A few weeks after his arrival at the Fed, Greenspan called Ken Duberstein, the deputy chief of staff at the White House. Duberstein was a wise counselor who would later become Reagan’s chief of staff. He was also a friend, and Greenspan needed a favor.
“Help!” Greenspan began. The president and Mrs. Reagan had invited him to a state dinner at the White House. But Mrs. Reagan did not approve of unmarried couples at formal events. Andrea had not been invited.
“Do you mind interceding with Mrs. Reagan and asking her if I can bring Andrea?” Greenspan pleaded. He explained that this would mean a lot. It would be the first time that he had attended a big public event with Andrea.
Duberstein knew Andrea well because she covered the White House. But he was not convinced that the first lady’s sense of etiquette was his problem. “Alan, you are a big boy, you ask her,” he retorted.
“No way,” Greenspan protested. He did not sound like a big boy; he was doing his best to come over as a small boy—charmingly shy and awkward. “I am not calling Mrs. Reagan on the phone about this,” Greenspan went on. “Please, do me this favor.”
“Alan, you are a big boy,” Duberstein insisted. Greenspan was the most powerful economist in the world. Surely he could place a call to Mrs. Reagan.
Greenspan protested some more, and eventually Duberstein said he would think about it.
A few moments after putting down the phone, Duberstein received another call. This one was from Andrea.
“Please!” she implored. “Do me this favor. This would mean so much to us. Will you please call Mrs. Reagan?”
“Alan could do it,” Duberstein objected.
“Oh please, Ken, it would mean so much to me.”
A little while later, Duberstein found himself in conversation with the first lady. He mentioned Greenspan’s request.
“What should I say?” Nancy Reagan inquired of him.
“I think you should authorize me to tell Alan, if he calls you, you’ll consider it.”
Duberstein called Greenspan with the news. The door had been opened, but Alan still had to do his part. It was up to him to push on it.
“Oh my God, I don’t want to call Nancy!” Greenspan protested. “You do it! I don’t want to do it!”1
In the end, Alan overcame his inhibitions; and on October 14, 1987, he escorted Andrea to her first White House state dinner. After covering many such occasions as a reporter, Andrea was thrilled to be on the inside; and she did her best to live up to the occasion by wearing an Oscar de la Renta gown that, as she wrote later, “almost broke the bank.”2 There were cabinet secretaries and celebrities and sports stars; there were ostentatious jewels and a buzz of beehive hairdos. After the dinner, the jazz vibraphonist Lionel Hampton played for the assembled throng. Acknowledging the guest of honor, José Napoleón Duarte of El Salvador, the jazzman dedicated a piece to “one of the great presidents from down there in that foreign country.”3
The day after the state dinner, Treasury Secretary James Baker met Greenspan for breakfast and gave a press briefing at the White House.4 Nancy Reagan’s glittering party had revived the glamour of the Gilded Age, but the financial markets threatened to upset the mood of celebration. Greenspan’s appearance on the Brinkley show had certainly not helped: his remarks had been received as a signal that the Fed meant to tighten interest rates, and both stocks and bonds were sliding.5 Interest-rate hikes in other countries were adding to the pressure by encouraging investors to shift money out of dollars. Baker meant to use his press conference to calm Wall Street’s jitters. To address the problem of dollars fleeing the country, he lectured Germany’s Bundesbank for raising rates.
“We will not sit back in this country and watch surplus countries jack up interest rates and squeeze growth worldwide on the expectation that the United States somehow will follow by raising its interest rates,” Baker said, showing scant regard for the Fed’s independence.6
Greenspan did not give Baker’s pronouncements too much thought. He went about his normal business for the rest of the day: a background interview with a newsmagazine at three o’clock; a meeting with Congressman Chuck Schumer at four o’clock; a tennis match with a colleague, Fed governor Wayne Angell, at six; a reception at the White House followed by a dinner with Andrea. But investors on Wall Street had parsed Baker’s statements carefully—far from being reassured, they found the prospect of a currency war alarming. The following day, Friday, October 16, the Dow Jones index dropped almost 5 percent, capping off its worst week since 1940. “It’s the end of the world!” one trader bleated.7
Baker realized that his remarks had backfired. Early on Friday afternoon, he returned to the White House, this time to a meeting with the president, Alan Greenspan, and Beryl Sprinkel, the head of the Council of Economic Advisers who had aspired to be Fed chairman.
