With one of the longest tenures in Federal Reserve history, chairman Alan Greenspan presided over a largely flourishing economy, prompting the longtime nickname ‘Maestro’ and enduring through a rotation of six different presidents, a carousel of both democratic and republican personalities. Despite early acclaim as a financial prodigy of sorts, Greenspan’s overall legacy would not turn out to be so flattering.
Rigorously data-driven and cerebral, Greenspan had a penchant for market fundamentals and heavily relied upon the smooth scientism of economic models. Historically, he had been known for being a disciple of free-market ideology. His ideological origins had their roots in the vein of classical libertarianism espoused by the famous Ayn Rand. In his earlier years, Greenspan questioned the blundering interference of government in the economy and financial markets. His commitment to the notion of the self-correcting economy arguably reigned supreme over the entire span of his governmental career.
However, this stalwart belief in the self-correcting economy was interestingly juxtaposed with a seeming shift in Greenspan’s beliefs about market manipulation by means of the Federal Reserve. There is undoubtedly a glaring irony in Greenspan’s perch at the Fed considering his professed distaste for governmental paternalism. A man that believed the government was best if it kept its hands out of the markets took the ‘throne’ at one of the world’s most powerful institutions designed to do just that.
One has to wonder to what degree Greenspan struggled with cognitive dissonance due to the incongruity of his earlier-professed convictions and his appointed duties as Fed chief. How exactly did he reconcile the two? Over the course of Greenspan’s tenure, his alleged libertarian status yielded to what would prove to be a deleterious habit of distorting the markets and unduly easing the economy.
The Federal Reserve famously “adjusts” interest rates, tightening the economy when they raise rates, and loosening it when the rate is cut. Interest rates — seemingly dry and technical devices — routinely cause large ripple effects in the economy. Interest rates act like a gas pedal or a brake to the economy, effectively invigorating it or reining it back in. They are the principal tools in the central banker’s toolbox. Greenspan, who seemingly distrusted the ability of the government to properly steer the markets, developed a near-obsession with interest rates.
For the nearly two decades he spent in the hallowed halls of the Washington D.C. Fed, Greenspan presided over a period of strong economic growth, low unemployment, and modest inflation. Investors were relatively buoyant and confidence in not only the markets but the seemingly clairvoyant genius of the Fed chairman himself was trending high. This period became known as ‘The Great Moderation’. The painful medicine the economy had endured in the form of Volcker’s interest-rate hikes at the onset of the 1980s were thankfully something of a distant memory. Optimism surged and a belief that Greenspan could do no wrong gripped the public. Perhaps he was just spectacularly good at what he did. Perhaps he did do a near-perfect job at watching the economy with a sharp, steady and discerning eye and fine-tuning rates with a finesse that was admirable (though problematic). Consequently, Greenspan became unwisely deified.
The Housing Boom
Though Greenspan left the Fed in 2006, slickly outmaneuvering being center-stage when the full brunt of the housing crisis and subsequent credit crisis hit, there is no doubt that the cataclysmic situation had long been in the cards and had been brewing during the Greenspan era. The mess of 2008, as many know, was initially triggered by an upset in housing markets. Lending rates were far too low, that is, interest rates were astonishingly small. This was in conjunction with a galloping rise in home prices the likes of which the nation had never seen before. Inflating the money supply and keeping interest rates unnaturally low for a protracted period of time had created a sheen of false prosperity, manifesting in rising home values, a phenomenon that was eagerly pounced upon by consumers.
Housing was a booming business. And history had provided evidence (or lack thereof) that home values never really fell. It was this belief, goaded along by an awfully lubricated economy, that resulted in the trend of home values skyrocketing, practically leaping off the charts in an exponential trajectory. Nobody necessarily wanted to not be a part of the froth, after all.
Few paused to consider the possibility of home prices falling. In large part because it hadn’t really been witnessed before! But had the nation ever experienced a similar meteoric rise in home prices? No; they hadn’t. So, theoretically, people should have been wary. But it’s hard to be wary when market conditions are cooked up — not by the market itself, but heavily by the central bank — to produce a widespread effect that everyone buys into, thus it feels perfectly legitimate.
It is often said that bubbles are easy to recognize only in retrospect. It is all too easy to attribute economic booms to economic progress but we should think twice before hastily drawing that correlation. Everyone wants to believe that, say, a steep rise in home prices is legitimate and indicative of actual economic growth but if that were truly the case, what could conceivably explain the explosion in home prices? Home prices had historically been quite flat and stable. It was strange, then, to witness in the early part of the 21st century a speculative market in housing, of all things, in large part because it hadn’t really been experienced before.
In the aftermath of the price tumblings in the housing market and the overall fallout of the economy, explanations started to emerge out of the rubble. And the dominant explanation that was provided was something along the lines of greed, ignorance, or — drawing on one of Alan Greenspan’s most memorable phrases — “irrational exuberance”. To suggest Wall Street had been too voraciously opportunistic was a popular story, and effectively demonized an entire sector of people for their apparent lack of moral scruples. To say that homeowners suffered from collective stupidity in accepting mortgages they could not afford was another explanation; a conveniently catch-all, kind-of vague explanation, at that. And thirdly, the notion of irrational exuberance — or excessive optimism — inserted itself.
