He liked to jog, but the jogs ended at McDonald’s. He frequented barbecue and Tex-Mex joints, hamburger dives and southern meat-and-threes; at Doe’s Eat Place in his hometown, he would devour a cheeseburger with jalapeño, lettuce, tomato, mayonnaise, pickles, and onions—all for under four dollars.1 If George H. W. Bush was at ease amid the bobbing lobster pots at Walker’s Point, William Jefferson Clinton was Big Mac man, a garrulous, flirtatious natural force that sprang out of Arkansas’ louche swamp, powered by an uncanny flair for politics and people. At a crucial moment in his campaign for the presidency, Clinton met an elderly woman who cried as she recounted her struggles to pay for both medicine and food. The candidate reached down, held her in a hug, and sobbed, “I’m so sorry.”2
Soon after his victory at the ballot box, President-elect Clinton invited Greenspan down to his transition headquarters in Little Rock, the Arkansas state capital. Paul Volcker had bargained intensively over the circumstances under which he would meet the new President Reagan, but Greenspan was willing to make the five-hour trip to this southern backwater, gritting his teeth only a bit over the tiresome layover and flight change. He would often say that he disliked politicians, especially after his experience during the Bush years. “This is a town full of evil people,” he had confided recently to a New York friend who was considering an administration job. “If you can’t deal with every day having people trying to destroy you, you shouldn’t even think of coming down here.”3 But the truth was that Greenspan courted politicians assiduously. After all, the Fed did not exist in a vacuum. To pilot the economy successfully, it needed to remain on cordial terms with Congress and the White House.
Arriving in Little Rock, Greenspan emerged from the aircraft walking wearily, a little stooped; if he had resembled an undertaker in his youth, the impression had only grown stronger. Dodging the news cameras at the airport, including the one posted by Andrea’s team from NBC, he climbed into a car and rode over to the big redbrick Governor’s Mansion with its white pillars and broad expanse of flat lawn. Inside, he was ushered through a stately foyer with cream-colored walls and an antique French chandelier. Then he was made to bide his time. Clinton’s tardiness was legendary.
After twenty minutes, his host finally appeared, bounding into the room, a blur of meaty energy. “Mr. Chairman,” Clinton said, striding toward Greenspan and smiling, reaching out to shake hands. Slightly to his surprise, Greenspan felt genuinely welcome.4
The president-elect knew what he wanted from the Fed chairman. His campaign had featured promises to match his gargantuan appetite: he wanted to halve the federal budget deficit, cut taxes on the middle class, boost spending on education, and provide for more training—even as he renewed the nation’s infrastructure. Now that he had been elected, Clinton had to choose which promises to keep. It would be a lot easier to go for deficit reduction if Greenspan offset the drag on the economy by lowering interest rates.
“We need to set our economic priorities,” Clinton told Greenspan. “I’m interested in your outlook on the economy.”5 It was good that he was muddying his real question.6 He respected the central bank’s independence enough not to pitch for lower interest rates explicitly.
Greenspan felt immediately comfortable. Presidents and presidential aspirants had been asking him about economic priorities for twenty-five years, since before Clinton had graduated from college. And with one slightly shaming exception—his time inside the Ford White House—Greenspan had argued consistently for budgetary restraint.7 The national debt had ballooned to the point where interest payments had become the third-largest federal expense after Social Security and defense, he now told Clinton. It was time for the government to live within its means, not burden future generations.
Greenspan made a further point, answering Clinton’s unasked question. Whatever the new president chose to do about the deficit, the federal funds rate was now down at 3 percent, which meant that the cost of short-term borrowing was roughly zero after accounting for inflation; the Fed could not be expected to cut interest rates any further. However, the thirty-year bond rate was up above 7 percent, and this was where Clinton’s deficit reduction could make a difference. High long-term rates reflected the market’s expectation of inflation, Greenspan explained; and that expectation in turn reflected the deficit. Bond traders remembered that the budget gaps of the late 1960s and 1970s had brought double-digit inflation; they feared that history would repeat itself. A show of fiscal discipline from Clinton would douse inflation expectations, bringing long rates down to the level that Americans had enjoyed under John F. Kennedy.
For a young leader who styled himself on Kennedy, that prospect was beguiling. If Clinton could reassure the bond market, a virtuous circle would ensue. Lower interest rates would spur purchases of homes, cars, dishwashers, and even vacations—these days, everything was bought on credit. Lower interest rates would simultaneously help businesses to borrow funds to ramp up production. Meanwhile, lower yields on bonds would drive investors into equities; the stock market would take off, creating yet another boost to consumption and investment. The old Keynesian idea that budget deficits boosted the economy would be turned on its head: because of the effect of deficit reduction on interest rates, austerity could be expansionary. “The latter part of the 1990s could look awfully good,” Greenspan mused, dangling a shiny orange carrot in front of Clinton’s nose. “I was not oblivious of the fact that 1996 would be a presidential election year,” he recalled later.8
Greenspan’s pitch was flimsier than he admitted. It involved two assertions that were at least open to doubt: first, that cutting the budget deficit would bring down inflation expectations; second, that lower inflation expectations would bring down the long-term bond rate. The truth, as Volcker had demonstrated, was that the link between deficits and inflation expectations could be broken; thanks to a determined central bank, inflation expectations had fallen in the Reagan years, even as the deficit had expanded to a postwar record. Equally, it was by no means clear that inflation expectations were the main driver of the long-term bond rate. Of course, other things being equal, investors who anticipated inflation would charge more for long-term loans. But high long-term interest rates might also reflect other factors: a recovering economy and hence a healthy appetite for loans; a paucity of savings, whether from Americans or foreigners; and so on. The Fed staff gently pointed out to Greenspan that if deficit reduction brought down long-term interest rates, it might not be for the reason that he claimed. Rather than bringing down inflation expectations, a smaller deficit might bring down the long-term interest rate simply because it meant less government borrowing. Reduced government demand for loans would mean that loans were cheaper.9
Even though Greenspan’s choice of argument appeared eccentric to the economists on the Fed’s staff, he had a way with politicians. His meeting with Clinton ran on for two and a half hours, with the president-elect soliciting advice on all manner of questions, including the quality of foreign leaders with whom Clinton would be working. Whenever Greenspan thought he might have talked enough, Clinton’s body language urged him on; Greenspan had not expected to remain for lunch, but lunch arrived anyway. They made an odd pairing, this kibitzing couple: the indulgent, ebullient baby-boomer Democrat, his hands always reaching out to gesture and to touch; the shy, austere Republican with thick lenses and a fashion sense that had frozen in the 1950s. But somehow the two men bonded anyway. Each had grown up without a father; each had played the saxophone; each delighted in the other’s intellect, which bridged party division. Besides, the Fed chairman and the future president each had a powerful reason to want to get along. Greenspan was eager to forestall a repeat of the Fed bashing of the Bush era. Clinton had campaigned on the economy—he wanted Greenspan’s cooperation.
