Publisher A CFR Book. Penguin Press
Release Date October 2016
Price $40.00 hardcover
Copyright © 2016 by Sebastian Mallaby. Courtesy of Penguin Press.
Introduction: "He Has Set a Standard"
On January 23, 1986, the members of the president's economic advisory board gathered in the Roosevelt Room in the West Wing of the White House. The group met in secret; to evade the irritating disclosure laws, the organizers had invited the CIA director and used his presence as an excuse to declare the meeting classified. Walter Wriston, the tall, slouched executive who had built Citicorp into the nation's top commercial lender, took his seat at the table; so did Milton Friedman, the diminutive libertarian iconoclast from the University of Chicago; and so did a dozen other luminaries from Wall Street and academia. After two hours of deliberation, a door opened. In walked Ronald Reagan.
The president had one subject on his mind: inflation. With prices rising at around 4 percent per year, the country was far better off than it had been at the turn of the decade, when the rate had approached 15 percent. But 4 percent was still not low enough, at least not for Reagan. Inflation must be forced down to zero, "or we go right back to where we were."
One adviser suggested that the rate of acceptable inflation might have risen. But the president had no patience with appeasement.
"How the hell are we going to level it off?" he demanded.
"You are 100 percent right," Milton Friedman responded. "Only one goal is right and that is zero." If people grew complacent, Friedman reckoned, inflation could be back up around 7 or 8 percent by the end of that year.
"Didn't Bastiat say that 'no civilization has survived fiat money?'" asked Reagan.
The president's appeal to a cultish nineteenth-century French economist silenced most of his counselors. It seemed unwise to challenge Reagan on his core convictions—in this case, that a currency founded on nothing sturdier than the good will of bureaucrats would fail in its basic purpose, which was to act as a store of value. At the start of his presidency, Reagan had set up a commission to consider a return to the gold standard. At some deep level, the president believed that the remedy to the inflationary malaise of the 1970s was to go back to a simpler time, when money was a tangible substance.
Friedman waded in again. He sensed where Reagan was going and moved to redirect his thinking.
"Today fiat money is taken as standard," the professor insisted. The president was right to fear inflation; but rather than dream of a return to the gold standard, it would be better to avoid inflationary excess by limiting the bureaucrats' money-printing instincts. Central bank discretion should give way to a monetary autopilot: the law should lay down that the supply of money must increase by, say, 4 percent a year—not more and not less. "We have to tame fiat money by rules," Friedman said. "Don't think we can go back to a commodity money."
Friedman generally had the last word on such questions. Since the 1960s he had been the reigning academic commentator on monetary matters, and his polemical skills were intimidating. "Everyone loves to argue with Milton, particularly when he isn't there," Reagan's secretary of state, George Shultz, wryly observed; a few contemptuous words from this gadfly could reduce grandees to stutters. But one man at the table was ready to stand up to Friedman.
"Why not a commodity standard?" a quiet voice demanded.
The quiet voice belonged to Alan Greenspan. He was in many ways a thoroughly unlikely figure. Neither a distinguished university professor nor a private-sector baron, he ran a low-profile New York consultancy. He had married briefly in his twenties; but now, at almost sixty years old, with an athletic frame, generous lips, and slick black hair, he played a curious dual role: introverted data guy and eligible society bachelor. Every Republican president since Richard Nixon had come to value his advice—he was the man who knew the arcana of the federal budget, next year's likely steel output, and the mysterious fragilities of finance. But he was also an accomplished dancer and a driver of ostentatious cars, and he courted beautiful women, not always sequentially. The previous year, Greenspan had appeared on TV in a broad-shouldered power suit to pitch the latest Apple computer, fusing his own brand of nerdy sex appeal with Apple's insurgent image. After demonstrating how viewers could use the device to track their finances, dial into their bank accounts, and pay bills electronically, Greenspan signed off with evident pleasure. "If you have any money left over, congratulations," he closed, with a sardonic arching of his eyebrows. "You're doing better than the government is."
