On Friday, August 13, 1982, while Greenspan was still treading water with the Social Security commission, a Yale-educated Mexican technocrat arrived at the Federal Reserve building in Washington. He had made this journey many times before and had learned to expect the lemon-meringue pie that was served unfailingly in the Fed’s executive dining room.1 But this visit was unlike the others of the past few months. Rather than briefing the Fed chairman on looming risks, Mexico’s finance minister, Jesús Silva Herzog Flores, had come to announce that those risks were no longer hypothetical—they had materialized. Having borrowed prodigiously from American bankers, Mexico could not repay. Its stash of foreign currency was dwindling by the hour. It would default when the markets opened on Monday.
Paul Volcker had been braced for Silva Herzog’s news since the beginning of the week, when a heads-up from his staff had caused him to cut short a fishing trip to Wyoming.2 He knew that Mexico’s bankruptcy was America’s problem—and his own problem, personally. Before rising to the position of chairman of the Federal Reserve Board in Washington, Volcker had headed the New York Federal Reserve, the most important of the twelve regional banks that, together with the board, make up the Federal Reserve System. During his four years as the New York Fed’s president, between 1975 and 1979, Volcker had shouldered the responsibility for regulating most of the so-called money center banks. The buildup of Latin American loans had occurred on his watch, and he had failed to prevent it. Upon taking the helm at the Federal Reserve Board in Washington, moreover, Volcker had assumed even greater responsibility. The Washington Fed employed an army of sophisticated bank supervisors, yet Volcker had failed to marshal these troops to stem the flood of Latin American lending.3 As a result, America’s top banks had lent Mexico so much that the country’s default now threatened their own viability.4 The nation’s financial system was on the brink, and Volcker deserved a large slice of the blame.
If this failure tarnished Volcker’s reputation as a disciplinarian, his response to Silva Herzog’s news confirmed that he was not tough all the time—despite his reputation as an unbending Old Testament scourge, he was capable of printing money in a crisis. Indeed, even before Silva Herzog’s visit in mid-August, Volcker had discreetly provided Mexico with a series of unannounced Fed loans: $600 million in April, $200 million in June, another $700 million at the start of August.5 Now that these attempted rescues had proved too small to do the job, Volcker resolved to prop Mexico up with a blockbuster bailout. Joining forces with Donald Regan at the Treasury, he put together a monumental $3.5 billion war chest—it was 50 percent larger than the federal bailout for New York that Greenspan had resisted seven years earlier.6 Thanks to Volcker’s lifeline, Mexico would have the resources to keep paying back the bankers after all. Having secured this promise of support, Silva Herzog went home a hero.
Volcker was inevitably attacked for allowing American lenders to expose themselves so much that such a bailout had become necessary. William McChesney Martin, who had chaired the Fed through the 1950s and 1960s, declared that Volcker was “very good” at conducting monetary policy but a “complete flop on bank supervision.”7 Volcker’s regulatory failure was especially disappointing because his own monetary policy should have alerted him to the financial risks. As Greenspan had argued in the spring of 1981, the battle against inflation had upended the relationship between borrowers and lenders, rendering some kind of debt crisis almost inevitable.8 Before Volcker’s policy revolution, borrowers had taken on debt carelessly, believing that inflation would erode its real value; after the Volcker revolution, inflation was falling, forcing borrowers to repay more than they had bargained for.9 The Fed chairman’s tough monetary policy ensured that his lax regulatory policy was dangerous.
When Volcker was cross-examined in the Senate about Mexico’s failure, his answers anticipated his successors’ self-defense in the wake of future crises. “None of us enjoys perfect foresight,” he pleaded, adding that regulators could not be expected to second-guess the decisions of Wall Street’s experts. “It remains central to our financial and economic system that the individual lenders reach their own credit judgments,” he maintained; and although he conceded the case for stricter bank regulation, he emphasized the risk in clamping down on Wall Street. “The danger of overreaction—of encouraging inadvertently an abrupt retreat from lending—is equally real,” he lectured the Senate. Regulation was needed, certainly; but it had “to be balanced against letting the system work.”
The redoubtable Senator Proxmire was incensed. “Danger signals were apparent to all but the willfully obtuse,” he rumbled; “Mr. Chairman, as we go through these hearings, I think we must get the answer to a very simple question: Where were our regulators?” The way Proxmire saw things, the Fed’s army of bank supervisors “advised, they monitored, they cajoled, they encouraged—in fact, they did everything except what they are paid to do, and that is to regulate.” The banks’ indifference to the Fed’s polite coaxing recalled Henry Higgins’s remark about women in My Fair Lady, Proxmire continued. “She will ask you for advice, your reply will be concise, and then she will do precisely what she wants,” he fulminated.
Fixing Volcker with his fiercest stare, Proxmire asked him directly, “Were the regulators forceful enough?”
