On June 25, 1950, ninety thousand camouflaged troops crossed the border from North to South Korea. They punched through the South’s defenses with a cavalcade of Soviet tanks, overrunning Seoul, the South Korean capital. Seven thousand miles away, in Washington, D.C., the Truman administration suspected that the Kremlin lay behind the North’s attack, and the president resolved to come to the South’s aid, even though he feared a global conflagration. Taking full advantage of its air power, the United States rained bombs on the North Korean columns; and General Douglas MacArthur, the camera-loving, pipe-smoking, jut-jawed American commander in the region, executed an audacious amphibious landing at the port city of Inchon, cutting off the enemy’s retreat and retaking the South Korean capital. But Truman’s fears of escalation proved all too justified. At the end of November, China sent 300,000 peasant infantrymen in warm padded jackets across the frozen Yalu River that marked its border with Korea. The Chinese swarmed American soldiers as they slept huddled on the frigid ground, stabbing them to death through their sleeping bags.1
When the Chinese attacked, Greenspan was several weeks into his PhD studies at Columbia University. Sometime in this period, he sat in a classroom watching his mentor Arthur Burns demand of his students, “What causes inflation?” Burns’s answer was that “excess government spending causes inflation”—the modern notion that loose monetary policy might be at fault did not seem to occur to him. Burns was not alone in this belief. In the 1930s and 1940s, economists paid little heed to central banks; indeed, they dismissed finance as an insignificant sideshow next to the farms and mines and factories that formed the “real” economy. But the economists’ indifference to monetary matters was about to be tested. In ways that neither the professor nor his student could anticipate, China’s crossing of the Yalu River kick-started the rebirth of finance.
Until the time of the Chinese attack, Burns’s view had been entirely reasonable. During World War II, the Fed had played a humble support role to the Treasury. The government spent whatever it took to win the war, and the Fed’s job was to create enough money to make that spending possible. There was nothing coy about this arrangement. The Fed openly promised to buy however much government debt proved necessary to keep the Treasury’s borrowing costs low: it guaranteed that the interest rate on long-term government bonds would never rise above 2.5 percent. Small wonder that Burns left the Fed and monetary policy out of his view of inflation. The purpose of monetary policy was not to stabilize prices. It was to finance the government budget and underwrite the war effort.
China’s intervention in Korea scrambled this arrangement. The prospect of a protracted conflict forced the United States to redouble its military spending, and the Truman administration became more anxious than ever to have the Fed control its borrowing costs. In early December the president telephoned Thomas McCabe, the Federal Reserve Board chairman, at home, and insisted that interest rates on long-term bonds must on no account breach the 2.5 percent ceiling. “If that happens that is exactly what Mr. Stalin wants,” the president lectured.2 But the Chinese attacks also set in motion a parallel development: the prospect of a protracted conflict kindled fears of wartime rationing, and consumers rushed to load up on everything from cars to washing machines, triggering a surge of inflation. In November 1950, the consumer price index rose at an annual rate of 20 percent, and in the two months following China’s invasion, it advanced even faster. The threat of radically unstable prices shocked the Federal Reserve’s leaders into doing what Burns and his contemporaries never imagined they would do. They resolved to control prices by forcing interest rates up, no matter how much Truman might invoke cold-war imperatives.