Reagan seemed to like Greenspan's remark about a gold standard. "I used to pay $50 for a suit," the president complained. "Now $50 will hardly get it cleaned." Vaulting from the mundane to the existential, he asked, "Is it possible for mere human beings to decide how much money should be put out?"
"The problem you have in the federal government is that it can print money," Greenspan observed sympathetically, in his trademark tone of soft authority. A gold standard might be the way to discipline the political classes: so long as there was a central bank that could create fiat money at will, politicians would always spend beyond their means, confident in the knowledge that their debts could be canceled by the printing presses. For precisely this reason, Greenspan had spent his twenties and thirties railing against the monetary status quo. Until Americans recognized that money-printing central banks were fundamentally deceitful—until they tied money to gold—inflation would remain a constant threat and the economy would rest on rickety foundations. Indeed, although few people remembered this, Greenspan had pushed this argument to its logical extreme. In what must surely rank as one of the twentieth century's great ironies, he had described the creation of the nation's central bank as "one of the historic disasters in American history."
A year and a half after his exchange with Reagan, on August 11, 1987, Alan Greenspan was sworn in as Federal Reserve chairman. For the next eighteen and a half years, he embodied the idea that he had frequently denounced: that the discretionary judgments of a money-printing central bank could stabilize an economy. Greenspan was so apparently successful in doing what he had deemed impossible that he became a global superstar, revered by economists, adored by investors, consulted by leaders from Beijing to Frankfurt. When he held forth at the regular gatherings of central bank chiefs in Basel, you could hear a pin drop; the distinguished figures at the table, titans in their own terrains, took notes with the eagerness of undergraduates. Through quiet force of intellect, Greenspan seemed to control the orchestra of the American economy with the finesse of a master conductor; he was the "Maestro," as an incautious biographer suggested. His oracular pronouncements became as familiar and comforting to ordinary Americans as Prozac and The Simpsons, the New Yorker's John Cassidy wrote, slyly citing moodlifters that debuted the same year that Greenspan was appointed.
Greenspan's triumph was not merely remarkable in light of his own history as a critic of paper money. It was a refutation of powerful economic ideas—ideas that made it difficult even to conceive of a Fed chairman as a maestro. Since opening for business in 1914, the Fed had presided over inflation during two world wars, converted the recession of the 1930s into the Great Depression, and then, in the 1970s, proved feckless in the face of the most serious peacetime inflation in the nation's history. Surveying this procession of disasters, monetary theorists argued that central bankers would always be soft on inflation—they were subject to irresistible political pressure to juice up the economy. Arthur Burns, who served as Fed chairman between 1970 and 1978, was ruthlessly bullied by Richard Nixon's henchmen; his successor, G. William Miller, was chosen by Jimmy Carter because he was politically loyal, then summarily removed after eighteen months in office. In 1979, Milton Friedman went so far as to write to Paul Volcker, Miller's replacement, confidently predicting his inevitable failure. "My condolences to you on your 'promotion,'" Friedman sneered, noting that the Fed faced double-digit inflation. "As you know, I do not believe that the System can rise to that challenge without major changes in its method of operation."
Despite Friedman's contempt, Volcker proceeded to conquer inflation. But the idea that there were political limits to the Fed's inflation-fighting capacity still seemed true. Volcker had gotten away with toughness because double-digit price rises had created a national crisis; it would be hard to keep the pressure on once inflation had moderated. Indeed, toward the end of Volcker's tenure, Reagan appointees at the Fed staged a revolt against his tight-money policy, humiliating him so much that he considered resignation. The lesson seemed to be that a central banker such as Greenspan, who took office at a time when inflation was no longer enemy number one, was almost doomed to fail. Barring a return to the gold standard, only Friedman's monetary autopilot could be counted upon to ensure that the money in America's wallets would hold its value into the future.