“I suppose, in retrospect, probably not,” the giant conceded meekly.10
As if humiliation on the regulatory front were not enough, it was followed by the abandonment of Volcker’s monetary revolution. The $3.5 billion rescue for Mexico had staved off an immediate banking collapse, but it had not eliminated the risk of some future meltdown, especially because a sharp recession at home was driving thousands of borrowers into bankruptcy, adding to the banks’ losses. “We are in a very sensitive period,” Volcker told his Federal Open Market Committee colleagues on August 24, pointing to “concern—and I’m afraid to some degree justified concern—about the stability of the banking system.”11 At the FOMC’s next meeting, on October 5, Volcker reiterated his fears, comparing the potential for banking failure to 1929 and declaring it was time for the Fed to execute a pivot. The moment had come for the Fed to switch focus from stabilizing prices to stabilizing finance. By a vote of 9 to 3, the committee resolved to cut interest rates rather than targeting a steady rate of money growth. It was the end of the experiment with monetarism.
Volcker announced this turning point with as little fanfare as possible. He said nothing whatever for a full five days; then he used the occasion of a meeting in Hot Springs, Arkansas, to slip the news out. “I thought I had a good idea a week or so ago,” he began coyly; “I had a little sense that maybe we wouldn’t put our usual emphasis on M1 as an operating target.” The shift from monetary targeting to the direct manipulation of interest rates was just a “little technical matter,” he went on; it was reversible, quite possibly temporary, and certainly not worth front-page headlines. A quarter of a century later, central bankers would come to regard clear communication as a central part of their tool kit. But in 1982, Volcker deliberately muddied his message. Torn between the fight against inflation and the fear of a financial meltdown, he set off in two directions all at once. His interest-rate policy was going one way, his communications policy the other.12
To those who understood that the monetarist chapter was over, Volcker appeared to have unbuckled his protective armor. During his three years in office, the Fed chairman had endured plenty of personal attacks—“This guy is killing us,” the White House chief of staff, James Baker, had protested, as recently as the summer.13 But Volcker had been able to defend himself by hiding behind the claim that he was targeting stable monetary growth, and therefore the punishing level of interest rates was not really his responsibility. Now, having abandoned monetary targets, Volcker could no longer take refuge in this way. Henceforth he would directly decide interest rates, so he could hardly pretend that high rates were not his doing. He had abandoned the rule guiding his policy, replacing it with nothing more concrete than his personal judgment.
In April 1983, the full extent of Volcker’s vulnerability became apparent. At a meeting of the President’s Economic Policy Advisory Board, Milton Friedman pointed a finger at the central-bank chief and turned to address Reagan. “Because of the policies of the Fed under that man, we’ve had an inflationary surge in the money supply which is going to have to be corrected,” Friedman insisted.14 Unable to hide behind a framework that might legitimize his decisions, Volcker endured the assault in silence. It was his judgment against Friedman’s. Nobody defended him.
• • •
On April 18, 1983, the conservative Washington Times reported that Reagan would not reappoint Volcker.15 His four-year term as Fed chairman would expire in August, and Treasury Secretary Donald Regan had convinced the president that he did not deserve another one. The White House denied the story, but the truth was that the political team around Reagan wanted a Republican at the Fed—somebody who would set interest rates with at least half an eye to the following year’s election. The mere fact that the president had not yet reappointed Volcker seemed to confirm the Washington Times piece—if Volcker was going to be the man, why turn him into a lame duck by keeping quiet about it? The chairmanship of the Fed was evidently up for grabs. And by popular consent, the front-runner was Alan Greenspan.
Quite how Greenspan emerged as the top choice was a subject of some fascination.16 It was evidently not because he stood for policies that differed from Volcker’s—“Greenspan is a Republican Volcker without the cigar,” Newsweek commented.17 On monetary issues, certainly, the two men were indistinguishable: Greenspan had emphasized the need to subdue inflation for at least as long as Volcker had; he had protected Volcker against attacks from the gold camp; his belief in policy discretion rather than rules made him a fan of Volcker’s break with monetary targeting. On regulatory issues, admittedly, Greenspan was more laissez-faire. But the difference was obscured in the wake of Mexico’s collapse, because Greenspan refused to position himself as a critic of Volcker, however much the media invited him to do so.
Appearing on Meet the Press on January 2, 1983, Greenspan had been given an opportunity to disparage Volcker’s regulatory record. In light of their reckless lending to Mexico, surely banks should be kept on a tighter leash? an interviewer had asked him.
Greenspan was not taking the bait. “Do I think regulation would help?” he asked. “I doubt it.”
The interviewer tried again. At the very least, he suggested, banks should have been prohibited from lending too much to one country?
Again Greenspan resisted. He was happy to concede that the banks had been reckless—bankers, like financial markets generally, were not always efficient. But he doubted that regulatory restraints would make the world safer. “It’s very difficult to impose those arbitrarily because somebody’s got to make that judgment,” he explained, referring to the question of how much lending to one country might cross the line into excess. “The trouble is that the person who is probably most able to make that judgment is an international banker,” he went on. “I don’t know of anybody in the government bureaucracy who is better able to make that judgment.”
