Sebastian Mallaby is the Paul A. Volcker Senior Fellow for International Economics at the Council on Foreign Relations. He is the author of a new book called “The Man Who Knew, The Life and Times of Alan Greenspan”
Things changed dramatically for the Federal Reserve on November 8.
Donald Trump’s victory means the end of more than twenty years of detente between the White House and the U.S. central bank. In 1993, the Clinton administration instituted a policy not to criticize the Fed that has survived ever since. But Trump has shown repeatedly that he has no problem criticizing decisions he doesn’t like.
Cordial relations between the Fed and the Oval Office came about while Alan Greenspan was the head of the central bank.
There is a temptation for the Fed to think of the Greenspan era as the golden age, when the central bank reached the apex of its influence in the corridors of power.
Now, a new biography has been published that examines Greenspan’s life, his 19-year tenure at the Fed and his legacy.
Greenspan’s stellar reputation was severely tarnished by the financial crisis. Conventional wisdom blames Greenspan for not taking forceful regulatory measures to tighten standards for home mortgages. But author Sebastian Mallaby, a fellow at the Council of Foreign Relations, argues in his book “The Man Who Knew” that Greenspan’s interest-rate policy is more to blame.
And Mallaby thinks the Fed can learn some lessons from Greenspan as it girds for the Trump presidency. In an interview with MarketWatch, he says that the Fed is going to have to leave its Ivory Tower “walk into the public square with your fists out and fight the politicians.”
The following interview was lightly edited for clarity.
MarketWatch: Greenspan was for a long time was a hero and he’s now the villain for the financial crisis. Your book seems like an effort to find the truth in between. You took the measure of the man. What did you find?
Mallaby: Well you’re right that he went from hero to zero, incredibly dramatically. I think the truth is he had a very distinguished career for a long time and then made a huge error at the end. Perhaps there is a lesson there about term limits, about the danger of remaining in office too long, about getting into a situation where you’ve seen every single problem you think present itself before and you think you know the answer and you stop being quite as curious as you used to be and determined to think afresh as you used to. And so Greenspan scored incredibly well as a public servant and as an analyst of the economy right up until really the last two years, 2005 being the last full year in office, and that’s when he should have been doing more to lean against the mortgage bubble. And not doing that cost us a lot.
Former Chairman of the Federal Reserve Alan Greenspan
MarketWatch: How culpable is Greenspan for the financial crisis?
Mallaby: He certainly shares some of the blame. You cannot be the world’s most powerful economist and then have the world economy blow up and say “it wasn’t my fault.” By definition, he must have some of the responsibility.
What is interesting, I think, is to understand where that mistake lay. The conventional wisdom is that interest rates were fine because inflation was on target before 2007 but that the mistake was with regulatory policy. And my argument is that is the other way around. That, in fact, regulatory policy was not quite as remiss as people say because when you do Freedom of Information Act requests, you find the Fed discussing subprime and doing something about subprime. But regulation is inherently flawed and weak and it is just too easy to do an end-run around it, and there is an alphabet soup of regulatory agencies in Washington that allow risky behavior to flow through the cracks. I believe that the real mistake, because I don’t have much faith in regulation, the real mistake was not to raise interest rates. That’s where Greenspan is to be faulted. Both for having interest rates too low and for having them too predictable because with the forward guidance, the sort of understanding that the Fed would only raise interest rates very gradually. I think those two things together, low interest rates and predictable interest rates, encouraged Wall Street to take crazy amounts of leverage.
MarketWatch: I’m not convinced that his regulatory policy was better as you argue. The Fed was ruling the roost in Washington. He might have had doubts and been constrained, but the Fed was going around Washington saying “if there is every a problem in Washington, we’ve got it.”
Mallaby: I think that’s a respectable point of view. It’s true the Fed was the most respected or heavyweight of the various regulatory agencies, and it is true that Greenspan himself was regarded as the maestro and so he had a lot of clout in Washington, and so therefore one might argue that he should have done more on regulation and then he could have prevented the trouble. But the reason I don’t, in the end, agree with that perspective is that there was so much balkanization of regulatory authority that even the Fed could not corral the CFTC, the SEC, the OTS, the Comptroller of the Currency, the FDIC, the state insurance regulators — [it was] just too much. And then if you want to something serious you have to get bills through Congress and that’s incredibly difficult. When the so-called Financial Modernization Act was passed in 1999, this was following no fewer than 14 attempts to go through Congress, it was incredibly difficult, because money from Wall Street would come and lobby.