Nobody knew what to do, and Sprinkel was concerned that the worst was not over. The German move would oblige Greenspan to raise interest rates to defend the dollar; but higher rates would spell disaster for the stock market.8
Reagan confided later to his diary that he agreed with Sprinkel—the Fed might be too tight for the stock market’s health. But he noted that Greenspan disagreed. The Fed chairman regarded the market’s fall as “an overdue correction.”9
• • •
A complete account of Greenspan’s view would have been more complicated. In the weeks after his nomination as Fed chairman, Greenspan had spoken at length with E. Gerald Corrigan, the president of the New York Fed, who had given him an earful about the dangers of financial instability.10 Lumbering, chain-smoking, brilliant, and profane, Corrigan had spent the past several years handling crises from Mexico to Continental Illinois, and he saw no reason to suppose that the world was about to become calmer. Greenspan needed little persuading on this score; in his half decade or so before arriving at the Fed, he had noted repeatedly that an extraordinary buildup of debt was making the economy more vulnerable.11 American households were devoting three times more of their income to interest payments than they had at the end of the Korean War. Nonfinancial corporations had allocated 10 percent of earnings to interest payments in the mid-1950s; now that share had leaped to 60 percent. This leveraging of America had lifted the economy to new heights, facilitating a burst of investment and spending. But it had also created vertigo. Because families and firms were on the hook to pay back debts, they were constantly at risk of toppling into bankruptcy.12
By the time Greenspan moved into his new office in Washington, he was thoroughly aware of Corrigan’s preoccupations.13 Financial fragility would be a central challenge of his tenure, possibly rivaling inflation. Worse, the twin challenges might come into conflict. In his comments on the struggling thrift industry in the early 1980s, Greenspan had noted that Volcker’s tough monetary policy might destabilize lenders—most of the financial sector depended on short-term funding, so interest-rate hikes quickly fed through into rising costs that threatened viability. There might be times when the Fed had to choose between raising interest rates to ensure price stability and cutting interest rates to ensure financial stability—and given the extraordinary cost of financial failures in a leveraged economy, the Fed might feel obliged to prioritize financial stability.14 The implication was profoundly unsettling for Greenspan. Just when Paul Volcker had established the Fed’s inflation-fighting credibility, leveraged finance might force his successor to abandon it.
Soon after his arrival in Washington, Greenspan asked to see the Fed economist who was in charge of tracking the stock market. Pretty soon, half a dozen PhDs reported to his office.
“I wasn’t expecting quite so many,” Greenspan said, in a tone of shy levity. He would have to get used to the fact that if he asked to see one specialist, that person’s boss, and probably that boss’s boss, would want to be in on the meeting.15 But Greenspan wasn’t about to object. With this much intellectual firepower at his beck and call, he felt like a kid in a toy store.
Greenspan announced that he thought the stock market was too high; he hoped it would subside gently rather than crashing. In the back of his mind, he remembered the precedent of the 1920s Fed, which he had excoriated for passivity in the face of a stock bubble. Now, looking around at his lieutenants, Greenspan asked what he could do to improve the odds of a calm outcome.
The staff offered him two options. He could raise interest rates, which might crimp corporate profits and raise the cost of leveraged buyouts, thereby letting some air out of the stock market. Or he could try giving a speech: if the Fed chairman declared that stocks were too high, investors might take notice. The catch was that neither of these options was certain to succeed—they might have no effect on stock prices or, alternatively, too much effect, triggering the crash that Greenspan was afraid of. No other weapon looked better. One popular remedy for equity bubbles was to raise margin requirements—the rules restricting loans to investors who wanted to buy stocks. But the staff had researched that option and discarded it. Equity investors who wanted to borrow would always find a way of doing so.16
Because there was no sure way of defusing the bubble, Greenspan commissioned some contingency planning. If the market did crash, what would the Fed do about it? The staff set about producing a pink-jacketed manual that considered contingencies ranging from a dollar collapse to a stock market crisis. But the result was not exactly comforting. According to the Pink Book, the Fed could not legally support a crashing market by purchasing stocks, so it would have to use indirect methods. It could browbeat securities firms into buying stocks on its behalf, but this would represent a troubling infringement on free enterprise. It could close the stock exchange, but suspending investors’ ability to sell would only exacerbate the panic. It could step up its “open-market operations,” buying short-term government securities with newly created money, and hope that the financial system would funnel that money into stock purchases. This last option seemed most promising, but it was a worryingly roundabout remedy.17
The stock market, in short, posed a serious problem. But as Greenspan had observed frequently, serious problems in finance do not always come with obvious solutions. Hence his apparent optimism in that encounter with Ronald Reagan, Beryl Sprinkel, and Jim Baker on Friday, October 16, 1987. He appeared hopeful about the stock market because hope was all he had. If the market’s fall of almost 5 percent that day turned out to be the harbinger of something worse, the guardians of finance would have few good options.
• • •
The following trading day, October 19, 1987, went down in history as Black Monday. Stocks fell sharply in Tokyo and London, and when trading opened in New York and Chicago, the pattern was repeated. Around midmorning, Greenspan convened a conference call of the Federal Open Market Committee. The market had fallen by almost a tenth in the first hour and a half. This was twice as bad as Friday.
Greenspan was due to fly to Dallas after lunch to address a meeting of the American Bankers Association. Manley Johnson, the Fed vice chairman, used the conference call to urge Greenspan not to go—his planned speech on banking regulation would sound out of touch if the market continued its free fall.18 But Greenspan still thought the best policy was to stay calm and project confidence. Eighty years earlier, J. Pierpont Morgan had learned of the 1907 Wall Street crisis while attending a conference of Episcopalians in Virginia; he had refused to rush back to New York, reasoning that a hasty return would telegraph panic. As a former Morgan director, Greenspan was steeped in the stories of the patriarch’s composure.19 He resolved to stick to his schedule and fly down to Dallas.
The FOMC conference call ended. Johnson himself was due to make a speech that day at the annual meeting of the American Stock Exchange, which was taking place in Washington. Following Greenspan’s business-as-usual example, Johnson made his way over to the Mayflower Hotel on Connecticut Avenue.
When he entered the hotel conference room, he confronted a mob scene. Every financial journalist in the city had arrived to hunt for interviews. Every prospective interviewee seemed to be running for the telephones.