If Greenspan had not emerged as the Fed’s chairman-in-waiting by promising a fresh policy approach, how had he done it? The answer came down to personal connections. Despite his low-key style, Greenspan had relationships in Congress and powerful allies in the White House; he had followers on Main Street and Wall Street; he had friends at the newspapers and political talk shows; and Barbara Walters, the queen of television news, had recently escorted him to Henry Kissinger’s sixtieth birthday party. The success of the Social Security commission had only burnished Greenspan’s allure; he had emerged as the pragmatic technocrat whom everyone could get along with. Liberal economists fell over one another to sing his praises. “Alan has managed to avoid all the way-out positions,” Otto Eckstein said approvingly. “He’s not a simple-minded supply sider, he’s not a simple-minded monetarist, he’s an all-around conservative economist.”18 “I had an image of him as the worst, flaming, right-wing bastard in the world,” Arthur Okun chimed in. “I still disagree with him but I enjoy arguing with him and I like him.”19
With the passage of the decades, Greenspan’s youthful diffidence had matured into a subtle strength: with just a few exceptions that were remarkably rare, his demeanor ensured that he did not alienate people. “He talks very quietly, and his manner does defuse people who might disagree,” mused Robert M. Ball, a Democrat who had served on the Social Security commission. “I don’t think he has such a thing as a personal enemy,” Barbara Walters reflected. This same relentless equanimity could make Greenspan a bland friend—“Sometimes you just want to say, ‘Damn it, Alan, tell me a dirty joke. Or at least listen to one,’” his undergraduate comrade Robert Kavesh said teasingly.20 But even if Greenspan’s personality lacked the rough patches to which soul mates might adhere, there was no doubt that his composure paid professional dividends. By forming acquaintances with anyone who was anyone—by proving incapable of anger and not giving offense—Greenspan had built a vast network. He had risen to prominence as the man who knew. Now that the Fed chairmanship appeared to be open, the key to his stature was that everybody knew him.
Paul Volcker, for his part, was of two minds about his future. When he had assumed the Fed chairmanship, his wife, Barbara, had remained in New York; her health was not strong, and after four years on the job, it was time for Volcker to return to her. But the chairman was reluctant to move on. He had force-marched the nation through two punishing recessions, and the rewards were only just materializing now: in the first quarter of 1983, inflation had come in at less than 4 percent. It was a remarkable victory, but it was still fragile. Volcker could not stand to leave his post until his legacy had been consolidated.
On Memorial Day weekend, Paul sat with Barbara in the lime-colored office of their East Side apartment.
“I’m asking for a meeting with the president next week,” he told her.
Barbara’s spirits seemed to lift. “Are you going to submit your resignation? You know that is what they would like. Everything I read says they still don’t trust a Democrat.”
“Not exactly . . .”
Barbara began to cry. “We have no money and I have no life,” she pleaded. “I have never stood in your way and I am proud of what you have accomplished. But now that you’ve beaten inflation your job is done.”
“For now.”
“What is that supposed to mean?”
“It’s just the end of the beginning—”
She cut him off: “You really think you’re America’s Churchill?”
It was a reproach more fitting than she knew. Less than four years earlier, Arthur Burns had lectured the world in Belgrade about how central banks were impotent. But her husband had turned the chairmanship of the Fed into a job of Churchillian proportions.
Volcker proposed a compromise. “I will tell the president that if he chooses to reappoint me I will leave midway through—after two years.”21
• • •
In the late afternoon of June 6, 1983, Volcker sat in the West Sitting Room of the White House, waiting to meet the president.22 Despite the Washington Times article, he knew he was still in the running to succeed himself. The Treasury secretary might want him gone, but plenty of Reaganites had come to respect his triumph over inflation. Besides, the Treasury secretary had no great love for Volcker’s putative rival, Alan Greenspan. In a rare exception to the rule that Greenspan made no enemies, his refusal to sell his consultancy to Regan back in 1979 had left a residue of ill will, exacerbated by the rumors in 1982 that Greenspan might be recruited as an economic czar at the White House. Moreover, Regan was the kind of man—gregarious but shallow, with the empty bravado of a salesman—that Greenspan found hardest to deal with; and the supply-siders on Regan’s Treasury staff resented Greenspan for his reservations about tax cuts. “I would rather kiss Paul Volcker on the mouth, cigar and all, than have Alan Greenspan as Fed chairman,” a leading Treasury official told Newsweek.23
Presently, Nancy Reagan entered the West Sitting Room in a red evening dress. She was known for spending lavishly on clothes. Her wardrobe for her husband’s inaugural events—“a bacchanalia of the haves,” some critics griped—was said to have cost $25,000.24
“Madam First Lady, you look quite beautiful,” the inflation killer offered.
The president hove into view. “Congratulations on your good taste, Mr. Chairman.”
The first lady soon left, and Volcker made his pitch to Reagan. “Mr. President, we are in a sensitive period, both domestically and internationally, and you do not need a lame duck as Fed chairman right now,” Volcker began. It was a way of needling the president into making a choice. Endless public speculation about the future of the Fed was not helping anyone.
“But there is something I should tell you before you announce a decision, whatever it is,” Volcker went on. “I think I’ve been here long enough so if you choose to reappoint me, I would expect to stay for only the next eighteen months or two years. I thought you should know this before you decide.”