Given the prevailing assumptions of the time, the Fed was bold to pick this battle. Most postwar economists doubted that the Fed could control inflation even if it mustered the nerve to raise interest rates in defiance of the administration. Inflation, it was said, stemmed not from monetary choices but from bottlenecks in the economy. If companies had trouble getting the raw materials or workers they needed, they would bid their prices up and pass the costs on to consumers. The modern notion that it is the job of monetary policy to avoid such bottlenecks was understood but rejected. In theory, higher interest rates might deter consumers and companies from borrowing to spend; in theory, this might reduce demand for products, raw materials, and workers, avoiding bottlenecks and inflation. But most economists believed that other factors mattered more than interest rates: shifts in workers’ negotiating power, gains in productivity by companies, new opportunities to sell abroad—any of these could have a more pronounced effect on prices.3 “Today few economists regard Federal Reserve monetary policy as a panacea for controlling the business cycle,” Paul Samuelson declared in the first edition of his famous textbook, published in 1948.4 In the words of the monetary historian Robert Hetzel, “After World War II, monetary policy was an orphan.”5
On the last day of January 1951, Truman impressed upon the Fed’s leaders the gravity of the Korean crisis. He summoned the entire membership of the Fed’s interest-rate-setting body, the Federal Open Market Committee (FOMC), over to the White House and did his best to frighten them. “The present emergency is the greatest this country has ever faced, including the two World Wars and all the preceding wars,” he menaced. But the central bankers stood their ground. Chairman McCabe objected that military power depended on economic power, and that this required price stability. The administration then tried to beat the central bankers into submission: it issued a public statement claiming that the Fed had pledged to defend the 2.5 percent borrowing-cost ceiling. But the Fed leaders countered by leaking their own account of the meeting, which pointedly excluded any such commitment. Faced with the reality that the Fed could unilaterally suspend purchases of Treasury bonds, the Truman administration backed down. Under the terms of a new “Fed-Treasury Accord,” the long-term interest rate was finally allowed to rise.6 Inflation came down abruptly, proving that monetary policy was not actually impotent.
The Truman administration was not quite done yet. It forced the resignation of Chairman McCabe and installed in his place a Treasury official, William McChesney Martin. But if Martin had been selected for his supposed loyalty to the White House, he soon proved his independence. Far from restoring the old interest-rate ceiling, he declared in his first speech that “unless inflation is controlled, it could prove to be an even more serious threat to the vitality of our country than the more spectacular aggressions of enemies outside our borders.” It was a remarkable statement—the imperatives of price stability trumped the imperatives of war and geopolitics—and it signaled a profound change. The toothless central bank that Burns casually dismissed was now a force to be reckoned with.
Some years later, Fed chairman Martin encountered Truman on a street in New York. The former president paused, stared at him, and uttered one word.
“Traitor,” he said, and then continued.7
• • •
Greenspan did not immediately grasp the significance of the Fed-Treasury Accord. He was too immersed in other work: his studies at Columbia and, increasingly, his research at the Conference Board. In the spring of 1952 he attracted attention with a two-part Conference Board article titled “The Economics of Air Power,” which quantified the impact of the defense buildup that came with war in Korea. The research behind these articles was a triumph of detective work. Military procurement plans were classified in wartime, so Greenspan began by reading Pentagon officials’ congressional testimony from the years before the war, when they had been happy to divulge how many aircraft were in a squadron, how many squadrons per wing, or the rate of noncombat losses. By combining that baseline with reports of the air force’s operations in Korea, Greenspan estimated how many aircraft the force must be buying. He ferreted out the weights of particular aircraft from engineering manuals, estimating the proportions of copper, aluminum, and other materials in each case; finally he projected the impact of military demand on metal markets.8 With defense spending accounting for about a seventh of the economy, the impact was considerable. The Conference Board’s member companies devoured Greenspan’s analysis, badgering him with requests for additional elaboration. An accelerating flow of freelance commissions began to come the young man’s way, including a role as an economic consultant to Fortune magazine. After false starts in music and baseball, he had found a line of work he excelled in.
At the beginning of 1953, Greenspan got a call from an investment adviser named William Wallace Townsend. His firm, Townsend-Skinner, was a member of the Conference Board, and Townsend had phoned occasionally to discuss Greenspan’s writings. But this time he had a different purpose. He invited Greenspan to lunch at the venerable Bankers Club, which occupied the top three floors of the towering neoclassical Equitable Building a few minutes from the stock exchange; during the 1920s the Equitable had been the world’s largest office block. On the appointed day, Greenspan rode the subway downtown, walked into the Equitable Building’s splendid marble entrance hall, and took the long elevator ride up into the sky over Manhattan. Stepping into the club’s lobby, he looked every inch the corporate cosmonaut. His grandparents had come from the hardscrabble Yiddish settlements of Eastern Europe, but this well-built, slick-haired, bespectacled young man might have walked out of an IBM advertisement.