Johnson found one of his hosts and asked what was happening. The previous speaker, he soon learned, had been David Ruder, the chairman of the Securities and Exchange Commission. Ruder had apparently told reporters that if the equity sell-off continued, it would be time to consider closing the markets temporarily.20 Sure enough, just as the Fed’s Pink Book had predicted, Ruder’s suggestion had triggered pandemonium. If the market was at risk of closing, it might become impossible to sell. Therefore investors wanted to sell now, immediately.
Johnson stood up and improvised a short speech, announcing that the Fed was monitoring the situation. Then he beat a retreat as quickly as possible. He knew he was not supposed to telegraph panic, but the market was panicking anyway.
When he got back to the Fed, Johnson found that Greenspan had already left for Dallas. He called together a small group of senior officials and established a crisis center in the mahogany-paneled Special Library, a den lined with leather-bound volumes on the Fed’s history, across the hall from his office. Sitting at a small round table, the group began to consider its options, ticking off the contingencies outlined in the Pink Book. Pretty quickly, a plan started to emerge. The Fed’s job was not to stop the market from falling—the market would have to find its own level. Rather, it was to contain the collateral damage from the crash. Just as with a run on a large bank, the task was to prevent contagion.
It was difficult to say what that contagion would look like. When Continental Illinois had been hit by a run, a few conversations with its managers had established which other banks were exposed to it. But a stock market crisis was different. Thousands of brokers and investors held stock portfolios. Somewhere, some of them would be in deep trouble. With the value of their holdings down, they would no longer look creditworthy to their bankers; and if they lost access to borrowing, they might be forced to dump stocks in a hurry, driving the market down further. But although Johnson and his colleagues could be certain that the financial system was cracking, it was impossible to foresee where the fissures would emerge earliest.21
Facing an invisible enemy, Johnson’s impromptu crisis committee needed some fresh tactics. During the Continental Illinois crisis, the Fed had lent directly to the troubled bank. This time, following the least-bad option outlined in the Pink Book, the strategy would be to pump money into the short-term borrowing markets. Abundant liquidity would help investors and brokers get access to credit, hopefully tiding them through the shock from the stock market.
Thirteen hundred miles away, Greenspan’s plane landed in Dallas. He was greeted at the airport by a representative of the Federal Reserve Bank of Dallas.
“How did the stock market finally go?” Greenspan asked immediately.
“It was down five oh eight,” said the man.
“Great,” Greenspan said. If the market had lost only 5.08 points, his decision to stick to his schedule had been vindicated. “What a terrific rally.”22
The man from the Dallas Fed looked pained, and Greenspan realized what had really happened. The Dow Jones Industrial Average had dropped 508 points, nearly a quarter of its value and the largest single-day loss in history.
Greenspan reached the Adolphus Hotel in Dallas and checked in as fast as possible. Once in his room, he got hold of Manley Johnson, who was manning the crisis response team at the Fed’s headquarters. By now it was around eight p.m. on the East Coast, and some of the regional Fed presidents had alerted Johnson to pockets of trouble—sure enough, the fissures were emerging. In New York the market’s plunge had overwhelmed the “specialists” at the stock exchange, who made markets in particular stocks by standing ready to buy or sell at any moment. With the market falling like a stone, the specialists were understandably refusing to buy—with the result that, for everybody else, selling had become impossible. Unable to convert shares into cash, everyone on Wall Street suddenly valued cash above all else. Lenders called in credit lines. Those who had cash sat on it.
Johnson had asked the Fed’s general counsel, Michael Bradfield, to ready a public statement assuring investors that the Fed would supply ample money to the markets. Bradfield wanted to be careful to delineate what the Fed could and could not do, and he and Johnson had gone through a dozen possible wordings.23 Now, with Greenspan back in touch, the crisis group at headquarters convened a series of phone calls, looping in some of the regional Fed chiefs as well as the White House and the Treasury.
Gerald Corrigan, the president of the New York Fed, was not impressed by Bradfield’s statement. He was impatient with lawyers at the best of times, and a crisis was not the right moment to get hung up on legal niceties. “It was this long-winded, highly technical discussion about section X, part B, subpart A of the Federal Reserve Act,” Corrigan recalled later. “I said wait a minute, I said that’s the last damn thing we need. What we need is a statement that has about ten words in it.”24 The Fed just needed to announce that it would flood the system with money. Anything else was superfluous.
Not everyone agreed. “Maybe we’re overreacting,” somebody cautioned. “Why not wait a few days and see what happens?”25
“We don’t need to wait to see what happens,” Greenspan snapped. “We know what’s going to happen.” He had not taken the lead in determining what sort of statement the Fed should make—he could always see the flaws in any proposed action. But when it came to diagnosis rather than prescription, he was absolutely clear. The market drop had wiped out paper wealth equivalent to the GNP of France, or California plus Florida. No financial system could sustain such a blow without suffering huge stresses.
“You know what people say about getting shot?” Greenspan recalls telling people on one of the conference calls. “You feel like you’ve been punched, but the trauma is such that you don’t feel the pain right away? In twenty-four or forty-eight hours, we’re going to be feeling a lot of pain.”26
As recently as breakfast time that morning, Greenspan had doubted that the Fed had the tools for dealing with a crash. But when a collapse of historic magnitude arrived, the Fed had no choice but to respond—even if its tools had to be improvised.