“Paul, I will be in touch shortly,” Reagan responded.25 That evening he wrote in his diary, “I met with Paul Volcker—? do I reappoint him as Chmn. of the Fed Aug.1 or change. The financial mkt. seems set on having him. I don’t want to shake their confidence in recovery.”26
It was not that the financial markets lacked confidence in Greenspan. Two days after Volcker’s visit to the White House, a poll of investment managers showed that if Volcker was not reappointed, 37 percent wanted Greenspan to get the job, with the second most popular option, Milton Friedman, garnering a mere 11 percent.27 But the same poll confirmed Reagan’s intuition that change would involve risk: fully 77 percent regarded a Volcker renomination as the first best outcome. Ironically, the same factors that had made Volcker vulnerable the previous autumn made him hard to budge now. Mexico’s debt crisis had been contained, but it was by no means over; it seemed risky to entrust its management to a new Fed chairman. And because Volcker had replaced the monetary rule with personal discretion, he had captured the credit for the economy’s revival.28 “For their finest accomplishment, reduced inflation, [Republicans] are deeply indebted to a Democrat appointed by Jimmy Carter,” wrote the conservative commentator George Will. “The Democrat—Paul Volcker—may be more important than Ronald Reagan this summer when the recovery hangs by a thread.”29 It was a remarkable tribute to Volcker’s Churchillian stature. The central-bank chief mattered more than the president.
“I think we’ll re-appoint Paul Volcker for about a year & a half. He doesn’t want a full term,” Reagan confided to his diary.30
• • •
A few days later, on June 18, 1983, the president announced his choice of Volcker in his weekly radio address to the nation. Greenspan proved that he could lose with grace. “The President’s indecision was unfortunate,” he wrote to Volcker in July. “But in the end—as he seems usually to do—he came out on the right side.”31 Milton Friedman sent Greenspan a commiserating letter. “I continue to believe that President Reagan made a serious mistake in reappointing Paul Volcker instead of appointing you as Chairman of the Fed,” he averred. “Delighted to have kept a friend, but sorry to have lost a Chairman.”32
There was no doubt that Greenspan had craved the job. “It’s in the very nature of the human species to seek to achieve personal fulfillment and to somehow create a sense of self-esteem,” he told a television interviewer in August; despite the distance he had come, the sideman was still burning to make his mark, to the maximum extent of his abilities.33 But life outside the government had its attractions, too. The business of being Alan Greenspan had grown more lucrative than ever: at the time of the contest for the Fed chairmanship, he was delivering some eighty paid speeches per year and pocketing almost $1 million from them.34 Besides, Greenspan did not object to earning more. For a man of his stature, there were many ways to do so.
At the start of 1984, Greenspan moved his consultancy into an art deco building at 120 Wall Street. The tower had once been occupied by coffee merchants, and a few still hung on; every so often the smell of roasting coffee beans would waft through the air-conditioning system. But by now Townsend-Greenspan was a diminishing part of Greenspan’s professional empire, for rather than growing his firm, Greenspan himself had grown beyond it. As well as milking the speaking circuit, he served as the pitchman for Apple’s TV ads, sporting his Woody Allen glasses and a broad-shouldered black business suit. He accompanied Henry Kissinger on visits to Kissinger’s consulting clients, providing an economic view that complemented the geopolitical one—evidently, by now, their shared commercial interests trumped old policy rivalries.35 Meanwhile, Greenspan held directorships on an A-list of corporate boards, among them Mobil, General Foods, the aluminum giant Alcoa, and J.P. Morgan. He experimented with joint ventures, too. A few years earlier, Greenspan had teamed up with a computer-services company called ADP, which had been built by the New Jersey senator Frank Lautenberg. Together they provided a souped-up version of the Townsend-Greenspan offering, bundling consulting, computing, and data processing into one product.
In September 1984, Greenspan allowed his fame to be affixed to an investment company. It was the brainchild of Marvin Josephson, a celebrated Hollywood talent agent. Coming from the movie business, where big money followed big names, Josephson created a fund-management outfit around two bankable stars, recruiting Greenspan as the romantic lead and a financial rainmaker named C. Roderick “Rory” O’Neil to play opposite him. Greenspan-O’Neil Associates acquired suitably lavish premises in Midtown Manhattan, and Greenspan would show up once a month to give his view on the economy. The firm’s investment thesis was not exactly cutting-edge. Its stock pickers would listen to Greenspan’s assessment of the business cycle and buy stocks that would do well if he was right: if Greenspan foresaw accelerating growth, banks might be poised for a good run; if he foresaw a downswing, utilities offered some protection. The resulting investment returns were barely respectable—after all, Greenspan was offering little more than the advice he gave to the roster of more sophisticated investment teams that retained him as a consultant. But the firm’s clearest failure had to do with marketing. Greenspan had been recruited on the theory that he would attract business from corporate pension funds, but he refused to use his Rolodex to land clients; indeed, he even discouraged the marketing staff from approaching companies he knew intimately. It was an example of how, in certain contexts, Greenspan’s scruples could dominate his behavior: he had been willing to lend his name to Josephson’s venture, but he was not willing to risk his reputation by urging friends to entrust money to it. Greenspan-O’Neil folded after about two years, costing the movie man $2 million.36