Greenspan duly began his tenure amid modest expectations. Observers predicted that he would be "unable to dominate the Federal Reserve Board the way Volcker had . . . [and] unable to intimidate the politicians." Sure enough, he was attacked repeatedly during his first years in office by the administration of George H. W. Bush; then, when a Democrat won the election of 1992, it was widely assumed that his days were numbered. And yet by the end of his tenure, Greenspan had achieved the exalted stature that Friedman had believed impossible. He received the Presidential Medal of Freedom, a British knighthood, and the French Legion of Honor, surviving in office for more than twice as long as Volcker, more than twice as long as Burns, and twelve times as long as the ill-fated Miller. Only William McChesney Martin, who led the Fed from 1951 to 1970, outlasted Greenspan by a hair. But in Martin's day, banking and credit mattered less and the Fed had little of its later stature.
Twenty-seven years after his caustic letter to Paul Volcker, Milton Friedman greeted the end of Greenspan's chairmanship by acknowledging a revolution. Greenspan had not only sustained Volcker's victory against inflation, he had also extended it. Prices had risen at an average annual rate of 5.2 percent in the Volcker era, and by 3 percent during his second four-year term. During the eighteen and a half years of Greenspan's tenure, they had risen at an average annual rate of just 2.4 percent.
"Alan Greenspan's great achievement is to have demonstrated that it is possible to maintain stable prices," Friedman declared.
"He has set a standard."
Milton Friedman died in November 2006, ten months after his tribute to Greenspan. He did not live to witness the financial crisis of 2008—or the dramatic reappraisal of his friend's reputation. In the years after Wall Street's meltdown, the reassuring maestro became a popular villain, blamed for inflating a monstrous bubble through heedless incompetence or wild laissez-faire ideology. From the vantage point of the postcrisis world, the fact that Greenspan had squeezed down consumer price inflation seemed almost beside the point. The crash had destroyed millions of jobs, wiped trillions of dollars off the value of household savings, and brought on the worst recession since the 1930s.
The financial crisis is indeed key to judging Greenspan's legacy. He cannot be blameless; the cost of the implosion was so great that more should have been done to avert or at least mitigate it. Yet although criticism is essential, it is worth stating something clearly at the start: much of the postcrisis commentary has reduced Greenspan to a caricature. He is accused, along with much of the economics profession, of believing blindly in models. He was in fact a leading skeptic of them. He is blamed for underestimating the propensity of financial systems to run wild. He had in fact spent fifty years warning of treacherous credit cycles. He is painted as an Ayn Rand– loving libertarian ideologue. Yet one of the many paradoxes of his rich life is that his bond with the uncompromising Rand coexisted with a malleable pragmatism. He was a Jew who advised the frequently anti-Semitic Richard Nixon. He was a conservative who could advocate tax hikes. He was a libertarian who repeatedly supported financial bailouts. He was an economist who often behaved more like a Washington tactician. A man who embraces the gold standard and then presides over the financial printing press is surely no simple ideologue.
Greenspan's roots as a gold bug render the crash of 2008 all the more perplexing. He believed in gold as a disciplinary device—governments would not bail out Wall Street if they could not print the money with which to do so. And yet as Fed chairman, he delivered multiple rescues, cutting interest rates aggressively to cushion the shock of Wall Street's 1987 crash, the fallout from Russia's default in 1998, and the tech bust of 2000. The upshot of the older Greenspan's policies was precisely what the younger Greenspan feared: financiers were encouraged to take ever wilder risks, confident in the assumption that the Fed would protect them. Why Greenspan was willing to cut interest rates and preside over a huge buildup in risk taking, and what might have happened if he had kept the cost of borrowing higher, are central questions in any judgment of his legacy. But if even this gold advocate shrank from sterner discipline, would another Fed chairman have acted differently? Was his use of monetary policy to backstop the financial system inevitable, given the political and institutional pressures he faced? Or did it reflect some weakness of character, some fear of confrontation, some lurking insecurity that had to be assuaged by power and popularity?