After the meeting, Clinton delivered his verdict on the Fed chairman. “We can do business,” he confided to his running mate.
Greenspan, for his part, arrived at a similar conclusion. “I don’t know that I’d have changed my vote, but I’m reassured,” he told a friend in Washington.10
• • •
Three weeks later, Alan and Andrea celebrated Christmas in their usual way: at the home of Al Hunt and Judy Woodruff. Al was the Wall Street Journal’s Washington bureau chief, and Judy an accomplished television journalist; the couple had three children, including a three-year-old who was Andrea’s goddaughter. Alan and Andrea had become part of the family, joining in for Christmas breakfast and an excited opening of stockings, then following the kids into the living room to unwrap what Al called “more presents than was really good for us.” The gift supply was so abundant, Al chuckled, that Alan emerged from every Christmas with a firm intention to raise interest rates; the children tore through glossy paper until it carpeted the floor, and Al unveiled his masterstroke, a special gift for the Fed chairman. There was nothing material that Alan wanted, so Al came up with a series of inventive gags: a life-sized cutout of Paul Volcker, an autographed photo of the hostile supply-side columnist Bob Novak, and so on.
For Christmas 1992, Al’s gift was especially successful. A few days earlier, the president-elect had sat for an interview with Hunt and his Wall Street Journal colleagues, and over the course of their discussion, Clinton had spoken warmly of the Fed chairman. “I had a very good meeting with Greenspan,” Clinton had told Hunt; “I liked him,” he had added. Al gift-wrapped the transcript of the interview and presented it to Alan, who responded like a boy engrossed in his first Lego set. Zoning out the children, Alan pored over the text; in one revealing passage, the president-elect drew a connection between the unstable complexity of modern finance and the case for reassuring continuity in the person of the Fed chairman.11 Greenspan could not have put it better himself. Clinton sounded as though he might be the first president ever to internalize the truth that Fed independence was in his own interest.
Moreover, Clinton was increasingly inclined to follow Greenspan’s preferred route on the budget. Even before the encounter in Little Rock at the start of December, his advisers had pressed their own argument for attacking the deficit: by getting its finances in order, the government would demonstrate America’s ability to solve its problems, and the boost to business confidence would invigorate the economy.12 As the first Democratic president since Jimmy Carter, Clinton had to show investors that he was not going to bring back stagflation; if only he could prove that he was different, long-term interest rates would fall significantly. But although Clinton understood the argument, he was not quite ready to bet his political capital on it. He was reluctant to give up his spending plans. And the idea that Keynesian theory could be turned upon its head sounded a little suspicious.13
On January 7, 1993, Clinton’s economic team convened at the Governor’s Mansion in Little Rock. Alan Blinder, a distinguished Princeton professor who would join Clinton’s Council of Economic Advisers, addressed the group; “I’ve been asked to do the pedantic stuff,” he confessed disarmingly. Then he did his best to settle Clinton’s budget doubts. In the long run, he said reassuringly, there was no question that a smaller deficit would increase growth: capital would be freed for private use, boosting investment and productivity. But in the short and even medium run, austerity entailed a risk. The drag from a tighter budget would probably prove stronger than the boost from cheaper borrowing. The balance would depend, Blinder concluded, on how fast the Fed or the markets delivered lower interest rates.
Clinton was turning an alarming red. “You mean to tell me that the success of the program and my reelection hinges on the Federal Reserve and a bunch of fucking bond traders?” he demanded.14
Blinder reiterated that growth would depend on how interest rates responded to a tighter budget. Perhaps Clinton should seek a quid pro quo from the Fed before cutting the deficit? “You need some pre-assurance from Greenspan,” he suggested to Clinton.15
The following day, Friday, January 8, Greenspan got a report on the proceedings. Lloyd Bentsen, the courtly, silver-haired Texan senator who would become Clinton’s Treasury secretary, arrived in Greenspan’s dining room for lunch. He was accompanied by Bob Rubin, the Goldman Sachs chief who would head Clinton’s National Economic Council, a new White House unit designed to be less academic and detached than the Council of Economic Advisers.16 Fortunately for Greenspan, neither visitor bought Blinder’s “pre-assurance” talk: both understood that the Fed chairman could not be expected to make promises on interest rates. It helped, no doubt, that Bentsen was a friend and tennis partner of Greenspan’s; he had watched the outgoing Bush administration’s attempts to constrain the Fed, which had backfired humiliatingly. Rubin, for his part, barely knew Greenspan, and suspected that a partisan Republican might lurk under the chairman’s technocratic demeanor; but Rubin had spent his career in the markets and understood that the more independent and credible the central bank, the milder would be the pain of squeezing down inflation. Bentsen and Rubin sat down with Greenspan, laid out their framework for deficit reduction—and then left. They did not solicit the Fed chairman’s endorsement. They did not even ask for his opinion.
Greenspan was getting the best of both worlds. He had pushed Clinton toward deficit cuts. But nobody was pushing him on interest rates.