If this failure demonstrated that Greenspan could wander into projects in a half-committed way, it was not the only example. His multiple board memberships required little more than listening; the corporate culture of the time did not encourage activist directors.37 Even the prestigious J.P. Morgan appointment fitted this model.38 Greenspan was thrilled to be a Morgan director: the board featured a who’s who of corporate titans, and ever since Greenspan had conceived a youthful fascination with the nineteenth-century robber barons, J. Pierpont Morgan had occupied a special place in his imagination. Years later, Greenspan would recall the awe he felt at entering Morgan’s theatrical headquarters at 23 Wall Street, passing through the unmarked corner entrance, proceeding underneath the opulent Louis XV chandelier with its 1,900 crystal pieces, and taking his place in the boardroom beneath the portrait of the glaring, walrus-mustached patriarch, with his bulbous nose and starched wing collar. To the kid from Washington Heights, it was almost as though he had realized his boyhood fantasy of playing baseball in the major leagues.39 But now that he had entered the sanctuary, Greenspan was not expected to do much. To the contrary, Morgan board meetings would feature a large lunch, capped off by an elaborate pastry; no liquor was served, but some of the directors had taken care of that deficiency before arriving. After lunch there would be a collective lighting of cigars, and the directors would process downstairs to the boardroom and sit back in comfortable chairs as a fog of distinguished somnolence descended upon the gathering. The entire ritual, a Morgan insider remembers, “was consistent with the way firms generally viewed their outside directors. You sort of took care of them, you made them comfortable, and kept them interested but you didn’t necessarily feel that they were running the show, as opposed to you running the show with them as adjuncts.”40 Morgan’s chairman, Lewis Preston, had no desire whatever to foster vigorous debate. By mustering a handful of probing questions, Greenspan performed above expectations.41
• • •
Around the time he launched his ill-fated investment firm, Greenspan was approached by Arthur Liman, a prominent attorney in New York’s financial circles. Liman needed some help for his client Charles H. Keating Jr., a lanky former Olympic swimmer with a wide smile and whiter-than-snow teeth, known for his fervent campaigns against pornography. Horrified by any hint of sexual license, Keating would lecture schoolgirls on proper behavior, telling one group in his hometown of Cincinnati that “men get lewd, sinful thoughts when they see a woman wearing shorts,” and specifying that “Bermuda shorts, too, can be an occasion of sin.”42 To recruit supporters for his antipornography campaign, Keating mailed out membership cards with a message denouncing “the pit demons of pornography.” “Just take this card in your hand. Hold it. Feel the bond with me, and with the hundreds of thousands of decent, God-fearing people across the country who stand in unbending line against the forces of absolute evil.”43
When Keating’s life intersected with Greenspan’s, he had recently purchased a mortgage bank called Lincoln Savings and Loan, based in Irvine, California. Though keen to eradicate pornography, Keating was a financial libertine; he wanted Lincoln to break out of its regulatory silo—to diversify out of mortgage lending by taking direct ownership stakes in corporate stock and real estate. Keating needed a well-placed ally to persuade the regulators to approve his plan, which was why his lawyer, Arthur Liman, had chosen to approach Greenspan.
Greenspan signed on as Keating’s consultant, and in November 1984 he submitted a brief to the Federal Home Loan Bank Board, which regulated Lincoln. This was not a heavy lift: the brief simply restated Greenspan’s long-standing support for financial deregulation.44 It stated that rules limiting thrifts’ investments “are unsound in principle and will prove harmful in practice.” It rejected the notion that direct investments in corporate stock or real estate were riskier than mortgage lending, suggesting to the contrary that they “should lower the industry’s overall level of risk and place it on a sounder footing.” “The industry as a whole requires the broad ability to make direct investments in order to restore and ensure its economic stability,” Greenspan asserted.45
Unfortunately for Greenspan, the regulators were not won over by his letter. Concerned that allowing thrifts to make riskier investments would heighten the threat of their failure, they vowed to come up with a rule that would restrict direct real estate bets.46 The regulators’ obstinacy drove Keating to step up his campaign, dragging his consultant in much deeper. On December 17, 1984, Greenspan consented to join Keating on a visit to Capitol Hill, where they explained their position to Senator Alan Cranston of California. Their methods of persuasion were not purely intellectual: Senator Cranston brought his campaign finance director to the meeting, and Keating and his associates would ultimately donate $850,000 to political organizations connected to the senator.47 Then, in February 1985, Greenspan applied his signature to another letter for Keating. This time he argued that if regulators insisted upon direct-investment restrictions for S&Ls, Lincoln deserved a special exemption from them.
Greenspan may have regarded his second letter as an innocent extension of his established deregulatory views; if he opposed investment restrictions for S&Ls in general, why shouldn’t he argue that a particular S&L should be excused from them? But his testimony now crossed the line from broad policy advocacy into the riskier territory of vouching specifically for Keating and his people. Greenspan assured regulators that Lincoln’s management was “seasoned and expert in selecting and making direct investments”; that it had “a long and continuous track record of outstanding success in making sound and profitable direct investments”; and indeed that Lincoln’s investments were “highly promising” and “widely diversified.” To deny Lincoln’s request for an exemption, Greenspan concluded, would be “a serious and unfair hardship on an association that has, through its skill and expertise, transformed itself into a financially strong institution.”48
These statements were, to say the least, incautious. To begin with, Greenspan had sounded the alarm repeatedly about the fragility of S&Ls. The entire industry was “basically running on virtually no tangible capital,” he complained in a television interview in March 1985; why did he suppose that Lincoln was more stable than the rest of the industry?49 Indeed, a little digging in the public record would have suggested that Lincoln might well be less solid than its peers. A few years earlier, the Securities and Exchange Commission had charged Keating with abusing funds at one of his other companies. Keating had ultimately signed a consent decree without admitting guilt, but the run-in had cost him a coveted appointment as Reagan’s ambassador to the Bahamas.50 Greenspan might also have wondered about Lincoln’s headlong growth; from his time as a director of Trans-World, Greenspan surely knew that the flashiest and most ambitious thrifts were often the ones that fell hardest.51 Years later, Greenspan would write that he had vouched for Lincoln before Keating “was exposed as a scoundrel.”52 This was fair—but only barely. The truth was that in the rush of a full life, Greenspan had ignored the red flags that were there to be discovered.
