet stocks also faltered. Amazon.com fell back to below $120. Yahoo! dipped below $180. It is interesting to speculate what might have happened next if happenings overseas hadn’t intervened. The stock market boom was posited on the belief that Greenspan would keep interest rates low, an assumption that had now been challenged. The next meeting of the FOMC was scheduled for late August. If the Fed had raised interest rates at that meeting, stocks would undoubtedly have fallen. It is impossible to know just how severe the sell-off would have been, but the bullish sentiment would have been badly dented. It is conceivable that the Internet stock boom would have come to an end then and there. More likely, several interest rate hikes would have been necessary to burst the bubble. Either way, the next two years would have looked very different.
II
As it was, international events prompted Greenspan to hold off from raising interest rates, and the parade of Internet IPOs continued. On August 11, 1998, GeoCities, an online community based in Santa Monica, California, went public. GeoCities encouraged people to use its Web site to publish home pages, which it then grouped into forty different “neighborhoods,” each with its own chat room. About 2 million people had already set up pages on the site, many of them containing pictures of their families and pets, and GeoCities had turned into the sixth most popular destination on the Web. In June 1998, it had 14 million visitors. The company had lost $8.9 million on revenues of just $4.6 million in 1997, but that didn’t concern most investors. In Internet terms, GeoCities had a solid pedigree. CMG Information Services, the Boston venture capital firm that had financed Lycos, was one of its big investors, and Goldman Sachs was underwriting the stock issue. The financial chat rooms were full of speculation that GeoCities’ IPO would be another Broadcast.com. This didn’t quite happen, but the stock went from $17 to $37, and that on a day when both the Dow and the Nasdaq fell.
Six days later, on August 17, President Clinton testified to the grand jury investigating the Lewinsky affair and went on television to admit misleading the public earlier in the year. In Moscow, the Russian government, led by Sergei Kiriyenko, the youthful prime minister, devalued the ruble and reneged on some of its debts. The move shocked international investors and angered ordinary Russians, who saw the value of their savings slashed by half. A few days later, Boris Yeltsin, Russia’s president, fired Kiriyenko and recalled Victor Chernomyrdin, whom he had fired a few months earlier. The Russian devaluation sparked an international financial crisis that President Clinton, speaking a month later, would describe as the “biggest financial challenge facing the world in a half-century.”
All around the world, financial markets shuddered, stabilized, then shuddered again. On Tuesday, August 31, the Dow fell by 513 points—its second-biggest points drop. The Nasdaq dropped 140.43 points—its biggest points fall. Internet stocks were particularly hard hit. Excite and Amazon.com both fell by more than 20 percent, Yahoo! and America Online by about 15 percent. Stocks bounced back the next day, as investors followed their usual pattern of buying the dips, but then fell again for three days in a row. At the week’s end, Time published a cover showing figures falling off a cliff-shaped stock chart, with the headline: “IS THE BOOM OVER?” With Asia already in a slump, Russia in turmoil, and Latin America teetering, there were widespread fears of a global depression developing.7
All eyes turned to Greenspan. After being pressed for months to raise interest rates, he now found himself being urged to cut them in order to calm the markets. Political leaders seemed powerless to act. Bill Clinton flew to Moscow to meet Boris Yeltsin, but the summit turned into near farce, with the American president being heckled by Vladimir Zhirinovsky, the ultranationalist Russian politician. “Clinton, you are an idiot!” Zhirinovsky roared. “Your dollar is dirt.” On Wall Street, there were many who could feel Zhirinovsky’s pain. Investors had taken massive losses as stock and bond markets the world over slumped. The biggest victims were hedge funds like George Soros’s Quantum Fund, which had lost $2 billion in a few weeks, and Long Term Capital Management, a Greenwich-based fund, which had lost a similar amount.
On September 4, Greenspan said in a speech that it was “just not credible that the United States can remain an oasis of prosperity unaffected by a world that is experiencing greatly increased stress.”8 This was a clear suggestion that lower interest rates were being considered, but Wall Street was too addled to be reassured by hints. The financial markets were in chaos. Currencies and bond prices that usually moved together were racing apart. Lenders were cutting off funds to borrowers. On September 20, Long Term Capital Management, which had placed big bets all over the world that were now turning sour, informed the Fed that it was on the brink of bankruptcy and might have to unwind tens of billions of dollars’ worth of investments. Bill McDonough, the chairman of the New York Fed, was worried that such a move might spark outright panic. Long Term was no ordinary financial firm. John Meriweather, a legendary bond trader, had set it up; two Nobel laureate economists were partners in it; and the Italian central bank, along with many wealthy individuals, had invested in it. Until its recent troubles, Long Term had been widely believed to be invincible. On Tuesday, September 22, McDonough summoned representatives from Wall Street’s top firms, many of which had lent money to Long Term, and asked them to bail out the stricken fund. Many of the Wall Street chieftains were reluctant to help out a rival that had got itself into trouble, but under strong pressure from the Fed they agreed to come up with $3.5 billion in return for ownership and control of the firm.