• • •
As the Bush administration exited and the Clintonites arrived, Greenspan managed the transition expertly. He took care to bid respectful good-byes, attending a dinner for the departing defense secretary, his old friend Dick Cheney, and making time for a midafternoon ceremony held in Cheney’s honor at Fort Meyer, near the National Cemetery in Arlington. He was equally assiduous about how he said hello, building on his good start with the president-elect and Bentsen. He asked David Mullins, the Fed vice chairman, to use his Arkansas connections to set up a breakfast with Thomas F. “Mack” McLarty, Clinton’s childhood friend and incoming chief of staff; and he invited McLarty to address the directors of the regional Fed banks when they visited Washington—for McLarty and the Clinton team, Greenspan’s offer constituted a valuable opening to a wealthy group of private-sector leaders. Learning that the first lady, Hillary Clinton, planned to take up health-care reform, Greenspan told McLarty that he would be delighted to discuss the issue with her: the fact that Clinton was proposing to extend government control over a vast swath of the economy did not keep Ayn Rand’s protégé from offering his assistance.17 Meanwhile, Laura Tyson, the upbeat Berkeley economist who was to head Clinton’s Council of Economic Advisers, received some practical advice: Greenspan had studied her television performances and offered her a tip—to tone down her body language. Too many hand gestures and facial expressions could undermine her credibility, Greenspan counseled. The CEA chairwoman should simply present facts, with as little visual commentary as possible.18
Even with Washington in transition frenzy, Greenspan continued to visit New York frequently. His mother was now ninety, lucid but unhappy, and he took every opportunity to relieve her loneliness. There were social, professional, and medical reasons to be in New York, too. The day after the visit from Bentsen and Rubin, Greenspan took the shuttle from National Airport to LaGuardia and checked into the Stanhope Hotel on Fifth Avenue—by now he had sold his apartment in the United Nations Plaza. Once installed at the Stanhope, he donned an evening jacket and black tie for a party given by Barbara Walters; the next day he ate brunch amid the old-world elegance of the Harmonie Club on East Sixtieth Street, returning to Washington by shuttle in time for afternoon tennis. A few days later, on January 21, Greenspan doubled back to Manhattan for a lunch at the New York Fed, and five days after that he boarded the shuttle once again, this time for a battery of tests at the New York Hospital–Cornell Medical Center. There were two hours of biochemical blood profiling and heart monitoring by echocardiogram and electrocardiogram: though he enjoyed remarkably good health, Greenspan believed in meticulous monitoring. The marathon of testing was capped off with checkups by two different doctors. After a brief respite at the Waldorf Astoria, Greenspan flew back to Washington. He had another tennis match that evening.19
The morning after his bout with the doctors, Greenspan had breakfast with Lloyd Bentsen, newly installed as Treasury secretary. Despite Alan Blinder’s talk of “pre-assurance” from the Fed, Bentsen still showed no sign of pressuring the chairman to cut interest rates. To the contrary, he wanted to enlist Greenspan’s help in pressuring the president. The Treasury secretary and his colleagues were coalescing around a plan to cut the deficit by $145 billion, but Clinton was still sitting on the fence, fearful of a slower economy. Just as Greenspan’s old friend Marty Anderson had turned to him to instruct Candidate Reagan on the economy, so Bentsen now asked Greenspan to explain the budget stakes to Clinton.
At 9:30 a.m. on Thursday, January 28, Greenspan arrived at the White House for a meeting with Bentsen and the newly inaugurated president. The responsibilities of office had not diminished Clinton’s appetite for discussion, and he listened earnestly as Greenspan emphasized that, if nothing was done about the deficit, it would grow to unmanageable proportions. “You cannot procrastinate indefinitely on this issue,” the Fed chairman said bluntly.20 The tutorial extended for an hour. The president gave it his full attention.21
It was not just the administration that wanted Greenspan’s opinion. Later that same day, Greenspan testified before the Senate budget committee. Kent Conrad, a Stanford-educated North Dakota Democrat, had digested the message that a responsible budget could have wonderful effects. But he wanted Greenspan to elaborate.
Seated before the microphone, looking up at the dais of legislators as he had done so many times before, Greenspan assured Conrad that a credible budget would bring down bond rates. The effect could be substantial because long-term interest rates were weirdly high—far above the levels that had been normal before the inflation surge of 1979, and “clearly well in excess of what they should be in a noninflationary environment,” Greenspan lectured.
“Could you put a number on that?” Conrad inquired. “Two points higher?” The senator was tempting Greenspan to be dangerously specific. To assert that deficit reduction would reduce interest rates was already quite bold. To quantify the reduction would be to stray far beyond the evidence.
Normally Greenspan was a master of evasion. Confronted with an invitation to get himself into trouble, he would meander around the subject, piling clause upon subclause, leaving his audience to suppose that they might have understood if only they had listened harder. The Nobel laureate Robert Solow once compared him to a bespectacled sea squid: sensing danger, Greenspan would flood his surroundings with black ink and then move away, silently.22 But now, confronted by Kent Conrad, Greenspan’s instincts failed. The senator was demanding to know how big the inflation premium in long-term interest rates might be. Having stressed the premium’s significance so many times, Greenspan could hardly refuse to answer.
“I would say two, maybe more,” Greenspan obliged. If the markets perceived a credible shift in fiscal discipline, the inflation premium would disappear, reducing long-term interest rates. “I mean, we’ve had them much lower. We’re now somewhat over 7 percent, and they have been well under 5.”23
It was an extraordinary assertion—far bolder than Conrad seemed to realize. Long-term interest rates had not actually been below 5 percent since 1967, a time when the global economy had been utterly different.24 Back in 1967, Regulation Q had held down interest rates artificially, and barriers to cross-border capital flows had bottled up Americans’ copious savings inside the country, further restraining borrowing costs. It was by no means obvious that the long-term interest rate of 1967 offered any sort of guide as to how far interest rates could fall in the 1990s.25
Having secured one answer from Greenspan, Conrad demanded another. “How much deficit reduction do we need over a four-year period or a five-year period to be credible, to get the interest rate reduction we all agree would be stimulative?” he asked him. The senator evidently thought Greenspan should be able to assign a numerical value to anything.
“I don’t think it is the actual dollar amount as much as the specific means by which it is done,” the guru hedged cautiously.
Conrad was not satisfied. “I have tried my best to get an answer, but I have not achieved one,” he declared accusingly.
Greenspan flinched. He was supposed to be the man who knew. He hated to disappoint people.
“Are you looking for a number, Senator?” he asked obligingly.
Conrad nodded. Precisely how much deficit reduction would it take to bring down inflation expectations?
“Let me just say to you that I don’t find the number that President Clinton has given to you to be off-base,” Greenspan offered.
“Which number?” Conrad demanded. He wanted Greenspan to go on the record as clearly as possible.
“The $145 billion, as I remember it.”
“I think you just made news!” Conrad exclaimed triumphantly.
“Splendid,” Greenspan deadpanned, to giggles from the senators.