Greenspan asked somebody to point out his host. Townsend looked to be in his sixties, older than Greenspan had expected. But when the two men shook hands, it was Townsend who was most surprised. Knowing Greenspan only from his data-laden writings and earnest telephone manner, he had expected to meet a forty-year-old, not a man in his midtwenties.
Townsend lost no time in explaining the purpose of the meeting. His partner, Richard Dana Skinner, had died some years earlier, and his son-in-law was leaving the firm to work elsewhere: he needed a new collaborator.9 To Greenspan, the prospect was instantly attractive. He had been at the Conference Board for more than four years, and he was growing restless. He was conscious, moreover, that even the most assimilated of Jewish professionals had to be at least a little careful in choosing a career path. His close cousin, Wesley Halpert, had been denied entry to medical school, even though he had graduated from the prestigious City College of New York; stymied by racial quotas, Wesley had become a dentist. Greenspan never complained about discrimination, nor did he even discuss it much with Jewish friends; but he did understand that it might make certain career choices difficult.10 As recently as the war years, Fortune had insisted on discussing Jewish “klannishness,” and you could scour the lists of senior executives at many of the Conference Board companies in the early 1950s and not find a single Jewish name among them.11 Bill Townsend, for that matter, was not Jewish either. But he was offering a partnership, undeterred by the discovery that Greenspan was thirty-eight years his junior.
The new firm of Townsend-Greenspan opened for business in September 1953, operating out of a nondescript office on Broadway, not far from the Bankers Club, where the two partners had first lunched together. Quickly, executives who had followed Greenspan’s writings at the Conference Board signed on as clients. The Wellington Fund, which later morphed into the Vanguard Group, came along first, followed by a string of steel companies and a handful of other names, including two that would later recruit Greenspan as a director—Mobil Oil and the aluminum giant Alcoa. Operating as a consultant, Greenspan could bypass ethnic barriers with no difficulty at all; he frequently made presentations in boardrooms filled with avid listeners, knowing that he was the only Jew present.12 Besides, Greenspan was bypassing something else as well. He wanted fame and fortune, but his personality was ill suited to climbing steep corporate ladders; he had no appetite for turf battles, no stomach for confrontation. As a business consultant he could succeed in his shy way, through sheer mastery of numbers.
Greenspan’s data sleuthing was perfectly matched to his new role at Townsend-Greenspan. Building on work he had done at the Conference Board, he created a detailed map of the steel business, filling in gaps in the public data much as he had done with military procurement. For example, U. S. Steel’s Fairless Works, a four-thousand-acre state-of-the-art complex, did not publish its production on a timely basis; Greenspan figured that if he knew how much iron ore was arriving at the mill, he could guess whether production was heading upward or downward. Unfortunately, statistics on iron ore deliveries were not published, but the sleuth knew that the ore came from Venezuela, and from the Mesabi Iron Range at the head of the Great Lakes, so he consulted reports on shipping tonnage and freight-car loadings, and he figured out the missing numbers. To convert his estimates of iron ore shipments into projections of steel output, he would consult engineering manuals on the quantity of iron ore needed to make various types of steel. Years later he would joke that he was the only Fed chairman to have studied a phone book–sized tome titled The Making, Shaping and Treating of Steel. Greenspan claimed to have read it in its entirety.13
Bit by bit, Greenspan expanded his grasp of the economy. Burlington Industries became a client, so Greenspan learned about the cotton industry. When Alcoa signed on, Greenspan replicated his steel map for aluminum. The analysis required minimal judgment, which suited Greenspan fine; the more he could rely on facts, the greater the confidence he felt in his projections. The facts could come from almost anywhere: engineering manuals, old congressional testimony, statistics on freight-car loadings; Greenspan’s appetite for eclectic detail was unlimited. The more facts he assembled, the more his list of clients grew. The more clients he had, the more facts he assembled.