• • •
While the central bankers debated their options, another crisis was brewing. Nine hundred feet above the streets of his city, Leo Melamed, a wiry, hot-tempered Polish immigrant who ran the Chicago Mercantile Exchange, left a dinner in the Sears Tower and descended sixty-six stories to ground level.27 It had been a day of vertiginous descents: the equity futures contracts traded on the Merc had led the New York stock market downward. In the months before the crash, anxious investors had bought a newfangled product called “portfolio insurance.” Their brokers had placed contingent orders to sell stock-index futures on the Merc, and these orders triggered automatically when the New York market began falling. But this insurance strategy accelerated the avalanche on Black Monday. Automatic sell orders in Chicago caused stock futures to collapse, driving down the underlying share prices in New York, which in turn triggered more selling in Chicago.
Melamed did not yet know whether his exchange would survive the carnage. After a normal day of futures trading, Merc members who had lost money were supposed to settle up with the clearinghouse that served the exchange, and the clearinghouse would distribute the proceeds to the day’s winners. But today’s after-hours clearing would take place on an unusual scale. Losers were on the hook to produce an astonishing $2.5 billion, about twenty times more cash than they typically delivered.
When Melamed got back to his office, his secretary handed him a list of phone calls: Alan Greenspan, Beryl Sprinkel, Senator Don Riegle, and so on. Melamed had no regard for senators: once, when he had received a visit from the senator-astronaut John Glenn, he had rebuked his secretary so loudly for showing the man in that Glenn had overheard the yelling.28 But Melamed felt differently about Greenspan, whom he had tried to recruit to the Merc’s board. Now that the Merc’s fate hung in the balance, Melamed was glad that Greenspan was at the Fed.29 It was good to have a central banker who had once been a futures trader.
Melamed returned Greenspan’s call and got through to his room at the Adolphus.
“Will you open tomorrow morning?” Greenspan asked. He wanted to know whether the market’s payment system was working. If the losing speculators defaulted, the winners would not get their dues. They would lose faith in the market, and no further trading would be possible.
“Mr. Chairman,” Melamed responded bravely, “I don’t think we have a problem, but to tell you the truth, it’s too early to tell.”
Greenspan assured Melamed that the Fed was going to help. Fedwire, the Fed’s system for moving money from bank to bank across the nation, would remain open overnight. If Chicago futures dealers were trying to get their hands on cash in order to settle trading debts, they would have all night to wire in cash from other cities.
Before putting the phone down, Greenspan told Melamed that he should call again at any time he needed. Strictly speaking, Melamed’s exchange and the brokerages that formed its membership lay outside the Fed’s safety net. But the failure of a clearinghouse would spook the whole system. If the Merc had a problem, Greenspan wanted to know about it.
Greenspan stayed up until around midnight. He had never been in the eye of such a storm before; and although his mind stayed crystal clear, he sometimes sounded to his colleagues like a fascinated onlooker, calm almost to the point of detachment. He was still determined to deliver his planned speech in Dallas the next day, however much Manley Johnson and Gerald Corrigan recommended that he cancel it.30
Shortly before he turned in that evening, Corrigan reminded Greenspan that he was not just a bystander. He was the leader of the free world’s financial system. “Alan, you’re it. Goddamn it, it’s up to you,” Corrigan urged. “The whole thing is on your shoulders.”31
• • •
Greenspan turned in for the night. Despite Corrigan’s admonition, he slept perfectly soundly. Meanwhile, in the North, the Merc was fighting for survival.32
Just as Melamed had feared, collecting $2.5 billion overnight was proving difficult. On ordinary evenings in Chicago, the Merc’s losing speculators drew on lines of credit from the city’s big banks and delivered the cash to the Merc’s clearinghouse. But now the day’s losses far exceeded the size of the credit lines—Morgan Stanley alone was down $1 billion. The banks, moreover, were not inclined to lend more than they had to. For all they knew, Morgan Stanley might go bust within the week. Why would any banker lend to it?
Around three a.m., Melamed could see he was in trouble. He thought of taking Greenspan at his word and waking him. But what could Greenspan do? Melamed decided instead to ask a colleague to call Morgan Stanley’s top executive and beg him to pay up. He warned the New York Fed that it might be impossible to clear all trades before the next day’s opening.
Just before seven a.m., with half an hour before the Merc was scheduled to open, Melamed called Continental Illinois. Having survived the crisis of 1984, Continental was one of the four Chicago banks that serviced the Merc’s members. Morgan Stanley was among its customers.
Wilma Smelcer, the Continental executive who managed the Merc’s clearing account, reported that most of the losing speculators had paid up. But the exchange was short $400 million.
“You mean we’re down to $400 million on $2.5 billion? That’s pretty good.”
“Yes, but it’s not good enough,” Smelcer told him. Until the Merc collected all the money to clear all its trades, it would be in default to yesterday’s winners. It would have to close before it racked up any further unpayable obligations.
Melamed was not going to swallow that. A few years earlier, he had suffered a gallbladder attack and refused to be taken from his hospital bed for X-rays until the Merc trading session was over. His secretary, summoned to his bedside, had found him with one tube attached to his arm, another in his nose, a cigarette in his mouth, and a telephone to his ear.33 He was not going to permit a middling bank official to decide the Merc’s destiny.