Sure enough, the following day’s New York Times reported Greenspan’s “ringing endorsement” of the emerging Clinton program.26 The Fed chairman seemed so invested in the case for deficit cuts that if the economy weakened as a consequence, he could be expected to lower interest rates, the Times speculated. Thanks to Greenspan’s testimony, a new policy consensus was taking shape. In the place of the loose budget policy and tight monetary policy of the Reagan-Volcker years, there would be tight budget policy and loose monetary policy.
For the Fed and Alan Greenspan, the new consensus was almost too good to be true. For years, politicians had spent wildly and forced the Fed to play bad cop. Now politicians promised to provide the discipline, allowing Greenspan to play the openhanded uncle. By leading the nation in its grueling war against inflation, Paul Volcker had built the Fed chairmanship into a heroic role. One decade later, Greenspan would be able to control prices just as surely as Volcker—but without the blood and sacrifice. If Volcker’s stout performance had turned him into a latter-day Churchill, the stage was set for Greenspan to emerge as a likable wizard: a maestro.
• • •
Greenspan’s Senate testimony had a profound impact on budget politics. The Clinton adviser Dick Morris later summed up economic policy in this period: “You figure out what Greenspan wants, and then you get it to him.”27 Even allowing for exaggeration, there was truth in Morris’s sound bite—now that Greenspan had laid out his views, he had set the terms of the debate for both the administration and Congress. A week after the Senate testimony, on February 5, Clinton’s economic team set out its budget options in a lengthy memo to the president, pointedly noting that “Greenspan believes that a major deficit reduction (above $130 billion) will lead to interest rate changes more than offsetting” the contraction caused by less government spending. Some Clintonites quibbled with the $130 billion target, but not with the impeccable authority of its source. Lloyd Bentsen objected that Greenspan’s preferred target was actually higher—$140 billion.28
After weeks of uncertainty, Clinton finally resolved to throw his lot in with the budget hawks. On February 17, he announced his commitment to deficit reduction in his State of the Union speech, and Greenspan was wheeled out to perform his familiar role as validator in chief—the White House arranged for him to listen to the address from a perch between the first lady, Hillary Clinton, and the second lady, Tipper Gore. When the president reached the part of his speech dealing with his budget plan, the TV cameras zoomed in on the red-suited first lady and the dark-suited Fed chairman, each applauding enthusiastically. Critics were quick to grumble that Greenspan was sullying the Fed with politics: “To my knowledge, this was the first time that the head of the supposedly independent Federal Reserve had shown his support for a president at such a highly charged public event,” former Treasury secretary Brady harrumphed, apparently forgetting how the Bush administration had wanted Greenspan in the camera shot for the announcement of the S&L bailout.29 David Mullins, whom Brady had installed as Fed vice chairman, was equally livid. But Greenspan was doing more or less what Volcker had done when he had lobbied for deficit reduction in the Reagan years. The chief difference was that Greenspan was succeeding.
Two days later, Greenspan appeared again before the Senate, describing the Clinton plan as “serious” and “credible.” He evidently had two audiences in mind: Congress, which would ultimately vote on the president’s budget; and investors, who had the power to reward the budgeteers with lower interest rates.
Phil Gramm, the Texas senator who had teased William Proxmire at Greenspan’s confirmation hearing, now turned his wit on the Fed chairman.
“Alan, I saw you in all of your splendor in the photograph in the paper between the first lady and the second lady,” Gramm drawled. “People asked me who that handsome guy was and I said, it’s Alan Greenspan, who controls the money supply of the United States. And had I been the president, I would have had you in exactly the same spot.”
The committee broke into laughter.30
Gramm was soon proved right. Greenspan’s deliberately visible support for Clinton’s budget plan impressed investors, and long-term interest rates began to fall, just as the Fed chairman had promised. The fiscal hawks on Clinton’s economic team were overjoyed: they had done the responsible thing on the budget; here was a rare case in politics of virtue being rewarded. No less a figure than the president himself announced enthusiastically to the nation that the yield on the thirty-year bond had dipped below 7 percent, its lowest level in sixteen years; and for the next several weeks, the mood in the White House bounced up and down with interest rates. “I used to think if there was reincarnation, I wanted to come back as the president or the pope or a .400 baseball hitter,” quipped James Carville, Clinton’s ebullient campaign strategist. “But now I want to come back as the bond market. You can intimidate everybody.”
Over the spring and summer, the good news persisted. At the end of May 1993, an amended version of Clinton’s deficit-reduction plan made it through the House of Representatives, and long-term bond yields fell; in August, the plan was triumphantly signed into law, and yields fell even further.31 The interest rate on thirty-year bonds fell by a total of 1.4 percentage points between the start of January and the middle of October, from 7.4 percent to about 6 percent: it was not quite the 2 percentage point reduction that Greenspan had touted to Senator Conrad, but it was nonetheless remarkable. And yet even as Greenspan appeared triumphant, something odd was going on: the mechanism that supposedly controlled long-term rates was not behaving as predicted. In his Little Rock conversation with Clinton, the Fed chairman had described how deficit reduction would bring down inflation expectations, and how lower inflation expectations would feed through into lower long-term interest rates.32 But much as the Fed staff had warned him, inflation expectations hardly budged—the University of Michigan’s surveys showed that they were defiantly stable.33 Greenspan was like the math student who gets his calculations wrong but somehow comes up with the right answer.
Discussing this puzzle privately with his FOMC colleagues, Greenspan admitted to some misgivings. “This bond rate decline is running faster than I think it probably should,” he confessed in March 1993; in the absence of falling inflation expectations, it was hard for him to see why long-term interest rates should be collapsing. Indeed, given unchanged inflation expectations, falling bond yields and the corresponding rise in bond prices might be regarded as an irrational bubble. “Frankly, if I were in the private sector at this stage, I would be having fits on the bonds in my portfolio,” Greenspan remarked to the committee.
Governor Lawrence Lindsey tried to push Greenspan to follow the logic of his own analysis. “We have overextended financial markets,” he agreed. “You said so yourself; you said you would be quitting the bond market.” The right response to a bubbly bond market was to raise interest rates, Lindsey continued. Better to squeeze some air out of the bubble now than to let it inflate further.34
At the next FOMC meeting, in May 1993, Richard Syron of the Boston Fed restated Lindsey’s warning. Unsophisticated savers were pouring money into bond funds. The moment the rally stopped, the dumb money would stampede for the exit.