As Greenspan flourished in his new role, his partner emerged as another substitute father. The old man delighted in passing on what he had learned; the young man absorbed the teaching eagerly. “I wish I could be around to see what you will become,” Townsend would say affectionately. This intimation of mortality proved all too justified: in 1958, Townsend died abruptly of a heart attack. Deprived of his mentor and still aged only thirty-two, Greenspan wondered whether he could keep the consultancy afloat. But he had built a powerful reputation, and his clients showed no inclination to abandon him.
Greenspan bought out Townsend’s heirs so that he owned the whole company. But he kept Townsend’s name on the front door in deference to the man who had opened a new world to him. “I wished he could have been alive to see what I achieved,” Greenspan said later. “I credit a lot of what I did to him.”14
• • •
Around the time he joined Townsend’s firm, Greenspan paid his first visit to the Federal Reserve Board in Washington. Part of a research team from Fortune, he made his way through the Fed’s formidable marble entrance and was shown to the office of Governor James K. Vardaman Jr. It was an unfortunate choice—Vardaman had been in the minority of Fed governors who refused to back Chairman McCabe in his fight with Truman, and he turned out to be as underwhelming as the Fed’s building was impressive. The son of a prominent Mississippi segregationist, Vardaman had been installed at the Fed as a reward for his service as a naval aide. He had been sworn in wearing the uniform of a commodore, and he personified the shortcomings of the 1940s Fed, both in his excessive loyalty to the White House and in his intellectual limitations. “It was the most extraordinarily dispiriting experience I’ve ever had,” Greenspan later recalled. “I mean, he literally knew nothing.”15
Even though the encounter with Vardaman seemed to confirm Arthur Burns’s dismissive view of the Fed, Greenspan’s interest in money and credit was deepening. At Columbia University, he had picked out a PhD topic that hinted at his future path: he proposed to investigate the savings patterns of American households. Once he went into partnership with Bill Townsend, he shelved his academic ambitions—there were too many clients to visit, too many reports to write for them. But his interest in savings and the way they flowed through the economy did not go away. And in one of those small coincidences that can bend history’s path, Bill Townsend’s consulting firm turned out to be the perfect perch from which to ponder finance.
Before launching his consultancy, Townsend had made a fortune in the bond market. Then, together with his original partner, Richard Dana Skinner, he had devised a method for monitoring the lending markets in order to forecast equity prices. Years before such monetary analysis had become fashionable, Townsend saw that if banks pumped out a large volume of loans, investors would have more cash to throw around, and some of it would push up stock values. Through the 1930s and 1940s, when most economists ignored money and credit, Townsend held fast to this insight—when he recruited Greenspan in 1953, he was still putting out a newsletter on savings and loan institutions, a species of bank that lent only to home buyers, and he continued to track data on bank deposits and the bond market. Once Greenspan signed on, he, too, became involved in these projects, helping to marshal the statistics and contributing to the newsletters.16
As it turned out, finance was just then on the cusp of an awakening. During the Depression and its aftermath, the credit-creating machinery of Wall Street had been almost comatose. It was said that you could walk the famous canyons near the stock exchange and hear only the rattle of backgammon dice through open windows. But by the early 1950s, financiers were active once again. The GI Bill had promised mass home ownership, turning a generation of Americans into mortgage borrowers; and once they had acquired a taste for mortgage debt, other kinds of borrowing soon followed. By the time Greenspan joined Townsend, consumer loans were becoming so ubiquitous that the bill collector emerged as “the central figure of the good society,” as one contemporary put it.17 Meanwhile, a southerner named Charles Merrill shocked the Wall Street establishment by promoting stock market investment to ordinary Americans.18 Thanks partly to Merrill’s hard-hitting advertisements, the amount of money invested in mutual funds shot up fivefold between 1950 and 1960.
As more money coursed through the economy, its significance became more obvious. As Townsend had seen all along, surges in bank lending could multiply the purchasing power in the economy, driving up the price of stocks, and indeed all other prices. Contrary to what Burns had asserted, excess government spending was by no means the main cause of inflation—bursts of private lending could be equally destabilizing. This in turn meant that monetary policy mattered more than in the past. The friskier banks grew, the more it became vital that the Fed should restrain them.