“I’m certain your customer is good for it,” Melamed assured Smelcer. Continental should credit the Merc’s clearing account on Morgan Stanley’s behalf and recoup the money later. “You’re not going to let a stinking couple of hundred million dollars cause the Merc to go down the tubes, are you?”
“Leo, my hands are tied,” Smelcer pleaded.
Now Melamed brought out the big gun. “Please listen, Wilma; you have to take it upon yourself to guarantee the balance because if you don’t, I’ve got to call Alan Greenspan, and we’re going to cause the next depression.”
There was a long silence at the other end of the phone. Finally Smelcer got back on the line: the chairman of Continental had just walked into her office. Then there was more silence.
Melamed could feel the time slipping away. In just a few minutes, the Merc was due to open.
Finally Smelcer delivered the verdict. “Leo, we’re okay,” she said. “You’ve got your money.”34
• • •
Greenspan rose early that Tuesday to review the public statement that the Fed planned to release before the markets opened. The hotel operator interrupted him with a call from the White House. It was Howard Baker, the president’s chief of staff.
“Good morning,” Greenspan said, with an air of playful nonchalance. “What can I do for you?”
“Help!” Baker responded. Greenspan seemed admirably calm in the face of the crisis, but there were times when a man could be too calm. “Where are you?”
“In Dallas,” Greenspan answered. “Is something bothering you?”35
There was. As the market had crashed on Monday, Treasury Secretary James Baker had arrived in Sweden at the invitation of King Carl Gustaf to go elk hunting. Having learned the news at the airport, he had reboarded his Concorde without seeing the king or any elk; but he was not yet back from his junket.36 Howard Baker and the White House did not relish the responsibility of managing the worst financial crisis of the Reagan years with both its top economic officials out of town.
“You’ve got to get back here!” Howard Baker told Greenspan. “I looked around and there’s nobody in town but me, and I don’t know what the hell I’m doing.”
Greenspan said he couldn’t get a flight until after his speech.
“Alan,” Baker replied, “we’ve still got airplanes and I’m going to get you back up here.”37
Greenspan could see that it was time to stop trying to be Pierpont Morgan. The world had accelerated since the patriarch’s era, and there was no point playacting business as usual when the market was collapsing. Besides, Greenspan had tried to edit his Dallas speech to make it appear relevant, but it was like taking the Congressional Record and rewriting it into a suspense novel. The best thing he could do was to forget Dallas. He would reassure the markets most if he returned to his command post.
Before Greenspan boarded the plane, he needed to approve the Fed’s public statement. From his office in Washington, Manley Johnson convened another conference call. Michael Bradfield, the general counsel, was still working with a draft that ran to about three paragraphs.
Greenspan indicated he was content to go with Bradfield’s version.38 The way he saw things, there was a fine line between a forceful promise to create liquidity and an excessive gesture that might backfire, stoking fears of inflation and damaging investor confidence. It was one of those moments when the Fed’s warring objectives were pulling in opposite directions: financial stability argued for a bold statement; price stability argued for caution.39 There was no sure of way of judging the balance, but Bradfield’s proposal seemed as good as any.
Gerald Corrigan thought differently. He weighed in forcefully, urging that the statement should be shorn of legalistic hedges. The Fed just needed to make clear that it would lend money freely, through whatever channels it saw fit. It should be an open-ended commitment—a declaration of “whatever it takes,” in the phrase that central bankers came to love after the 2008 crisis.
In the end, brevity won out: “The Federal Reserve, consistent with its responsibilities as the Nation’s central bank, affirmed today its readiness to serve as a source of liquidity to support the economic and financial system,” the statement read. Greenspan later thought it was as perfectly concise as the Gettysburg Address.40
Having won the battle of the statement, Corrigan pressed his next prescription. He was the man with the plan—though still only forty-six years old, he had more crisis experience than the rest of the Fed’s leaders. As soon as the FOMC conference call was over, he followed up with Greenspan personally.
“Alan, we’re going to have to back this up,” Corrigan insisted in his rumbling voice. Promising to pump money into the markets was a good start, but ever since this idea had appeared in the Pink Book, it had been seen as an indirect solution. The money would reach distressed institutions only if banks played their part. As president of the New York Fed, Corrigan declared he would call the city’s major banks and tell them to keep lending—whether to firms like Morgan Stanley, with losses in Chicago, or specialists on the floor of the stock exchange, who lacked the capital to make markets. “I just want you to know that I’m going to start to make calls,” Corrigan told Greenspan.
Greenspan was taken aback. He had spent most of his career arguing that the government should not tell bankers whom to lend to. He asked Corrigan how he would convey his message.
Corrigan told Greenspan that he would strike the right balance. The formula for these phone calls was not written down in any central banker’s manual, but Corrigan had been through this before—he knew how to do it. He would call up a bank chief and stipulate that all business and credit decisions should be the bank’s alone; the Fed would not second-guess them. But then he would deliver his punch line: “There is a bigger picture out there. You’ve got to be sensitive to the well-being of the system as a whole. If the system becomes unglued, you won’t be insulated.” Corrigan would infuse this lecture with his trademark mix of charisma and menace. The bank chiefs would get the message.41
Greenspan signaled his assent. He had little choice: the Fed had to lead the nation through this crisis. Then he boarded a military jet and headed back to Washington.