Given his long preoccupation with finance, Greenspan might have been expected to heed these signals. In his magisterial 1959 article, he had complained that the Fed ignored asset bubbles at its peril; indeed, his support for the gold standard was grounded in the fear that central banks would accommodate “speculative flights from reality” in markets.35 But at the FOMC meetings in March and May, the mature Greenspan behaved precisely as the young Greenspan had feared: he refused to listen to the hawks, preferring to keep the federal funds rate ultralow, fueling the dramatic rally in bonds that he himself viewed as excessive.36 The mature Greenspan was driven to these choices by the inherent uncertainties of finance. Even though Greenspan, the former Wall Streeter, had far more confidence in his view of the markets than any previous Fed chairman, he could only guess as to their right level. No Fed chairman—indeed, no market seer or investor—can ever be completely sure that a bubble is inflating. To raise interest rates in the face of a bubble is always to pay a certain price to head off an uncertain threat—and to incur the wrath of politicians and the public, who love nothing better than a soaring market.37
Perhaps unsurprisingly, Greenspan was careful not to advertise the tension between his youthful writing and his mature behavior. He seldom spoke about his 1959 paper; and when a Wall Street Journal reporter tried repeatedly to obtain a copy of his PhD dissertation, of which the 1959 article was a central part, the library at New York University replied that the dissertation had gone missing.
• • •
By the fall of 1993, even the cautious economists on the Fed’s staff were concerned about the bond market. They did not presume to know what the “right” level of the market was, but they were increasingly unnerved by it. Long-term interest rates were continuing to tumble in the absence of a fall in inflation expectations, and it was unclear whether the government’s reduced borrowing needs were enough to justify the repricing. And yet the dominant view of the bond market—championed by the irrepressible baby boomer in the White House, aided and abetted by the lugubrious child of the Depression at the Fed—survived unquestioned and unchanged. Ever lower interest rates were only good. They had been down at 5 percent under Lyndon Johnson; why shouldn’t they be down that low under Bill Clinton?
Mike Prell, the head of the Fed’s research and forecasting division, set his staff to work on the drivers of the bond market. What was really pushing rates so low? If inflation expectations were stuck, what were the decisive factors?
On September 21, 1993, Prell presented the fruits of his staff’s work to the Federal Open Market Committee. The message was startling—although Prell was far too courteous to say so, the research suggested that Greenspan’s pitch to the president-elect in Little Rock had been fundamentally misguided. Long-term interest rates were not primarily driven by inflation expectations, Prell’s findings suggested, and even the effect of less government borrowing on the demand for capital might not be the key driver. Rather, the main factor explaining long rates was the recent level of short rates. “The persistence of low short rates will gradually lower investors’ perceptions of what is normal and sustainable,” Prell explained. After all, the long-term interest rate was composed of a sequence of short-term rates. If investors learned to take rock-bottom short rates for granted, they would bid down the long rate.
Prell presented his evidence in a dry, just-the-facts way: Greenspan’s strictures on body language were clearly unnecessary in his case. But his message was provocative enough. Rather than falling because of Clinton’s deficit reduction, long-term interest rates were falling because of Greenspan’s own monetary policy. The Fed had slashed the federal funds rate to 3 percent back in September 1992; one year on, investors were coming to behave as though cheap money were the new normal. Moreover, the longer Greenspan kept short-term credit ultracheap, the further long-term bond yields would come down: Prell suggested they could end up even lower than Greenspan’s 5 percent target. And contrary to what Greenspan had argued publicly, ever lower long rates would not be a good thing. Because they were not supported by a fundamental shift in inflation expectations or the supply and demand for capital, they could not be sustained. When the Fed eventually raised short rates, long rates would shoot up—or to put the point another way, the bond bubble would implode precipitately.
Greenspan had clashed with Prell before, and this time he hit back with a thought experiment. If the FOMC took the staff advice literally, it could cut the federal funds rate to zero and look forward to ever lower long-term interest rates. Surely Prell was not suggesting that such a strategy would work? The Fed’s superloose stance would ignite inflation fears, driving the long-term interest rate upward.
Prell was not impressed. Greenspan’s reductio ad absurdum shed little light on the Fed’s immediate policy choices. Of course, if the federal funds rate was pushed to an extreme, it could be decoupled from long-term rates. But in the real world—as opposed to the world of thought experiments—short rates drove long ones. Prell’s staff had tested the correlations going back four decades, and the results were quite clear. Even during the 1980s, when inflation and inflation expectations had been on everybody’s minds, their influence on long-term interest rates had been marginal.
Vice Chairman David Mullins, who would soon leave the Fed for the efficient-market-minded hedge fund Long-Term Capital Management, could scarcely contain himself. Prell’s model was “transparently nonsensical and violates enormous evidence which has been accumulated on the way markets work, including market efficiency,” he insisted. A core assumption of academic finance was that investors were forward-looking—what mattered was not their experience of short rates in the past, but rather their expectation of short rates in the future. Wouldn’t Prell’s model be better if he included “some measure of inflation and inflation expectations?”
“It is possible that such a model as you hypothesize might be serviceable,” Prell retorted condescendingly. “But I suspect that we have experimented enough that this formulation has proven more robust. I think saying that this model is nonsensical and totally at odds with reality runs up against the point that . . . it has worked,” he added tartly.
Mullins hit back. “The reason I say it’s nonsensical is because it doesn’t make logical sense,” he insisted.
The two slugged away at each other for a while. Mullins was confident in his own brilliance; the Fed staff was confident that he was irritating. Presently, Mullins threatened to explain “another theory that I don’t know if we want to get into.”
“We don’t,” Greenspan said curtly. He had heard enough efficient-market dogma from Mullins. But he was not going to take his cues from Prell, either. He would not be railroaded into doing battle with a potential bubble—raising interest rates in order to bring the bond market down was a fool’s errand. Perhaps the lesson of 1987 was in the back of his mind: if a bubble did burst, the Fed could handle the consequences. But there was another factor, too. In the climate of Washington, it felt altogether safer to focus the Fed’s efforts single-mindedly on containing inflation. This was the heroic undertaking that Volcker had established for the central bank; this was the mission that the White House at long last seemed willing to respect; and whereas financial bubbles could not be identified with certainty, the signs of incipient consumer price inflation seemed easier to monitor. The case for focusing on asset prices—the case Greenspan had himself advanced in 1959—was swept under the carpet.