After Greenspan moved to the Fed, Keating’s true character was revealed in its entirety. He wiretapped supervisors who were examining Lincoln’s books.53 He flew into a rage with them, screaming to his secretary, “Get Alan Greenspan on the phone for me”—though by this time Greenspan had wisely instructed his office to direct Keating’s calls to the Fed’s general counsel.54 Finally, in 1989, Lincoln collapsed, and the federal government was forced to pick up the pieces, selling Keating’s “highly promising” direct investments for whatever anyone would pay for them. There was a preposterous hotel project, complete with a swimming pool lined with mother-of-pearl tile; there was a half-built residential community near Phoenix, where Keating meant to ban pornography.55 The S&L’s failure ended up costing taxpayers an astonishing $3.4 billion—more than any other thrift of the era.56
“I was wrong about Lincoln,” Greenspan said later.57 It was an understatement.
• • •
If Greenspan’s failure to secure the Fed job freed him to dabble in some dubious business ventures, Paul Volcker faced his own set of challenges. As the economic recovery continued into 1984, he began to push up interest rates, reversing the loosening that had followed Mexico’s near meltdown. The tightening was undoubtedly needed—inflation was creeping up again.58 But Reagan’s political counselors did not see things that way: they had no patience with interest-rate hikes in an election year, especially not from a Democratic Fed chairman. “If the Fed continues on their tight path now, it will have an effect on November and December,” Treasury Secretary Regan complained publicly on May 9, 1984. “Is that politics and does that have us worried? You bet your life it has us worried.”59
Political attacks were the least of Volcker’s problems, however. The same day that the Treasury secretary came after him, financial markets panicked about Continental Illinois National Bank and Trust Co., the eighth-largest bank in the nation. Continental had traditionally financed America’s auto and steel business from its stately bastion on South LaSalle Street in Chicago, but in the late 1970s it had expanded hastily, buying up loans that had been originated by others. Then Continental discovered, as many were to rediscover in 2007 and 2008, that banks that make loans with a view to selling them are sometimes tempted to lend carelessly. As Continental’s loans proved uncollectible, traders from Asia to Europe began to fear that it might fail; and the day that Regan harrumphed about Volcker, the jitters turned into a full-blown panic. Banks cut credit lines to Continental as quickly as they could; and the clearinghouse of the Chicago Board of Trade, Continental’s neighbor and one of its largest customers, withdrew a $50 million deposit. History’s first electronic bank run had begun. There were no mobs of frenzied customers outside Continental’s doors. There were just numbers flashing on computer screens, heralding disaster.60
On Friday, May 11, the Federal Reserve Bank of Chicago hastily propped up Continental with a loan of $3.6 billion—more even than it had taken to stabilize Mexico. But despite that infusion, Continental was still teetering. It had taken in an astronomical $40 billion in deposits, mostly in the form of bulky chunks of capital from other financial institutions, many of them foreign. Once this hot money began to run, the exodus of cash could quickly overwhelm the Fed’s emergency loan. In desperation, Continental sought help from its competitors.
Hoping for a line of credit that would be large enough to change the game, David Taylor, Continental’s lean, aristocratic chairman, turned to the one bank that all the industry revered—J.P. Morgan. There was a rich echo in this turn of events. The most famous moment in Morgan history had occurred during the market panic of 1907, when J. Pierpont Morgan himself had led Wall Street’s elite in rescuing the financial system, at one point locking his fellow bank chiefs in his library until they pledged to support his bailout program. Now, seventy-seven years later, Pierpont’s successors rounded up the nation’s banking chiefs to back Continental, urgently pleading that its failure would hurt all of them. This time there was no locked library, no majestic wall tapestries or illuminated manuscripts—there were simply frantic calls to credit officers, one of whom was contacted while windsurfing.61 By Sunday evening, the House of Morgan had persuaded the nation’s top lenders to step up. It pulled together a private credit line of $4.5 billion to backstop the Fed’s backstop.