After Townsend’s death in 1958, Greenspan took over the firm’s financial work, including the newsletter on the savings and loan industry. The new responsibility drove him to immerse himself in the financial and monetary debates that were swirling around him. Milton Friedman, the future father of monetarism, was in the process of transforming economists’ thinking on central banking and finance. Through the 1940s, Friedman had accepted Burns’s view of inflation as the product of excess government spending.19 But by the late 1950s, he was approaching the point when he would declare that “inflation is always and everywhere a monetary phenomenon.” As the financial system expanded, and with it the volume of borrowing and lending, the price of capital was coming to be recognized as the central price in a capitalist system. Far from being marginal to the real economy of oil and chemicals and steel, the central bankers and financiers who set that price drove just about everything.
As he read his way into these debates, Greenspan grew fascinated by John Gurley and Edward Shaw, whose contribution was to look beyond the banks to the financial system more generally.20 Banks could create money by taking in a dollar of deposits and issuing several dollars of credits. But the same unnerving ability to manufacture spending power existed to various degrees in other parts of the financial system. The entire paraphernalia of the stock market, with its speculators and brokers and mutual funds, could be seen as creating money, too. Its function was to take illiquid ownership interests in companies and transform them into certificates that could be freely bought and sold, so that a stake in a mine or factory today could be cash in your pocket by tomorrow. The most fixed of fixed investments—a car assembly line or a steel plant—could be converted into spending power at the drop of a hat. And the more these ownership stakes circulated, the more their fluctuating prices affected the confidence of businesses and families—and hence the fortunes of the economy.
As he stretched his mind around Gurley and Shaw, Greenspan absorbed one further message. Some commentators emphasized the risks in this banking and finance, but Gurley and Shaw stressed the advantages. A sophisticated financial sector offered citizens myriad ways to hold savings—an investor could commit money for the long term by owning a private company not quoted on the stock exchange, or he could avoid long-term commitment by holding a demand deposit. He could assume risk by buying a technology stock such as Xerox, or he could avoid risk by holding short-term government debt. By enabling people to construct portfolios that precisely suited them, sophisticated finance reduced the price at which citizens would commit savings. The result was a lower cost of capital, and therefore greater prosperity for all. Greenspan never shed this fundamentally optimistic conviction about finance, even when events repeatedly challenged him to do so.
• • •
One year after Townsend’s death, Greenspan produced his own contribution to the understanding of finance. In a long paper delivered before the American Statistical Association in the last days of December 1959, he laid out the connections between the financial sector and the real economy, going further than almost any of his contemporaries in teasing out their interactions. Squarely confronting the notion that financial markets are merely a casino of meaningless side bets, he laid out an insight for which the Nobel laureate James Tobin would later capture the credit. Stock prices drive corporate investments in fixed assets, Greenspan observed. In turn, those investments drive many of the booms and busts in a capitalist economy.21
To put Greenspan’s insight at its simplest, consider the construction industry. If the market value of an office block rises above the cost of building it, entrepreneurs will erect new office blocks to sell at a profit. As they procure steel and concrete and employ cranes and workers, the entrepreneurs’ spending will set off a broader boom in the economy. But if the market value of office blocks falls below the cost of building new ones, the dynamic goes into reverse. Entrepreneurs will no longer have an incentive to put up new office blocks, because they will sell them at a loss. Their spending on raw materials, machinery, and workers will halt. The loss of this powerful source of demand may trigger a recession.
The same principle, Greenspan went on, applies equally to companies. If the market value of a company—that is, the value of its shares as determined by investors on the stock exchange—rises above the cost of the company’s capital stock, entrepreneurs have an incentive to expand the company or create a new one. Just as the construction entrepreneur will erect an office block for $10 million if it can be sold for $15 million, so a manufacturing entrepreneur will build a new industrial enterprise for $100 million if he can expect to sell shares in it for $150 million. But if the company’s market value falls below the cost of its distribution warehouses and production lines, entrepreneurs cease to have an incentive to invest in new capital assets. In the upswing, high share prices spur business investment, fueling a broader boom. In the downswing, low share prices destroy that incentive, triggering a slowdown.