Three months later, Greenspan endured a final assault on his position. In an argument that anticipated the debates of coming years, Governor Lawrence Lindsey explained to the FOMC why low inflation might offer a false signal for monetary policy. The consumer price index appeared stable because imports were getting cheaper: low-cost emerging nations were joining the world economy; globalization restrained prices for everything that could be traded. In this environment, the Fed could supply a surprising amount of easy money without being punished by inflation. But it did not necessarily follow that easy money was desirable. As Lindsey reminded his colleagues, rock-bottom interest rates prevented savers from earning a return on the cash in their bank accounts; it induced wealthy Americans to shovel savings into equities, commodity futures, holiday homes in Wyoming—and into the bond market. Meanwhile, ordinary Americans were being tempted into borrowing imprudently.38 The resulting fragilities—asset bubbles on the one hand, precarious towers of household debt on the other—could upset the smooth path of the economy just as surely as inflation.
Greenspan’s monetary policy during 1993 has never attracted much criticism. He was presiding over a period of deficit reduction and falling inflation; having peaked at 6.3 percent on the eve of the Gulf War, consumer price inflation dropped to 2.7 percent by the time of Lindsey’s attack on him. With inflation so nearly defeated, what was not to like? Yet the seeds of Greenspan’s controversial later choices were planted at this time—and Lindsey diagnosed the pitfalls in his chosen path with admirable foresight. By refusing to respond to the evidence of a bubble, Greenspan was neglecting a potential danger to the economy’s progress. By defining the Fed’s mission narrowly in terms of price stability, he risked fighting the last war—the war of the 1970s.39
• • •
Two months later, on January 21, 1994, Greenspan headed over to the White House to deliver a warning to the president. He had finally decided that the time had come: the Fed would have to raise interest rates. Regardless of what he felt about the bond market, seventeen months of zero real interest rates were enough: inflation, remarkably, was still subdued, but the economy had grown by 5.4 percent in the final quarter of the previous year—a rate that promised bottlenecks and higher prices in the not-too-distant future. Back in 1988, Greenspan had been slow to rein in the expansion because he had worried about the fragile equity market. This time he wanted to raise interest rates before inflation reared its head. If he was going to make price stability his primary objective, he wanted to be sure that he delivered it.
Addressing Clinton and his entourage, Greenspan explained the Fed’s dilemma. It could raise interest rates modestly if it acted against inflation early, or it could wait and be forced to tighten more aggressively later. Either way, Greenspan emphasized, the administration should resist the urge to criticize the central bank. The Fed would be deaf to the attacks, but the markets would hear them. If investors began to worry that the Fed would be prevented from acting firmly, inflation expectations would rise, forcing the Fed to respond with even higher interest rates.
Fifteen months after their first meeting in Little Rock, this was the first test of the odd couple’s relationship. Greenspan could see that Clinton was annoyed—why raise interest rates before inflation had materialized? His irritation underlined the political problem with Lawrence Lindsey’s advice. There was no telling what Clinton would have said if the Fed had jacked up rates to pop an alleged bond bubble.
After a moment, Clinton’s composure returned. “I understand what you may have to do,” he conceded.40
Greenspan felt relieved. The Little Rock camaraderie had survived its test: Clinton was not like his predecessor, George H. W. Bush; he was not going to come after him, not even in private. Whatever Clinton’s reputation for baby-boomer indulgence, he was the most disciplined president in memory when it came to Fed independence.
Two weeks later, on February 3, 1994, the FOMC convened for its next meeting. The members of the committee knew that it was time to tighten—indeed, most had wanted to do so at the previous meeting. Greenspan proposed that they should mark the change in monetary direction with a change in procedure: they should announce their action in a press release. This innovation would be in keeping with the push for open government that was sweeping through Washington; recently the Fed had been browbeaten into publishing the transcripts of past FOMC meetings. More to the point, an FOMC press release would magnify the impact of a move in the federal funds rate. In the new world of deep and global capital markets, the Fed did not so much control borrowing costs as aspire to influence them: a hike in the federal funds rate would have a significant effect only if traders reacted by bidding up market interest rates. If the Fed wanted to play the influence game, it would have to speak clearly and publicly.41
“What I’m saying is that the first time we move the funds rate after this extended period, we are hitting a ‘gong,’” Greenspan said. “And I think we ought to stand up and hit it.” A few years later, his percussion metaphor would give way to a vast scholarly literature on the significance of central bank communication.
Greenspan promised that his press release would be a one-off: it would not establish a precedent. Nobody objected. But when the Fed chairman proposed a tightening of a quarter of a percentage point, he confronted a revolt. A majority on the committee wanted to hike the rate by twice as much as he suggested.
Greenspan had never yet lost an argument on monetary policy. Sometimes he won by wielding obscure facts: he had understood troop positioning in the Persian Gulf because of his direct line to Dick Cheney. Sometimes he rallied colleagues by appealing to duty, commonly claiming that the FOMC was meeting at an uncommonly momentous time, requiring unity on monetary policy. On still other occasions, Greenspan exploited disagreements within the committee to steer it into a stalemate—whereupon it would postpone its decision, issuing an “asymmetric directive” that left the chairman with the power to move the federal funds rate between meetings. In February 1994, faced with the most serious FOMC revolt of his tenure, Greenspan combined a head feint with a dash of intimidation.
Seeing that his committee wanted to tighten by more than he proposed, Greenspan began by hinting that smaller might paradoxically be bigger. Acknowledging a suggestion from a colleague, he reflected that a hike of 25 basis points might be seen as the start of several moves; it might therefore pack a bigger punch than a hike of 50 basis points, which would be dismissed as a one-off adjustment. Because of the expectation of successive rate rises, the quarter-point rate rise would “subdue speculation in the stock market,” Greenspan mused; “[by] having a sword of Damocles over the market we can prevent it from running away,” he added. Apparently, the chairman was happy for monetary policy to target asset prices if this helped him to win over his critics.
Having humored his colleague, Greenspan switched course: smaller would be smaller, he now firmly insisted. Indeed, a quarter-point rate rise would be preferable to a larger one precisely because it would be judiciously gentle, and so would avoid scaring the equity market. “The stock market is at an elevated level at this stage by any measure we know of,” he reflected sagely. “I’ve been in the economic forecasting business since 1948, and I’ve been on Wall Street since 1948, and I am telling you I have a pain in the pit of my stomach.” If the rest of the committee wanted to trigger a repeat of Black Monday, they could go ahead and vote for a 50 basis point increase, Greenspan’s implication went. If the economy blew up, they would be responsible for the disaster.