Even that was not enough, however. Together, the Fed loan and the Morgan syndicate represented less than a quarter of Continental’s deposits; amazingly, Continental was larger than the combined size of all the banks that had failed during the Depression.62 When the markets opened on Monday, Standard & Poor’s fueled the panic by lowering its rating of Continental’s debt; and on Tuesday morning the front page of the New York Times proclaimed that Continental’s collapse could trigger “a wave of failures worldwide.”63 Western banks had already been battered by the Latin American shock, and now Continental’s woes threatened to push them over the edge. In the American Midwest, some fifty banks were said to have deposits at Continental that exceeded their total capital.64
At ten o’clock that Tuesday morning, a worried Paul Volcker convened a meeting with his fellow bank regulators, the comptroller of the currency, and the head of the Federal Deposit Insurance Corporation. The Reagan Treasury was enthusiastic about the idea of the Morgan-led “private solution,” but the markets were screaming that something bigger was needed. The scale of the challenge dwarfed 1907, when Pierpont Morgan had succeeded in ending the panic with a war chest of around $300 million—about $3.3 billion in 1984 dollars.65 Now, with a single institution requiring a bailout many times larger, a private solution would not work. The Fed, which had been founded after 1907 precisely to end the unnerving reliance on private bailouts, had created the stability that had allowed finance to expand. As a result, when crises did occur, they happened on a scale that demanded Fed action.
Volcker suggested to his fellow regulators that they should meet the leaders of the Morgan syndicate. He asked J.P. Morgan to gather Wall Street’s elite at its headquarters the following morning.
The next day, Wednesday, May 16, 1984, Volcker slipped into New York and entered the Morgan offices through the service garage. The last thing he wanted was for financial traders to know of his visit; the news would only intensify the panic. He also did not want to be late for his next engagement. He was due to attend that afternoon’s commencement exercises at Columbia University, where he would be awarded an honorary degree. His absence would be conspicuous.66
Volcker made his way from the garage up to the Morgan boardroom. The imposing portrait of Pierpont glared down on him from the wall, and when the meeting got under way, some of those present invoked the patriarch’s past glories. A few of the bank chiefs suggested grandly that they could save the system once again, without the taxpayers’ involvement. But it was just talk. They were not about to risk their money on the scale that would be necessary.
William Isaac, the young chairman of the Federal Deposit Insurance Corporation (FDIC), explained that he was readying a rescue package of $2 billion for Continental. Prompted by Don Regan at the Treasury, he wanted the assembled bankers to cover a quarter of that sum. But several of the bankers resisted even this modest request, doubting whether a further $2 billion could possibly make much difference. So long as Continental’s creditors entertained any doubt whatever about the bank’s survival, they would race each other for the exit.
The meeting broke up, and Volcker prepared to leave for the commencement ceremony at Columbia. But before he departed, the FDIC chairman pressed an idea on him. At present, only deposits up to $100,000 were covered by FDIC insurance, and these represented just a tenth of total deposits at Continental. If the government pledged to protect other creditors—larger depositors as well as investors who owned Continental bonds or short-term paper—the panic could be calmed. The FDIC’s $2 billion rescue loan would then be enough to end the run on Continental.
Volcker was not keen on guaranteeing uninsured creditors. “That would set a bad precedent,” he cautioned. “Frankly, I think that between your capital infusion and our loans at the discount window we should be able to stabilize Continental.”
“That’s easy for you to say,” the FDIC man responded. “All your exposure is collateralized.” He was pointing out that the Fed’s emergency loans were provided against the security of Treasury bonds or other assets. If Continental went down, the Fed would take possession of its collateral. But the FDIC was more exposed. “We’re on the hook for $2 billion if Continental is forced into bankruptcy,” he continued. “I can’t afford to let that happen.”
“Well, I’ve got to go and get that damn honorary degree or people will start thinking we’ve really got a problem,” Volcker harrumphed. “Just try to keep the wording as vague as possible.”
The following day, the government and Wall Street jointly unveiled the largest bank bailout in U.S. history. The FDIC duly provided the $2 billion loan, having arm-twisted the bank chiefs into underwriting part of it. The Morgan syndicate’s private credit line was expanded to $5.3 billion, and the Fed promised to keep its discount window open until the crisis abated. But the most lasting consequence of the disaster was the one against which Volcker had warned. The government issued a statement declaring that no Continental creditor, large or small, would be permitted to lose money.
Back in 1970, Arthur Burns had initially resisted pressure to bail out Penn Central; then he had reversed himself completely. In 1975, Gerald Ford had resisted calls to bail out New York City; then he had caved under pressure. Now even the Churchillian Paul Volker had followed the same path. On Mexico and again on Continental Illinois, he had thrown public money at defaulters and allowed private creditors to escape unscathed. The doctrine of “too big to fail” had been established.
• • •
Greenspan himself had mellowed on bailouts. The month after Continental’s rescue, he devoted two of his regular public television commentaries to the affair, conceding that the Fed’s actions “may well have been necessary given the potential dangers of a major run.” But he still focused on the dark side. Creditors to large banks could now expect to be rescued, whereas creditors to small banks presumably could not; armed with the advantage of implicit government insurance, big banks would now grow bigger than ever. At the same time, moreover, big banks would grow more reckless, too. Hitherto, large, uninsured creditors had supposedly restrained bank managers from taking too much risk; if they saw signs of unsound lending, they would quickly yank their money out. But now that large creditors were de facto insured, that restraining discipline was gone; risks would build up, and more large banks would fail in the future. The government would be on the hook for almost limitless bailouts, requiring “taxpayer money and probably a good deal of Federal Reserve printing press money as well,” Greenspan predicted.67 The warnings contained in his Challenge essay, written to mark the fiftieth anniversary of the 1929 crash, were coming true. The larger the financial system grew, the scarier the prospect that it might crack. Any bank that got into trouble “would have to be bailed out by its central bank,” Greenspan had observed in his essay.