Greenspan, meanwhile, gathered his FOMC colleagues on a conference call and told them he wanted to cut interest rates. Two days later, he went to Capitol Hill and all but announced that a policy easing was on the way. “I think we know where we have to go,” he said.9 The Dow, which had slipped below 8,000, immediately jumped 257 points. Wall Street was hoping that the Fed was ready to take dramatic remedial action. On September 29, the FOMC met and cut the federal funds rate from 5.5 percent to 5.25 percent. In a statement, it said the move was intended “to cushion the effects on prospective economic growth in the United States of increasing weakness in foreign economies and less accommodative financial conditions domestically.”10 After the announcement, the Dow fell by 100 points. Traders had been expecting a bigger interest rate reduction, and they were disappointed that the Fed had made no mention of further moves. During the next two weeks, the financial markets in the United States and abroad gyrated wildly. Internet stocks were some of the biggest losers. By the second week of October, Amazon.com and America Online were both 40 percent off their highs. Yahoo! was down 20 percent. GeoCities had fallen by 75 percent since its recent IPO. The new IPO market had virtually closed down, with more than twenty issues either postponed or canceled. Of more immediate concern to Greenspan, government and corporate bonds continued to be riled by unusual price movements, as investors fled from anything smacking of risk. For many pension funds and other institutional investors, bonds are just as important as stocks, maybe more so, because they are supposed to be safer. But amid the panic many investors were refusing to buy any but the safest of U.S. government bonds. In a speech to the National Association of Business Economics, Greenspan warned that uncertainty and fear were prompting investors to “disengage” from the financial markets, a development that, if sustained, could lead to a disastrous credit crunch.11
On October 15, in another conference call, Greenspan told his colleagues he intended to cut interest rates again. It was highly unusual for the Fed to change policy between FOMC meetings, but Greenspan thought the situation merited such a move. He didn’t even ask for a vote. In a statement issued shortly after 3 P.M., the Fed announced another quarter-point reduction in the federal funds rate, saying it was a response to “growing caution by lenders and unsettled conditions in financial markets more generally.” This time, investors were more impressed. The Dow jumped 200 points before the close. Wall Street interpreted the rate cut as a signal that the Fed would do whatever was necessary to restore stability to the markets. Stephen Slifer, an economist at Lehman Brothers, commented: “Without actually saying it, Greenspan is saying: ‘We’re going to supply liquidity to the system, and we’re going to keep the U.S. economy out of recession in 1999.’ ”12
III
The analysts had read Greenspan’s mind correctly. In cutting interest rates when there was little sign that the American economy was in trouble—GDP grew at an annual rate of more than 3 percent in the third quarter of 1998—Greenspan demonstrated the primacy of Wall Street interests in the Fed’s deliberations. The financial troubles of George Soros and John Meriweather had little to do with ordinary Americans. Much of the money lost in Russia, Asia, and elsewhere had been invested in high-risk ventures by people who could afford to lose it. The losses in the U.S. stock market were more widely shared, but they were hardly catastrophic. Taking the past five years, the Dow was still up by more than 100 percent. In easing policy in such circumstances, Greenspan seemed to indicate that his policy of not letting the financial markets dictate monetary policy only applied while prices were rising. When prices had started falling, Greenspan had quickly changed policy. His actions added to the growing belief that the Fed would always be there to bail out investors if anything went wrong, and this made investors even more willing to take risks.
The tendency for people to act recklessly when they don’t think they will suffer if things turn out badly is known to economists as “moral hazard.” Moral hazard is often associated with insurance markets—car owners with insurance, for example, tend to drive less carefully than those without insurance—but it also applies to the financial markets. In allowing investors to look to him as a potential savior, Greenspan, however inadvertently, ended up further inflating the Internet bubble. The two interest rate reductions confirmed to many people on Wall Street that in a crisis the Fed chairman could be relied upon to take prompt and dramatic action to protect their interests. As Bill Dudley, the chief economist at Goldman Sachs, commented after the second rate cut: “This is a way of telling everyone, the lifeguard is back on duty; you can go back in the pool.”13
The bulls hardly needed persuading. “We feel the cyclical bear market is over,” Ralph Acampora, of Prudential Securities, announced on October 28.14 Abby Joseph Cohen, of Goldman Sachs, reaffirmed her year-end target of 9,300 for the Dow. James Cramer said that it was time to start buying Internet stocks again. Prices might be crazy, he conceded, but they were going to get crazier. If the e-mails posted on TheStreet.com’s Web site were any guide, most individual investors shared Cramer’s view. Scott Worcester, an active Internet stock trader, wrote: “I agree, things are bound to get even crazier. After all, I sold my Excite at 39 1/2 after thinking it hit major resistance at 40, and a few days later it goes through the roof! Yeah, probably now is the time to buy. The market makes suckers out of all of us.” One J. B. Bauk was equally upbeat, declaring: “We are about to enter phase two of Internet stock mania.”15