• • •
In the first hour of trading that Tuesday, stocks recouped two fifths of Monday’s losses. The Fed’s statement seemed to be having the desired effect, and Corrigan was on the phone, urging the banks to keep lending. But around 10:30 that morning, the rally petered out. Seeing the market turn against them, the New York specialists, still nursing losses from the previous day, all but halted the purchasing of shares, and the fall became a cliff dive. Years later, commentators would blame computerized “high-frequency traders” for market gyrations.42 But 1987 proved that human traders were just as capable of exacerbating crises.
Now everyone began to panic. In Chicago, the Mercantile Exchange suspended trading in stock-index futures and the Options Exchange suspended trading in stock options. John Phelan, the head of the New York Stock Exchange, called Howard Baker at the White House to announce that he, too, intended to suspend trading. By late morning the market had given up its early gains and was falling like a stone. The system was disintegrating.
With Greenspan still out of touch, Howard Baker called Corrigan to ask how he should respond to Phelan’s plan to suspend trading.
Corrigan declared that closing the stock exchange would be a catastrophic error.
Why did he feel so strongly? Baker prodded him.
“Because if you close the goddamn thing, you’re gonna have to figure out how the hell to open it.”
There was a moment of silence.
“I always believed you have to trust the guy who’s on the front line,” Baker said presently. He would take Corrigan’s advice; but if the advice proved to be wrong, the New York Fed chief would be history.43
Corrigan was sure of his message, and he was equally sure that the system would freeze up if the banks did not maintain their lending. Bank credit was essential to the smooth functioning of the clearinghouses in Chicago; it was essential to the securities firms that were members of the clearinghouses; it was essential to the investors who were the customers of the securities firms. If any link in this chain failed for lack of ready cash, the rest of the chain could follow. Already firms such as Goldman Sachs and Kidder Peabody had extended loans to customers who had lost money on Monday. Because the banks had pulled back, those customers had not been able to repay their brokers—by noon on Tuesday, Goldman and Kidder combined were owed about $1.5 billion.44 To make it through this cash crunch, the brokers turned to their bankers. If the banks refused to help, the brokers would be in trouble.
Corrigan could not be certain how the banks would respond to these distress signals. He had done his best to browbeat them, and the Fed was pumping liquidity into the money market, buying short-term Treasury securities for cash. But the banks that got the cash seemed to be playing it safe and scrambling to buy back Treasuries rather than lending the money to other banks or brokers. As a result, the interest rate on Treasury bills fell way below the rate for private borrowers. This so-called TED spread, a standard gauge of market fear, hit a record that stood unbroken until the depths of the 2008 crisis.45 Low rates on Treasuries were all very well, but they were not going to help the brokers and traders who were gasping for liquidity.
With Greenspan still airborne, Corrigan was getting desperate. If yesterday’s fall had almost sunk the Merc, another meltdown could sink the whole system. With no good options left, Corrigan contemplated an extreme response. If the banks refused to keep the money flowing, the Fed might have to shoulder some of the risk itself—it might have to find a way to use its discount window to lend to the brokers.46 The central bank’s safety net, supposedly for banks, would thus be extended. In the heat of a crisis, the Fed would backstop almost anything.
• • •
Landing at Andrews Air Force Base just outside Washington, Greenspan boarded an official car and placed a call to Manley Johnson.47 The news was grim: there were trading interruptions in Chicago; the New York specialists had stopped making markets; sell orders were swamping the stock exchange’s ability to process them. Paper chits were piling up; order-processing machines were breaking down; the men who depended on the machines were close to breaking also.48 At one point in the mayhem, four specialists trying to make a market in a major blue-chip stock found themselves besieged by furious sellers; “Finally I yelled ‘shut up’ and shoved the biggest one of them back into the crowd,” one of the specialists recounted later.49 Now at his wit’s end, John Phelan felt the exchange needed a time-out before it could recover.
After hearing from Manley Johnson, Greenspan took a call from Howard Baker. The chief of staff wanted to know what he should do about Phelan’s plan to suspend trading. Greenspan insisted that the market must remain open. He agreed with Corrigan.
The trouble was that the White House could not require the market to keep trading. The law gave the government the power to close the exchange in an emergency; it did not provide it with the authority to force it to keep open. Viewing markets with suspicion, Congress had been careful to ensure that trading could be stopped; it had failed to imagine that the best antidote to chaotic trading might be, paradoxically, more trading. Yet that was plainly the case now. If stock prices were overshooting because some market makers were on strike, the worst thing to do would be to close down the exchange and take all market makers out of action.
Baker asked the White House lawyers how he could put Phelan in a box. The lawyers suggested that the president declare that he expected the market to stay open—if Phelan did not know the law, he might hesitate to defy Reagan.50 There was no guarantee that this would work, but it was the best the lawyers could come up with.
Much like the Fed, the administration was finding itself short of crisis-fighting options. Also like the Fed, it now abandoned its free-market principles. Howard Baker and the Reagan team began calling contacts on Wall Street, doing everything they could to persuade people to support the market. “It is really important for the country that you start buying,” they implored—the subtext being that we might remember if you don’t, and also that we’re calling everyone we know, so you stand to profit handsomely if you buy this rally early.51 Dozens of corporations chose this moment to buy back their own stock, responding, as one report said, to “a none-too-gentle nudge from Washington.”52 But the market kept on falling.53
A few minutes past noon, Stanley Shopkorn, the cigar-chomping head trader at Salomon Brothers, took a call from Dick Grasso, a senior official at the New York Stock Exchange. Shopkorn had been on the receiving end of calls from the administration, too, but the message from Grasso was altogether more pointed. The specialists were overwhelmed, Grasso declared. Unless something happened fast, there would be no market to trade on.