If Greenspan's stance on interest rates is puzzling, his regulatory stance is commonly seen as the unsurprising result of his libertarian ideology. In the view of most commentators, Greenspan resisted tougher regulation because he naively believed that markets were efficient. He trusted financiers too much, failing to imagine that their dazzling inventions could destabilize the economy. But the truth is more subtle and more complex than this account implies. Greenspan never was a simple efficient-market believer, and he sometimes voiced grave doubts about the risks in financial innovation. If he nonetheless welcomed the advent of options, swaps, and new-fangled securities, it was partly because he felt he had no choice. The inflation of the late 1960s had destroyed the comforting system of fixed exchange rates and regulated caps on bank interest rates; meanwhile, technological change and globalization made it impossible to resist the explosion of trading in derivatives. To cite just one telling illustration, between 1970 and 1990 the cost of the computer hardware needed to price a mortgage-backed security plummeted by more than 99 percent. No wonder securitization took off during this period. So when Greenspan and his allies judged that certain regulations were obsolete, they were not the deluded victims of some libertarian fever. Rather, they were grappling with how best to manage the old system's inevitable demise. Policy makers could not have preserved the controlled financial system of the 1950s and 1960s even if they had wanted to.
Besides, it was by no means obvious that financial modernization should have been resisted, even if resistance had been feasible. The evident risks in the new financial methods had to be balanced against real benefits. Once currencies began to fluctuate, for example, exporters feared a dollar appreciation that would make their goods uncompetitive; importers feared a dollar decline that would push their costs up. Currency derivatives offered exporters and importers a way to meet in the futures market and cancel out each other's risks—far from rendering the world unstable, financial engineering promised to make it safer. In similar fashion, the securitization of mortgages allowed risks to be dispersed among thousands of investors; swaps and options, while dangerous if abused, had the same risk-spreading propensity. And when it came to managing the attendant perils, it seemed reasonable to bet that banks and investment houses would do better than regulators who operated at one or two removes. Contrary to caricature, Greenspan and his allies did not expect private actors to avoid manias and crashes, but they did hold the view that supervisors would do no better at averting them. They were not naive efficient-market believers. They were government-can't‑do‑better realists.
Greenspan began his public and political career when he signed on with the Nixon campaign in the summer of 1967, at a time when modern finance had yet to be invented. Over the next four decades, he was involved in every significant financial debate: as chairman of President Ford's Council of Economic Advisers (CEA), as a Reagan administration confidant, as chairman of the Federal Reserve, and as a leading interpreter of capitalism. Along the way, the allies he collected came from both sides of the political divide. It was Jimmy Carter, a Democrat, who got rid of the last vestiges of interest-rate regulation for banks. It was Bill Clinton, another Democrat, who signed the banking reform of 1999 that ratified the breakdown of the Depression-era separation between banks, insurers, and securities houses. It was, for that matter, a global club of technocrats who, in setting rules for bank capital, deferred to banks' own risk models, effectively handing the teenagers the keys to the Mercedes. To paint financial deregulation as the product of some right-wing conspiracy is laughably off the mark. Intelligent people were grappling with deep forces driving financial evolution, and making the best judgments they could. The sincerity of their purpose makes their errors all the more illuminating.
One of the virtues of biography is that it allows readers to understand decision making as it really is—imperfect, improvised, contingent upon incomplete information and flawed human nature. Greenspan and his contemporaries blundered: they were insufficiently wary of the distorted incentives within large financial institutions; they were too complacent about bubbles and leverage. But while one task for the historian is to judge past generations, a second is to show future generations how and why their capable predecessors strayed. After all, tomorrow's financial statesmen will grapple with the same limitations that Greenspan confronted. They will be expected to forecast crises but will lack the tools to do so. They will be called upon to eliminate financial risks when such risks are inescapable features of the human condition. The delusion that statesmen can perform the impossible—that they really can qualify for the title of "maestro"—breeds complacency among citizens and hubris among leaders. The story of Alan Greenspan may perhaps serve as an antidote.