Greenspan was assigning a greater significance to finance than nearly all of his contemporaries. Arthur Burns and other business cycle experts had viewed the stock market as a good forecaster of the economy; Greenspan countered in his article that stock prices were “not a forecast but rather a crucial determinant of economic activity.”22 The economics profession was starting to see that money, and not government spending or production bottlenecks, could be the cause of inflation; now Greenspan was adding that financial markets could be the cause of booms and recessions.23 Greenspan sent copies of his paper to a number of eminent economists, and Milton Friedman himself was sufficiently impressed to write him an appreciative letter, even though the two men did not yet know each other.24 Years later, Greenspan showed the paper to Lawrence Summers of Harvard, at a time when Summers was deputy Treasury secretary. “You had it right,” Summers wrote in response. Alluding to Sweden’s Nobel Prize committee, he went on, “I think the people in Stockholm should reallocate half of Tobin’s money.”25
Greenspan coupled his insight about the link between asset prices and investment with a related one about consumers. Just as a rising stock market triggers higher capital expenditures, so it will trigger additional spending by families. Finding that their stock portfolios have gone up, well-to-do Americans will spend some of the windfall on one-off purchases: a car, a special holiday. If the portfolio gains persist, consumers will come to rely on them as a permanent source of additional income; they will allow their regular spending to go up commensurately. Though he did not use the term, Greenspan was describing the “wealth effect” that would later be well recognized. Again he was ahead of nearly all of his contemporaries.26
Having explained the effect of stock prices on investment and consumption, Greenspan delivered a policy lesson that makes for extraordinary reading in light of his Fed tenure. He insisted that central bankers must not ignore asset prices. As rising stock prices cause a surge in investment and consumption, Greenspan explained, there are two possible outcomes. If the stock market boom is allowed to run on, the spending surge will outpace the economy’s ability to supply goods; bottlenecks will bring inflation. Alternatively, if the stock market boom turns suddenly to bust, entrepreneurs who had been eagerly erecting factories will freeze their projects; households with stock portfolios will cut back on spending; and the economy will collapse into recession. “The higher the stock market gets at its peak and hence the greater decline required to return to ‘normal,’ the deeper the decline in economic activity,” Greenspan observed. If central bankers aspired to smooth out the peaks and troughs in the business cycle, they would have to control asset bubbles.
Greenspan drove home this point with a lesson from history. In the 1920s, the stock market had broken one record after another, yet the Fed had ducked its responsibility to choke off the bubble by raising interest rates. Instead, it had sided with commentators who rationalized the bubble, arguing that the abandonment of the rigid pre–World War I gold standard had inoculated the United States from boom-bust cycles, thereby neutralizing one of the main risks to investors and justifying a huge revaluation of the stock market.27 As Greenspan put it:
The belief, widespread at the time, that the business cycle had finally been controlled by the institution of a managed currency, induced a sharp drop in risk premiums, presumably to irrational levels. . . . The sharp upward gyrations in stock prices—and other capital values—made the subsequent stock market reversal inevitable.
New Dealers and Keynesians had advanced one explanation for the Depression: as the economy had slowed, consumers and businesses had cut spending, exacerbating the slowdown and setting off a vicious spiral. If that was right, the remedy was extra government spending to make up for weak private spending, plus a robust pep talk to buoy private-sector confidence—“We have nothing to fear but fear itself,” Franklin Roosevelt had told the nation. But Greenspan was advancing an alternative theory:
[After the 1929 crash,] the resultant collapse in capital values took huge chunks out of effective demand. It was not simply an issue of people losing confidence—they were actually significantly poorer. Their curtailment of expenditures were not so much fear induced, as financially induced.28
Half a century after Greenspan wrote these paragraphs, the world succumbed to another violent stock market decline, and economists pronounced learnedly on “balance-sheet recessions”—ones that follow a crippling destruction of wealth rather than a mere falloff in spending. The pronouncements were frequently coupled with denunciations of the Greenspan Fed: if only Greenspan had understood balance-sheet recessions and how painful they could be, he surely would have acted more decisively as the bubble of the 2000s inflated. But the truth, as revealed in Greenspan’s 1959 paper, is that he had been thinking about balance-sheet recessions for decades—in fact, he had been aware of them for longer than many of his critics had been breathing. The fact that he nonetheless allowed bubbles to inflate on his watch demands an explanation that goes deeper than his purported ignorance.