Shopkorn responded by conferring with Bob Mnuchin, his counterpart at Goldman Sachs, and together they agreed to flood the market with buy orders.54 Shopkorn agreed to buy up to $500 million worth of shares that the specialists could not absorb, and Mnuchin did the same; and the show of confidence from two respected players on the Street was enough to turn the market. From around 12:30 p.m. onward, stocks headed up. The Reagan team breathed easier, and the stock exchange did not close after all.
Now back in Washington, Greenspan went over to the Treasury and spent an hour with Jim Baker, newly returned from his aborted elk hunt. Greenspan reported that the Fed was flooding the markets with liquidity; Baker and the Treasury team were duly impressed by the unique power of the central bank during a panic.55 Together, Greenspan and Baker conceived another measure that might give the market life, and they went over to the White House to sell it to Ronald Reagan. The president should announce his willingness to work with congressional Democrats to cut the budget deficit, they urged. Reagan did what he was asked; and although budget politics remained firmly gridlocked over the next weeks, Greenspan felt sure that the promise of sound fiscal policy had boosted market confidence.56
In the last two hours of trading on Tuesday, stocks recovered their losses and ended in positive territory. By the end of the week, the panic was over. America’s financial system had survived its worst moment in the postwar era.
• • •
Greenspan’s conduct during the crash boosted confidence in his leadership. Both Howard Baker at the White House and James Baker at the Treasury would later describe Greenspan as a pillar of strength—he had arrived back in Washington around lunchtime on Tuesday, and the market had recovered.57 The Fed’s one-sentence press release that morning was remembered as a stroke of genius, more powerful than any act of Congress; and James Baker doubted that Volcker would have acted so decisively to pump money into the financial system.58 A month after Black Monday, the Wall Street Journal published Greenspan’s picture on its front page. “Fed’s New Chairman Wins a Lot of Praise on Handling the Crash,” proclaimed the long headline. “Alan Greenspan Was Aided by His Ability to Foresee Problems and by Planning.”59
How far Greenspan deserved this praise was a different matter. The miraculous Fed press release had not been mainly his idea; the White House calls to Wall Street were not his initiative; he had been tempted to resist Corrigan’s browbeating of the bankers.60 Postmortems of the crisis found that Corrigan’s phone calls to the bank chiefs had been especially potent—perhaps more so than even Corrigan himself suspected. During the week of the crisis, the ten largest New York banks almost doubled their normal lending to securities firms, enabling brokers to meet cash calls from the Chicago clearinghouses and stave off a disastrous spiral of fire sales.61 Corrigan’s effect on John S. Reed, the chairman of Citicorp, was particularly spectacular. On Tuesday alone, Citi’s lending to brokers skyrocketed to $1.4 billion, up from the usual $200 million to $400 million per day. Corrigan must have bitten off Reed’s ear.62
It was no accident that Greenspan got the credit for saving the markets, whether or not he deserved it. He was not necessarily the best crisis manager at the Fed, but he was undoubtedly its best politician. He had spent years cultivating allies in the White House, the Treasury, and the media, fighting through his natural shyness to attend society functions and state dinners. Now that investment had come good. Greenspan was the man whom everybody knew, and if the Fed got something right, people were inclined to see his lucid mind behind it—after all, he was the chairman. In his brief time at the Fed, moreover, Greenspan had already done a masterful job of winning over his potential foes. He flattered Wayne Angell, a particularly volatile governor, by complimenting him on his television performances and inviting him to play tennis; he invited other senior colleagues and their wives over to Andrea’s for dinner.63 As a private consultant, Greenspan had clashed with the Fed’s general counsel, Michael Bradfield, even trading heated personal insults after disagreeing about the regulation of the S&Ls on a public panel. But now Greenspan made amends, treating Bradfield and his wife to a concert at the Kennedy Center. When the Journal’s crack reporters called around their sources for comments on the new chairman, they encountered nothing but warm praise. Greenspan had covered all his bases.
If Black Monday boosted Greenspan’s reputation, the same could not be said for laissez-faire capitalism.64 The presumption of market efficiency, which had dominated academic finance since the late 1960s, now demanded a rethink. Statisticians pointed out that extreme falls in prices occurred far more commonly than was assumed in the efficient marketers’ equations. Behavioral economists invoked psychological experiments that showed the limits to investors’ rationality.65 For Greenspan, who had never bought into the efficient markets hypothesis, none of this revisionism upset his settled views; but there were other lessons from the crash that did challenge his thinking.66 Black Monday forced him even further from his youthful conviction that central banks ought to allow private financiers to go bust; and it drove him to reconsider his belief that a steep fall in the market would drag down the real economy. Combined, these two lessons amounted to a fateful change in Greenspan’s approach to central banking.