Rounding off his appeal, Greenspan played on his colleagues’ sense of loyalty. “I also would be concerned if this Committee were not in concert because at this stage we as a Committee are going to have to do things which the rest of the world is not going to like,” he admonished. “We have to do them because that’s our job. If we are perceived to be split on an issue as significant as this, I think we’re risking some very serious problems for this organization.”
Their heads spinning a little, the rest of the committee paused at this. They did not want to push their chairman into a corner, particularly not on the first rate hike in fully half a decade—and the first ever to be announced in a press release. Perhaps, one member suggested, they could move a quarter point now, but hold open the possibility of a further hike before the next meeting?
“That’s perfectly fine with me,” Greenspan responded. The FOMC was about to do what it so often did: agree to an asymmetric directive that left the power to decide policy between meetings in the hands of the chairman.
But this time Greenspan was denied victory. Lawrence Lindsey—the governor who had already upbraided Greenspan for neglecting asset prices, the governor whom the Bush White House had rightly regarded as trouble—declared that he could support an intermeeting hike only if Greenspan committed to consult the FOMC by conference call beforehand. Moreover, Lindsey wanted to tie the chairman’s hands on the timing. He demanded that the conference call be held within two days of Greenspan’s upcoming congressional testimony.
At this, Greenspan grew testy. “I’ve been Chairman of this Committee now for over six years,” he retorted. “I hope I have enough credibility to know when a telephone call is appropriate.”
“But there will be a phone call?” Lindsey pressed.
“Yes,” Greenspan conceded.
With that, the committee rallied round and Greenspan won the vote, sidestepping the humiliation that Volcker had suffered when he had lost a vote on monetary policy and come close to resigning. But the FOMC meeting of February 1994 nonetheless marked a turning point in three ways. First, there was that press release; despite Greenspan’s promise that it would set no precedent, the Fed never returned to its old practice of changing short-term interest rates without announcing anything. Second, Lindsey’s intervention put an end to interest-rate moves between meetings on the chairman’s discretion; after the troublemaker drew a line, Greenspan abandoned this method of bypassing his committee.42 Third, after half a decade in which the Fed had not raised interest rates, the February 1994 meeting delivered a rate hike.43 Nobody could be sure how markets would react. The next weeks might be bracing.
The day after the FOMC meeting was a Saturday. The newspapers reported that Senator Paul Sarbanes, Democrat of Maryland, had compared the central bank to “a bomber coming along and striking a farmhouse”—evidently, the Bush administration’s penchant for Fed bashing was alive and well in some quarters.44 But Greenspan went about his weekend business as usual. He rode his limousine across town to the Senate tennis court, where he was due to play with Lloyd Bentsen; and the next day he went to the French ambassador’s residence for brunch before playing tennis yet again—this time with Wayne Angell, who had just stepped down as a Fed governor. Angell footfaulted sneakily, which offended Greenspan’s deep desire to win.45 But if the Fed chairman aimed to get on the tennis court four times per week, he needed people to play against, and Angell was better than a ball machine.
On Monday the markets reopened for business. Equities seemed mercifully calm; bonds were selling off a bit. All things considered, it was a reassuring mix: Greenspan had feared another stock market crash; but given that the rate hike had signaled the Fed’s vigilance on inflation, he felt confident that bonds would rally. But by the last days of February, Greenspan was proved dramatically wrong. The thirty-year bond rate, which had been climbing anyway thanks to the economy’s hot growth, now jumped from 6.3 percent at the start of the month to around 6.7 percent at the end of it. It was the outcome that Mike Prell’s research had anticipated, and that Greenspan had brushed aside: higher short-term interest rates would lead to higher long-term ones. Moreover, Prell was being vindicated in an oddly powerful way. Somewhere in the belly of the bond market, something strange was stirring.
• • •
The personification of that something was seated at a bow-shaped trading desk in Midtown Manhattan, a portly figure with a bristling mustache and a bald pate, blinking at a phalanx of computer screens. His name was Michael Steinhardt, and he was in the vanguard of a new phenomenon: bond-trading hedge funds. After the recession of 1990, Steinhardt had seized the opportunity presented by the Fed’s loose policy: he took out short-term loans from his brokers, paying the rock-bottom short-term interest rate, then lent money to the government by buying longer-term Treasury bonds, collecting the higher long-term rate. Thanks to the easy profits in this “carry trade,” Steinhardt and his fellow hedge funders had expanded at a monstrous pace. Until around 1990, the very biggest hedge fund had less than $1 billion in assets. By the start of 1994, Steinhardt was managing $4.5 billion, and the number of hedge funds had leaped from a bit over one thousand in 1992 to perhaps three thousand a year later.46 In at least one Treasury bond auction, in 1991, Steinhardt and another hedge funder contrived to buy 100 percent of the bonds offered—they owned the entire market.47 In this brave new incarnation of Wall Street, the determinants of long-term borrowing costs were not merely inflation expectations, the pattern of short-term interest rates, or similar abstractions in economists’ models. They included the emergence of an unfamiliar breed of superman speculator.
The rise of bond-trading hedge funds, along with hedge-fund-like operators inside Wall Street houses such as Goldman Sachs, was partly helpful to Fed policy. Reacting to a cut in the short-term rate by gobbling up bonds and driving down the long-term rate, traders amplified the Fed’s decision to loosen—precisely what the Fed wanted when it was trying to stimulate the economy. In the wake of the S&L bust and the crippling losses at other traditional lenders, hedge funds were especially useful: by borrowing short and lending long, they were standing in for wounded banks—partially compensating for what Ben Bernanke, the Princeton professor, had termed the broken credit channel. But the hedge funds’ amplification of monetary policy could be alarming, too—particularly because the power of the amplifier was variable and unpredictable. The hedge funds built their bond portfolios by piling debt upon debt: they lent money to the government by buying bonds, then pledged the bonds to their brokers as collateral so that they could borrow more, then used the proceeds of that borrowing to buy more bonds from the government. For every $100 million of U.S. Treasury bonds in Michael Steinhardt’s portfolio, he had borrowed an astonishing $99 million, financing only $1 million of the purchase with capital belonging to himself or his investors. The result of this audacious leverage was that markets were primed to react fast. A fall in the bond market of just 1 percent would wipe out Steinhardt’s entire equity stake, so he had no choice but to bail out at the first sign of trouble.