And yet I don’t think any of these explanations are sufficient, or even necessarily correct. If you’ll notice, all three are derived from the capriciousness of human behavior. And the human component in markets is notoriously difficult to pin down; frustratingly fickle. These explanations interestingly avoid mentioning anything about the underlying structure of the economy. They are all topographical explanations.
Invoking human emotion as the missing part of the equation that adds up to financial crises is popular, in part because ‘human emotion’ is a very pliant, very open-ended type of element people toss in that can effectively patch up queries about the reasons for financial market quirks — precisely because nobody can ever prove human emotion or fact-check it or otherwise distill it down to something mathematically measurable. What Greenspan’s Fed was doing was not addressing the structural flaws of the system.
In fact, there was a trace of intellectual dishonesty in Greenspan’s famous “irrational exuberance” line. After all, it had been his policies and his interest rate shenanigans that were largely responsible for the 2008 market-crumbling. Undoubtedly, Greenspan’s actions had fueled the housing bubble, and additionally built up speculation in the financial markets, both of which led to, as we know, the Great Recession.
And the Great Recession came about precisely because there was such a thing as a ‘Great Moderation’. The latter, when it had come to pass, inspired notions of ‘finally getting it right’, of finding the sweet spot in monetary policy. But it was unreasonable to consider we had escaped the cyclical pattern of economics. Perhaps the boom/bust cycle is easy to forget — perhaps it is something we consider in a historical context but rarely entertain in the present moment. Because as it was, from his roost at the central bank, Greenspan had embroiled himself in artificially sustaining prosperity. But the pendulum was bound to swing back — and it did. And it was a messy surprise, but maybe it shouldn’t have been. It is often forgotten that excessively long booms aren’t usually natural. And more often than not, they beget damaging busts.
After all, it is usually market distortion via monetary tools that result in heightened levels of exuberance, or alternately, fear. The component of human psychology is inevitable, and some might say, tragically present, in financial markets but it is the heightened intensity of these moods that can be traced back to a source of artificially low interest rates, as one example. The extreme varieties of these emotions are derived from the distortion in the markets. Think about it: when the markets eventually correct again — roughly and unpleasantly jolting us back to economic reality — why do we look around, aghast at what has happened? Why does it become so difficult a task to figure out what has transpired?
People naturally will respond in relative tandem to how loose or tight the credit markets are, but if monetary policy is perpetuating a false level of easy money, then people will unsurprisingly respond to that false level. And then we wonder why the markets crash into colossal blunders like what was uncomfortably experienced in 2008.
Free Market Blame
With Greenspan, why so much talk about market ‘irrationality’? If people respond to what the market is signaling, is it really correct to say the people are behaving irrationally or might we stop to consider that it is the market itself that contains the irrationality? As it was, Greenspan was darkly troubled and confused about the market meltdown, belatedly admitting that he had, simply put, not foreseen the approaching disaster. Because in free markets, people supposedly behave largely rationally but here in front of Greenspan lay the daunting evidence of convulsing irrationality that had ended in a market disaster the likes of which would be scrawled in the pages of history books.
Post-2008, a large swath of the public roundly proclaimed that free markets could not be trusted, or otherwise left alone, lest they repeat the meltdown just witnessed. But such blame was actually cast on something illusory — that being the idea that we had a truly free market in the first place. Because this wasn’t the case! And certainly not in the financial markets and the housing industry, in particular. Language swirled about that free markets required some sort of scaffolding and maybe even several extra layers of regulation in order to be “safe”. And yet to blame the markets themselves and not the market-distorting measures became the name of the game.
People condemned the free market of the 2008-era for producing the apparent greed and irrational optimism sufficient to whip up a housing bubble and widespread asset inflation. But there wasn’t honestly a free market to blame. Main Street had simply been responding to a climate of low interest rates and loose credit by buying houses that many of them shouldn’t have — a climate engendered by the Fed. Unsurprisingly, this trend en masse inflated the financial markets unduly.
It would seem that Greenspan, over the course of his tenure, capitulated to the lure of central banking. A terrifically smart man and an impressively data-educated one at that, these attributes were nevertheless at odds with the foggy mystification Greenspan displayed in the aftermath of a financial crisis he had helped to create. Was it really that confusing where the effects stemmed from? Is it that people do not want to see the connecting threads? Isn’t it interesting that in said aftermaths people are apt to suggest we augment the markets, with more regulations, for instance, rather than examining whether there are structural flaws present and maybe they are the culprit?
As a proponent (in rhetoric, anyways) of free markets, Greenspan subscribed to the notion of Adam Smith’s Invisible Hand. But it was precisely this “mechanism” that didn’t seem to have been “properly working” circa 2008, thus causing the unusually unpleasant market meltdown. But it must be remembered: the Invisible Hand will not work if risk is divorced from responsibility in the markets. And yet this relationship was partially severed, much to the detriment of the economy as a whole. So then, is it really accurate to attribute market messes to failures of free markets?
Greenspan’s shift is obvious over the course of his nearly two decades spent in office. In the end, he gave the markets the resources, via magisterial government decree, that they needed to bring about their own demise. And demise it was. It is too bad he appeared to relinquish his earlier dedication to free markets, wordlessly swapping it with the newfound convenience of central-bank levers and switches. Later, he would be so baffled and disconcerted about the monster of a financial predicament he had helped to produce. Greenspan’s legacy, then, became tainted by his own ideological slide.