There were three specific examples of where regulation should have been pursued more aggressively and was not. One was they should have done more to clamp down on crazy subprime situations. Second is, they should have clamped down on Fannie and Freddie, which were underwriting fully half of all the mortgages in the economy at a subsidized rate because they had a taxpayer backstop, and thirdly they should have pushed over-the-counter derivatives onto exchanges to make them less dangerous. These are three clear errors in regulation that should have been pursued more aggressively. But my point is that it is not that Greenspan was a naïve laissez-faire ideologue who believed in the self-policing efficiency of markets and that’s why he didn’t do anything. Actually, he did try on subprime mortgages as I discovered though the FOIA request. On Fannie and Freddie, he also tried. He went and testified quite aggressively in 2004 and made an alliance with the White House to try to pass legislation to cap the size of Fannie and Freddie’s mortgage portfolios.
But, you know, the response to that was that Fannie and Freddie ran a television commercial to warn members of Congress that if they backed the Greenspan reform, they could face enormous barrages of negative ads in their districts come the next election. And so, all the support in Congress evaporated. That was a clear case of money corrupting the policy process.
And the last one is derivatives, where Greenspan did not support the regulation that should have taken place. So that’s where he is the most culpable in all these three, because he really didn’t try at all. But I think he didn’t try, not because he was foolishly faithful that derivatives would be safe. He knew they weren’t always safe because he’d lived through a significant blow-up when Orange County, California in 1995 had enormous losses in its Treasury operations because of derivatives, when Procter & Gamble and Gibson Greeting Cards blew up because of derivatives. Long-Term Capital Management was a derivatives blow-up in 1998. So anybody could see that derivatives could be dangerous. But the reason he didn’t support regulation of this stuff is that he just thought it wouldn’t make it through Congress. That was Bob Rubin’s judgment, that was Larry Summers’s judgment. Bob Rubin is the most interesting example, because temperamentally Rubin was quite inclined to regulate, but politically he thought it was a lost cause.
MarketWatch: I was struck how you argue that Greenspan was a smart, deft politician. I don’t think there were many smarter and more deft than he was.
Mallaby: Yes, I agree with that. I think that goes back to his apprenticeship on the Nixon campaign in 1967-68 and after that when he was operating in the White House with Gerald Ford and having to go toe-to-toe with Machiavellian operators like Henry Kissinger. He was learning tricks from Dick Cheney and Donald Rumsfeld who were in the Ford administration with him. I think all those experiences of political warfare set him up to be a very deft political operator as Fed chairman.
MarketWatch: I get the sense that no president will ever want to put somebody as Fed chairman who is that politically astute again. Bernanke, Yellen are very smart academics, but they’re not politically savvy.
Mallaby: I think that’s broadly right. I think Bernanke was a bit savvier than he let on. He could be pretty determined to persuade those who didn’t agree with him. But Janet Yellen is interesting. She’s presiding over a Fed where, if you ask the question “how much of the signal coming out of the central bank comes from Janet Yellen” it is probably only 50% because she allows everybody else to speak up. And journalists listen to the other Fed officials because it is understood that actually their opinion might sway the next vote. In the Greenspan era, if you ask how much of the signal coming out of the Fed was from the chairman, the answer was kind of 99%. And so, I agree with you that Yellen is more of a technocrat’s technocrat and less of a politician.
MarketWatch: It seemed to hurt the Fed in their dealing with Congress, extremist voices like Ron Paul’s were able to dominate the airwaves.
Mallaby: I agree. I think the reason for that is that if you have the Fed being attacked, the Fed needs to counter-attack with one clear message. And if there is a cacophony of different people at the Fed saying different things, you muddy the message
MarketWatch: And Greenspan was famous for his seat-of-the-pants monetary policy making but Congress wants to rein in the Fed, with John Taylor leading the effort.
Mallaby: The support for the Taylor rule, particularly in the House, is interesting. That’s a revival of the old libertarian hankering to escape the phenomenon of a central bank with a lot of discretion. It feels [to them] of too much government activism in the economy.