The first rethink led Greenspan to repudiate his Randian lectures. In 1963 and 1964, he had celebrated “money panics” as salutary enforcers of economic discipline. By the time of Continental Illinois’ rescue, Greenspan had begun to soften his stance—modern democracies were not prepared to take the pain of big financial failures, so a lender of last resort would have to dampen money panics. But after Black Monday, Greenspan completed his conversion. Testifying before William Proxmire and the Senate banking committee in February 1988, he argued that central-bank rescues were not merely inevitable given democratic pressures. They were desirable.67
This was music to the old peacock’s ears. “Thank you very, very much, Dr. Greenspan. You’ve done an excellent job,” Proxmire gushed. “We’re in your debt and you rise in esteem every time you appear before us.”
The key to Greenspan’s new thinking lay in a distinction that had been curiously absent from his youthful writings. Financial crises, the mature Greenspan now recognized, involved both rational and irrational components. To the extent that investors and creditors were waking up to real risks, a sharp market correction could be salutary. But in the heat of a crisis, panic was likely to feed upon itself, so that corrections overshot dramatically. The Fed’s strategy during Black Monday had been “aimed at shrinking irrational reactions in the financial system to an irreducible minimum,” Greenspan told the Senate banking committee: he was laying out a rationale for repeated interventions later. Moreover, the case for fighting crises had been compounded by the growth of finance itself. In 1964, when the younger Greenspan had contemplated the money panics of the previous seventy years, he could just about construct an argument for letting financial institutions fail; finance was still sufficiently small to make this a believable (but still radical) prescription. But by the late 1970s, as Greenspan had noted in his Challenge essay, finance had grown scarily complex; and by the time of his arrival at the Fed, the sheer size of the financial sector made a contagious failure unthinkably costly. In the twenty-three years since Greenspan’s Randian lectures, the sector’s debt as a share of the economy had more than quintupled, rising from 7 percent to 37 percent. Banks and other depository institutions had expanded their assets almost a hundredfold, from $46 billion to $4.1 trillion, or from 66 percent of GDP to 84 percent. The outstanding stock of corporate bonds had gone from 15 percent of GDP to 23 percent.68 The leveraging of America, which Greenspan had discussed with Corrigan during the summer, had been accompanied by the emergence of a financial system that simply had to be propped up—it was not just individual banks that were too big to fail; the whole nexus of exchanges and brokers and clearinghouses collectively fitted that description. If Greenspan was retreating from the Randian principles of his youth, it was because his eyes were open.
If the Fed had to fight market irrationality during a crash, Greenspan also recognized its role during the aftermath. Rejecting the do-nothingism of his past—he had claimed in his Randian lectures that activist monetary policy “opened a Pandora’s box of business instability”—Greenspan cut interest rates after Wall Street’s dive, believing that the market shock would otherwise slow the economy. The logic of his magisterial 1959 article was very much on his mind. Having experienced a bout of terrifying volatility, businesses would no longer feel confident in their stock prices; uncertain how the market might value their assets, they would be reluctant to invest in building more of them. The resulting decline in capital investment would be compounded by weaker consumption. Expecting a pernicious drag on growth after Black Monday, Greenspan guided the federal funds rate down from over 7½ percent just before October 19 to around 6¾ percent in the middle of November.
Yet within a few months, Greenspan’s fear of slower growth turned out to be self-canceling. The economy grew at a blistering 6.8 percent in the fourth quarter of 1987; far from rising after Black Monday, unemployment actually came down a bit.69 The market crash proved to be less toxic than Greenspan had feared, and the antidote of lower interest rates proved more powerful than anticipated. At his appearance before Proxmire’s committee in February 1988, Greenspan expounded on why this had been so. Stock market panics in the pre-Fed era had dragged down the economy because they had triggered a reinforcing jump in interest rates; during the panics of 1893 and 1907, brokers had been forced to endure borrowing costs as high as 74 percent.70 But now that the nation had an active central bank, no such spike in interest rates needed to happen—an activist Fed could clean up the mess left by a bursting bubble. It followed that Greenspan was free to worry about bubbles a little less obsessively than he had done in the past; he could focus his efforts instead on targeting lower inflation. In sum, the crash of 1987 led paradoxically to less fear of a crash. It had been Light Black Monday.71
After the Great Crash of 2008, Greenspan’s reaction to 1987 would come to seem complacent.72 Yet he was not alone in his conclusions. Far from the pressures of public office, in the quiet of Princeton, a shaggy-bearded rising star in academia was struck by a similar logic. The crash, he argued in the Review of Financial Studies in 1990, had revealed terrifying weaknesses in the nation’s financial system. The Chicago clearing-houses in particular had been shown to be fragile, and there was little they could do to reduce their vulnerability. In theory, a clearinghouse could protect itself during a crisis by suspending payments to winning traders—that was effectively the course that Wilma Smelcer had proposed to Leo Melamed. In practice, nonpayment by one clearinghouse would trigger panic among the members of others—it would cap one institution’s losses by compounding losses elsewhere in the financial system. Yet although the financial system appeared scarily fragile, it had one potent saving grace: if you factored in the presence of an active central bank, the vulnerability of the clearinghouses magically evaporated. “When the financial system is conceived broadly to include the government as the ‘insurer of last resort,’ the current institutional setup seems satisfactorily robust,” the professor concluded.73 There was no need to worry about financial stability—so long as the Fed stood ready to act in the next crisis.
If that was the verdict from Princeton, it was perhaps not surprising that the Fed chairman should share it. But the Princeton perspective was memorable for another reason, too. The shaggy young professor was Ben S. Bernanke, Greenspan’s successor as Fed chairman.