Greenspan’s attack on the 1920s Fed involved one further argument. The Fed’s mistake in the 1920s was not merely to rationalize the stock market bubble by embracing the talk of a new era of stability, akin to the “Great Moderation” that economists unwisely celebrated in the 1990s and 2000s. Rather, the Fed’s key error was to underestimate its own contribution to the stock bubble. The rise in the market had set off a rise in investment and consumer spending, which in turn had boosted profits and stoked animal spirits, triggering a further rise in the stock market. The 1920s Fed had been the enabler of this feedback loop—in order for investment and consumer spending to take off, companies and consumers needed access to credit. Faced with a jump in the appetite to borrow, the Fed had decided to “meet the legitimate demands of business,” as Greenspan put it. No doubt this had seemed safe: the resulting surge in lending was flowing to companies and households, not directly into asset markets. But money, once created, was bewilderingly difficult to trace. Like heat-seeking rockets, the newly minted dollars found their way into hot stocks, no matter which way they were fired initially.
Pursuing this logic in 1959, Greenspan adopted a radical position: the United States should return to the gold standard of the nineteenth century. By tying money and credit to a fixed supply of gold, the nation could prevent toxic surges in purchasing power, Greenspan asserted. If a rise in the stock market caused entrepreneurs to want to invest more, their rising demand for loans would meet a fixed supply of lendable funds, with the result that interest rates would jump, dampening the stock market before it generated a bubble. Thanks to gold’s corrective discipline, the economy would be stabilized. “The pre–World War I gold standard prevented speculative ‘flights from reality’—with their disastrous consequences,” Greenspan insisted.29
For the rest of his career, Greenspan never quite recanted his belief that gold represented the ideal monetary anchor.30 He became the steward of the world’s preeminent paper money, yet he continued to argue that the Fed should conduct itself “as though there were a gold standard.” His 1959 paper spells out what this ought to have entailed. Rather than allowing the money supply to expand to “meet the legitimate demands of business,” as it did with disastrous consequences in the run-up to the 1929 crash, the Fed should have reacted to the danger posed by “speculative flights from reality.” It should, in other words, have responded to the stock bubble by raising interest rates.
• • •
Greenspan’s interest in finance was not purely abstract. He also tried his hand at commodity trading. He had been fascinated by speculators since his jazz days, when he read Reminiscences of a Stock Market Operator; and a few years later, his father had tried unsuccessfully to sell him on the idea of using charts to divine the markets’ future. But around the time that he went into business with William Townsend, Greenspan came around to his father’s ideas, though his door remained closed to any father-son collaboration. Plotting the movements of financial markets with pencil and paper, Greenspan began to seek out patterns that offered profitable clues about the future.31
One day, as he gazed at the shape of price movements in wheat futures, Greenspan spied an irresistible staircase formation. Wheat would trend upward, then lose half its gain; then it would head up again before giving back half of its progress. “This is easy!” the young seer exulted to himself. Right after wheat had completed one of its half retreats, Greenspan bought contracts for a thousand bushels. The futures rebounded, and he got out with a profit.