This was what explained the sharp jump in long-term interest rates that confronted the Fed in the last days of February. Hedge funders like Michael Steinhardt were rushing to sell bonds, and once the rush began, it cascaded unpredictably. Brokers who had happily lent hedge funds $99 million for each $100 million of collateral were now forced to reassess. With the bond market falling, the hedge funders’ collateral was worth less, so the brokers changed their terms: henceforth, Steinhardt and his friends would be allowed to borrow $19 million, not $99 million, for every $1 million of real money. This abrupt withdrawal of credit put Wall Street into shock. Hedge funds were now forced to dump four fifths of their bond portfolios.
At the Fed’s early February meeting, Greenspan had fought his colleagues to avoid an interest-rate hike of half a percentage point. By March 1, the rates on five- and ten-year Treasuries were up by half a percentage point anyway. Huge losses at the hedge funds were mirrored by losses on the bond-trading desks of the big banks; and rumors about their viability ricocheted around the Street, causing a temporary suspension of trading in shares of J.P. Morgan and Bankers Trust on the New York Stock Exchange. The insurance industry lost as much money on its bond holdings as it had paid out for damages following the recent Hurricane Andrew; “I’m starting to call this Hurricane Greenspan,” quipped one insurance analyst. Anticipating the 2008 crisis, a hedge fund that traded exotic mortgage-backed securities blew up in particularly fine style, triggering a panic among its lenders and forcing yet more fire sales.48 By the end of March, the five- and ten-year interest rates had jumped a further half a percentage point. Lawrence Lindsey’s warning—that the bond bubble would pop—was beginning to prove prescient.
The market disruptions did not amuse the president. Thanks at least partly to prodding by Greenspan, Clinton had risked his political capital on deficit reduction, betting that the bond market would reward him. But the five-year bond rate was now higher than it had been at the time of his election, and the ten-year rate was at almost the same level.49 In a further proof of his self-discipline, Clinton did not lash out against the Fed. But on March 31, 1994, he interrupted a vacation in California to phone Robert Rubin, the ex–Goldman Sachs chief who served as the top economic adviser in the White House.
For about half an hour, Rubin did his best to soothe the president. Long-term interest rates were only loosely tied to inflation expectations, despite what Greenspan might have said; besides, finance had evolved and the bond market was behaving unexpectedly. The new world of leveraged traders was a world of unpredictable connections: everyone was borrowing from everybody else, and any interruption to this chain could send interest rates off course, regardless of fundamental economic logic. Meanwhile, the market for debt securities had expanded dizzyingly over the past dozen years, and Wall Street firms were hiring physicists and equipping them with supercomputers as they designed ever more fanciful products. Complexity and leverage were weakening governments’ ability to anticipate the market’s moves, let alone control them.
The president finished his telephone conversation and walked out to face a small scrum of reporters. “No one believes that there’s a serious problem with the underlying American economy,” he declared bravely. “Some of these corrective things will happen from time to time, but there’s no reason for people to overreact.”50
• • •
For the Fed chairman, however, some soul-searching was in order. On an FOMC conference call on the last day of February 1994, Greenspan recognized the truth he had resisted earlier: the bond rally of 1993 had indeed been a bubble. “Looking back at our action, it strikes me that we had a far greater impact than we anticipated,” he admitted. “I think we partially broke the back of an emerging speculation in equities. . . . In retrospect, we may well have done the same thing inadvertently in the bond market. . . . We pricked that bubble as well,” he concluded. Later in his Fed tenure, Greenspan would strenuously resist the notion that a small shift in the federal funds rate could deflate a bubble—his denial was part of the case he developed for neglecting asset prices. But now he conceded that a modest act of tightening had forced speculators to retrench. Monetary policy could be a powerful tool—if the Fed chose to use it.
Greenspan offered up another confession for good measure. Every so often, he mused to his Fed colleagues, it paid to catch Wall Street unawares: shocks were the best antidote to complacency. “We also have created a degree of uncertainty,” he reflected; “if we were looking at the emergence of speculative forces . . . then I think we had a desirable effect.” Again, this observation contradicted Greenspan’s subsequent stance: later in his tenure, he would be known for not surprising the markets. For much of the 2000s, he moved interest rates steadily and predictably, telegraphing his intentions via speeches, congressional hearings, and the FOMC’s postmeeting statements; and the impact of his transparency was exactly as he had anticipated in 1994—traders were emboldened to leverage their portfolios, confident that the cost of borrowing would not move against them unexpectedly. If the Greenspan of 2004 had acted on the Greenspan observation of 1994, the bubble of 2006 might have been less disastrous.51
As the bond market continued its fall, Greenspan went further. Not only did the Fed have the ability to prick bubbles, it should be acutely conscious of its power, because bursting them could send the economy into a tailspin. The chief danger to stability, he told his FOMC colleagues on March 22, was not necessarily inflation; rather, “the only real danger to this economic outlook, as I see it right now, is the financial structure.” A central bank that sought to dampen costly swings in the economy should not be blind to finance, Greenspan seemed to be saying: “If the financial system were to be ruptured, it would not be terribly difficult to bring the economy down very quickly.” Lest his colleagues doubt his warning, he invoked the crash of 1929. “Go back and read the business annals,” he implored. “They show economic conditions looking absolutely terrific three weeks before the roof caves in.” A little later in the discussion, Greenspan invoked the 1920s again. Just as in the 1990s, inflation had been absent and growth had appeared strong. The implication was that getting employment and inflation right might not prevent a central bank from being humbled by finance.
During the so-called Great Moderation of the coming years, neglecting the fragility of finance would prove to be a costly error. Seen with the benefit of hindsight, therefore, the cycle of 1993–94 was a dry run for the future. Yet the more immediate lesson of this episode could be read the opposite way: finance was indeed fragile, but it might not affect the real economy. When the dust settled after Hurricane Greenspan, it was evident that Lawrence Lindsey had been right to diagnose a bubble, and right that its implosion could produce a nasty shock. But the shock was nasty—and then gone; the economy had been growing so strongly that it shrugged off the turmoil in the markets. Like the equity crash of 1987, the bond crash of 1994 barely mattered for Main Street. Having ignored Lindsey’s warnings and then escaped unscathed, Greenspan was encouraged to take risks with financial stability later.