Maestro: about Greenspan

I think today I will just give another book report. Another worthwhile book:

Bob Woodward, “Maestro [Greenspan’s Fed and the American Boom], Simon & Schuster, 2000

Pg. 17: The Fed sets two short-term interest rates. The less important rate is the discount rate, the interest rate the Fed charges other banks for overnight loans. Although it has only a small actual effect on the economy, at that time (prior to 1990’s) the discount rate was the Fed’s only publicly announced rate. As a result, changes to it had considerable psychological impact on the financial markets and the economy.

pg. 27: The law gives the Fed power to trade in the bond market. The FOMC can direct the “easing” of credit by having its trading desk in NY buy U.S. Treasury bonds. This pumps money into the banking system and eventually into the larger economy. With more money out there, the fed funds rate drops, making it easier for businesses or consumers to borrow money. Lowering the fed funds rate is the normal strategy for averting or fighting a recession. (Fed can tighten credit by selling Treasury bonds).

Pg. 65: 1989 S&L Fiasco. Savings and loans, known as “thrifts,” had been established in the 1930s in order to promote home construction during the Depression, and they were federally insured. Initially, thrifts could issue only fixed-rate 30-year mortgages to homeowners within 50 miles of their own offices. Over time, it became clear that if short-term interest rates went up higher than the rate the thrift collected from its investments, the S&Ls were going to start losing money. To make S&Ls more competitive many of the restrictions on thrifts were slowly pared down during the 60s, 70s, and 80s. S&Ls began to invest in junk bonds—and since a deposit with an S&L was federally insured, investors could seek high returns without substantial risk. Extensive fraud ensued, as single investors ran high-risk S&L ventures with enormous amounts of leverage—as much as $100 invested for every $3 that the S&L actually owned in deposits. S&Ls began to fail. William Seidman, the man who chaired the Resolution Trust Corporation, (RTC; formed to dispose of the propertys) said: “We provided them with such perverse incentives that if I were asked to defend the S&L gang in court, I’d use the defense of entrapment.”

Pg. 102: The way he (i.e., Greenspan) read the history of the 1950s and the 1960s, the Fed had been able to have a fairly expansionist, low-interest rate policy that helped the economy grow without significant inflation. There was almost a presumption that the system would not allow inflation to take hold. As a result, the key long-term interest rates were very low through the entire period. The cost of the Vietnam War eventually cracked the system, and the deficits blew up in the late 1970s. In one period in 1979 long-term interest rates went up an incredible 15%. This was the runaway inflation that his predecessor Volker had tackled.

The lingering residue of that runaway inflation was that and inflation expectation, which had been nonexistent prior to Vietnam, was now apparently built into the system. One result was a psychology of inflation that was, at least initially, more important than real inflation.

Pg. 109: Senator Daniel Patrick Moyinhan had written a scholarly article in the Washington Post, June 6, 1993, about Baumol’s disease. Baumol had argued that jobs in which productivity does not increase substantially over time tend to wind up as part of government. Moynihan cited, among these, the police, the postal service, sanitation services and the performing arts as fields that were once entirely private but now depended on government funding because they had not been able to become more productive.

So, as socially useful enterprises ceased to become more productive and lost out in the marketplace, the government took them on in order to keep them going—thus increasing its obligations. Moynihan and Greenspan worried that Hillary Clinton’s new health care initiative might prove the same thing about health care.

Pg. 110: In August 1993 Clinton’s deficit reduction plan passed Congress by 218 to 216 in the House, and 51 to 50 in the Senate. Not a single Republican had voted for the plan, which cut $500 billion from the deficit over the next four years by increasing taxes and cutting some federal spending. The only real Republican support had come from Greenspan.

Pg. 174: Conventional economic models showed that the service businesses, from the gas stations to the sole proprietorship's and partnerships—roughly one-third of the businesses in the country—showed a 1/2 percent decline in productivity over the last two decades. Greenspan viewed this as impossible and became convinced something was wrong with the model. The service productivity numbers, which were negative, had to be wrong. These wrong numbers were dragging down the aggregate productivity numbers for the economy as a whole. Therefore, productivity was higher across the board. On top of this, Greenspan noted that the consumer price index was overstating inflation by approximately 1%, because the CPI did not accurately measure new products, rent and other consumer goods. Nonetheless, the core inflation rate as reported by the government was only 2.6% over the last 12 months—the smallest increase in three decades (1996).

Pg. 199: LTCM fiasco: At the Greenwich, CT, headquarters of Long Term Capital Management, a secretive and powerful speculative partnership of very wealthy investors, the Russian collapse had triggered an earthquake. Founded in 1994 by John Meriwether, the former vice chairman of the Salomon Brothers investment bank, and former Fed Vice Chairman David Mullins, LTCM included two Nobel Prize winners and dozens of Ph.D.’s. LTCM was a hedge fund. Hedge funds aggressively play both the expected ups and downs in the market, essentially doubling their bet by investing heavily in the stocks expected to rise and short selling those expected to decline. LTCM was also highly leveraged, meaning it borrowed 95% or more of the money it invested.

LTCM’s overall investing theory, based on complicated mathematical formulas, was to identify temporary price discrepancies in various world markets and to bet that those discrepancies would converge toward historical norms. Many trading numbers or rates operate around a norm. Notice the variations, invest assuming that the numbers will return to the norm and most of the time and investor will be right. On one level, it was an important discovery, to capitalize on small variations that seemingly made no sense.

As an example, in an early investment LTCM’s data showed that 29 1/2 –year Treasury bonds were less expensive than the 30-year Treasury. The partners in the firm figured that the values of the two bonds would converge over time, so the bought $2 billion of the 29 ½-year bonds and sold short another $2 billion of the 30-year bonds. By putting up only $12 million of their own capital, LTCM took a $25 million profit on the transaction just six months later.

In 1994 and 1995, LTCM made more than 40% profit each year for its partners and investors, who had put billions into the firm. Another $100 billion was borrowed from banks and various large investment banking firms such as Goldman Sach. Competition from other firms who started to use the same methods soon increased, and LTCM began to buy into various stock market investments and foreign currency transactions—not just bonds.

Then the Russian default started a stampede. Instead of converging, bond prices moved away from the norms that LTCM was counting on. In early September, LTCM notified its investors that it had lost $1.8 billion, or nearly half the investors own capital that had been put in the firm. A large number of their current investments could not be sold, because the worldwide bond market was nearly frozen. But this was not getting out to the public because they were focused on the Lewinsky scandal report just released by Ken Starr.