Greenspan soon came up with variations on this strategy. He noticed the asymmetry in commodity prices—the amount by which they can fall is limited because they cannot go below zero; but their potential to rise is unlimited. It followed that if you waited for low prices, usually reflecting a big harvest that caused a temporary glut, you could load up on wheat or corn or soybeans without troubling to find out about their prospects. If the price was already near zero, the potential loss was minimal; but if a transport strike or a natural disaster caused the market to tighten, the gain could be significant. Greenspan would accumulate stakes in several depressed commodities and then bide his time. The ones that did badly would decline by a couple of percent. The ones that did well would take off like rockets.32
In 1959, the year that he published his groundbreaking paper on finance, Greenspan took his trading to a new level. He had parlayed his expertise in steel and aluminum into a system that tracked inventories of metal products; if stockpiles of goods containing copper were abnormally low, for example, this was a signal that manufacturers would step up production—and that the boost to copper procurement would drive copper prices upward. Greenspan’s inventory indicator was generating handsome trading profits, so he bought a seat on the New York Commodities Exchange (Comex), calculating that he would do even better if he stopped paying brokers’ commissions and traded directly. The Comex was conveniently located just across the street from the Townsend-Greenspan office at 39 Broadway, and Greenspan would show up for ten or fifteen minutes at the morning opening, pop back again at lunch, and make a final appearance at the close of the trading session; he aimed to catch the most active periods in the market without stealing more than forty-five minutes from his consulting business. But after a few months of multitasking, Greenspan had to reckon with a rude surprise. Cutting out commission costs by trading directly had somehow failed to pay off. Unschooled traders in the metals pits were running circles around him.33
The experience shaped Greenspan’s understanding of finance. As he watched the frenzied traders on the Comex floor, Greenspan learned that prices reflected economic fundamentals only imperfectly. They were driven, at least in the short term, by screams and hand signals and animal spirits.34 The operators who thrived in this environment frequently knew nothing about the metals they traded or the news that might be driving the prices. Yet somehow they could sense turns in the market, so that they bought at the beginning of an upswing and got out before the market started down again.
In slow moments in the trading pit, Greenspan would sometimes ask a neighbor how he knew when to buy.
“I felt that the market was bottoming,” the trader would respond gruffly, leaving Greenspan none the wiser.
“What did you do?” Greenspan would wonder to himself. “Feel the market? What, feel the wall? What does that statement mean?”
The meaning gradually revealed itself as Greenspan spent time on the trading floor. His rivals might not know inventories and fundamentals, but they understood two other terms: overbought and oversold. If the big traders in the pit went on a buying spree, sooner or later they would have bought all they could afford; in the absence of fresh buyers, the market’s next move would have to be downward. Likewise, if the big men were dumping contracts, there would come a time when they would stop; with no more selling pressure, the next move would be upward. And if the pit was divided between big sellers and big buyers, then psychology kicked in. You had to read the body language of the adversaries: which side had more capital; which side had the balls to bet the biggest? Greed and fear and human ego trumped the dull particulars of inventories. Markets were not completely rational. They were simply too human.35
Some of this understanding found its way into the long paper that Greenspan presented to the American Statistical Association at the end of 1959. The writing was peppered with the language of traders—longs and shorts, bulls and bears, overbought and oversold—terms that did not appear in other academic papers of the period.36 And although much of the argument focused on the consequences of bubbles, Greenspan also had some nuanced things to say about their causes. Investors were mainly rational—they responded to real events with real business consequences, whether these were technological breakthroughs from industrial laboratories or policy proposals from Congress. But investors filtered such news through their own moods and emotions; their judgments were too slippery and fragile to be called efficient. Anticipating the findings of behavioral economics in the 1970s and 1980s, Greenspan noted that lurches toward fear were generally more sudden and dramatic than lurches toward confidence. Markets could crash instantly, triggered by a modest shift in fundamentals. In contrast, bubbles inflated only gradually.37
If markets could be irrational, how could an observer know when they were overshooting? Years later as Fed chairman, Greenspan sometimes suggested that bubbles were impossible to recognize, but in 1959 he took the opposite position. In a market economy, he explained confidently, the future is by definition unknowable. New management tricks and technological advances are certain to scramble forecasters’ projections; a war or natural disaster may come out of left field; the unexpected is to be expected. Because the future is necessarily uncertain, investors who bid risk premiums down to nothing have clearly taken leave of their senses. “When commitments are made on the assumption of certain cost-price stabilities existing for the next twenty years that is clearly irrational optimism,” Greenspan proclaimed. At such moments of confidence, investors were forgetting the limits “of what can be known about future economic relationships.”38 Sooner or later, their hubris would be punished.