If the Continental rescue had been both necessary and appalling, what was the solution? The answer, Greenspan insisted at a discussion convened by the New York Times in August 1984, was that banks should protect both taxpayers and themselves by maintaining thicker capital cushions. For a moment, it sounded as though Greenspan were demanding regulatory action; for the previous few years, the Fed had tried halfheartedly to impose capital standards on U.S. banks, never summoning the nerve to force large lenders to comply with them. But having seemingly laid out a policy prescription, Greenspan quickly undermined it.
“Mr. Greenspan, do you have a figure in mind for what the appropriate capital-asset ratio should be at this time?” a journalist inquired, reasonably.
“Yes, I do, but that’s irrelevant because it depends on the individual bank,” Greenspan replied. “It depends on the type of liabilities it has. For example, a bank which has nothing but certificates of deposit that mature in ten years can do with a lot less capital than one which has borrowed overnight money.”
Greenspan’s logic was correct: if Continental had locked up funding for ten years, it could have brushed off rumors about its health without overnight depositors running. Indeed, Greenspan’s logic could be extended to the other side of a bank’s balance sheet, too. A bank that lent to dicey start-up businesses needed more capital to buffer losses than a bank that only lent to the U.S. government—the appropriate amount of capital depended on the individual bank, exactly as Greenspan suggested. But if Greenspan was arguing that the right capital-asset ratio could not be described by a rule—just as the right monetary policy could not be described by a rule, and just as the right amount of lending to a Latin American country could not be described by a rule—then he was offering a counsel of despair. He was insisting that banks should hold more capital; and yet he was also arguing that regulators could not force them to do so, because they had no way to decide how much capital was needed.
One of the Times’s journalists forced Greenspan to confront the implication of his thinking. Banks were risky, yet Greenspan had no advice on how to rein them in. Should the banking system therefore “be structured as a noncompetitive utility?”
“I think we’re getting to the really crucial issue,” Greenspan responded. “Look, there are extraordinary advantages to the American standard of living in having the type of banking system that we have had. In other words, we keep looking at the problems but remember that the financial institutions that we’ve developed in this country have been a very important factor in why we have this pre-eminent standard of living. . . .”
Banks were hazardous, Greenspan was conceding; and no capital rule could tame them. But reducing banks to tame wards of the state was not the right answer, because prosperity depended on sophisticated finance. The experts who decided how money flowed through the economy were providing a vital service. Even though they made mistakes, there was no way to do without them.
Greenspan’s bottom line marked a shift in his outlook. Since the 1950s and 1960s, he had argued that bankers must be trusted to manage their affairs; far from wanting to turn finance into a “noncompetitive utility,” he had favored deregulation. But this part of his thinking had rested on the presumption that financiers would pay for their errors—they should be free to manage their own risks, but they must also be incentivized to manage them. Precisely because he was adamant that financiers should bear the cost of their mistakes, Greenspan had denounced the creation of a lender of last resort—the founding of the Fed had been “one of the historic disasters in American history.” By the same token, Greenspan had consistently opposed financial rescues during the 1970s, opposing assistance for Penn Central, Lockheed Martin, and New York City. But sometime in the mid-1980s, this two-part logic was allowed to blur. Greenspan continued to favor the deregulation of finance; but it grew obvious that government safety nets were there to stay—financiers would not pay for their errors. An affluent democracy was simply not willing to let its financiers go bust. Yet Greenspan continued to support deregulation anyway.
Greenspan was perfectly aware that his worldview was fraying. He could see, for example, that the progressive expansion of deposit insurance had dulled banks’ incentive to hold the extra capital buffers that he thought necessary.68 In the laissez-faire nineteenth century, banks had needed ample capital to attract deposits; in the paternalistic late twentieth century, depositors knew that the government insured them, so capital was passé. But even though market discipline was atrophying, Greenspan retained more faith in financiers than in regulators who faced no market discipline at all. A bank’s judgment about how much capital to hold might be distorted by the government backstop; but a regulator’s judgment would be worse than distorted—it would fail to reckon with such elementary matters as the duration of a bank’s borrowings or the riskiness of its lending. Neither banks nor markets were perfectly efficient, Greenspan understood. But however inefficient banks might be, regulators might well be even less efficient.
Greenspan’s willingness to give bankers the benefit of the doubt owed something to his Randian roots. Ever since his anti-antitrust article of 1961, he had underestimated the destructive power of skewed incentives within companies.69 Greenspan’s experience on the board of J.P. Morgan may have colored his view, too.70 More than any other major institution on Wall Street, Morgan embodied his ideal of what a bank should be—financially self-sufficient, intellectually independent, culturally moored to the ethos of the nineteenth century. But whatever the roots of Greenspan’s deference to bankers, it would have huge consequences for the evolution of finance. Greenspan had lived through the Mexico crisis and the Continental Illinois crisis—he had seen that financiers were capable of grievous errors. And yet he still believed that bankers were better placed than others to allocate credit. There would be blowups, to be sure. But there was no better prescription.
“Life is risky,” Greenspan concluded at the New York Times forum in the summer of 1984.71 Despite the many financial disasters that ensued, this passive bottom line remained the best that he could offer.