And there is this recurring thing, either for gold, which is one kind of anchor central bankers couldn’t manipulate, or for Milton Friedman’s famous rule, where Friedman said you should just set an auto-pilot such that the money supply increases by 4% a year and that’s it, you just leave it like that. And the latest version of this thing is where you’d have a Taylor rule that binds the policy makers and removes discretion. It’s all variations on wanting to take the power of discretionary decision-making away from central bankers because the phenomenon of unelected technocrats having power is something libertarians don’t like.
MarketWatch: Talk a little about Ayn Rand and Greenspan and their relationship and objectivism. How do you define objectivism.
Mallaby: That’s a good question. It is basically hyper-individualism. It’s a belief in untrammeled individual freedom and minimal obligation, possibly no obligation to anybody else. It is a kind of romanticization of the headstrong lone genius, the Nietzschean hero. And this appealed to Greenspan, I think partly because of who he was. He had grown up worshipping the 19th century robber-barons, J.P. Morgans, Rockefeller and Vanderbilt, and he regarded those headstrong self-made millionaires as sort of an ideal because they were people who had pulled themselves up out of nothing and had acquired power and wealth. And that is what inspired him. And I think that shows you partly how ambitious he was in himself. He was this mixture of external shyness but internal drive. And so I think it was natural that the Ayn Rand objectivism appealed to him.
MarketWatch: Doesn’t it give some intellectual credibility to ignoring the less fortunate. One of the few mentions of African-Americans and Greenspan are the memo he wrote Nixon about the riots in the 1960s after Martin Luther King died. And although Greenspan loved statistics I never heard him mention the gulf between the household income of whites and blacks. The Fed never viewed that as part of its remit.
Mallaby: It’s quite hard to set an interest rate that addresses the racial income gap. And I don’t see what he would have done. I think you can definitely believe in social justice and redistributing money and taking account of historic injustice but that’s a fiscal policy, not really a monetary policy issue.
MarketWatch: But the Fed under Yellen is starting to talk about economic mobility. And how important that is in an economy. If the Fed isn’t talking about issues in the economy, then pretty much they’re not talked about. They set the agenda.
Mallaby: I think it’s a fair point if you’re saying they should raise the issue because it would be good to get it on the national agenda, then that’s a fair point. There should be policies but they’re not going to be central bank policies
In the past I’ve expended large amounts of ink as a Washington Post editorial writer precisely on inequality and why it matters. I just don’t know the central bank is the institution I would look to for the answer.
MarketWatch: What lessons do you think Donald Trump will take away from your book? What kind of deal is he going to want to make with his nominee to be Fed chairman?
Mallaby: I think it’s more interesting to ask what would the new Fed chairman learn from Greenspan in terms of how to be independent even if you get appointed by a president who wants you to do his bidding. Because this is what Greenspan did. He was appointed by Ronald Reagan as a Republican loyalist, somebody who had always been helpful to the Reagan administration when he was on the outside, chairing the Social Security Commission for them for example and doing so in such a way as to reduce the Democrats’ ability to make political points out of Social Security. And that was basically Greenspan’s mission when he chaired the Social Security reform process in 1982 was to protect the mid-term elections from excessive Democratic gains.
So the Reagan team chose Greenspan as a political loyalist and when he got in he immediately tried to assert Fed independence. And that’s the lesson relevant to today. How does a chair of the Fed, faced by an aggressive White House that doesn’t mind beating up the Fed, in a way that, by the way, hasn’t existed since Clinton came into power. I mean 1993, the beginning of the Clinton administration, was the end of the attacks on the Fed. Now we seem to be going back to the pre-Clinton, it’s-okay-to-attack-the-Fed world. And I think you have to look at how Greenspan responded to those attacks very successfully by counter-attacking. Greenspan was willing to use that Machiavellian political skill to plant stories in the press to discredit his adversary in the Treasury. If the Treasury Secretary was beating him up, he fought back by planting something in The Wall Street Journal. And so I think there are lessons about how you protect Fed independence, not by disappearing into your Ivory Tower and pretending you can ignore politics. You have to walk into the public square with your fists out and fight the politicians.