CHAPTER ONE
The Fed
The Inside Story of How the
World's Most Powerful Financial Institution
Drives the Markets
By MARTIN MAYER
Free Press
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The Magician on the World Stage
Since the last great universal crisis of 1867 many profound changes have
taken place. The colossal extension of the means of transportation and
communication — seagoing steamers, railroads, electric telegraphs, the Suez
Canal — have made the real world market a fact...Infinitely greater and varied
fields have been opened in all parts of the world for the investment of
superfluous European capitals, so that it is far more distributed, and local
overspeculation may be more easily overcome. By means of these things, the old
breeding grounds of crises and opportunities for the growth of crises have been
eliminated or strongly reduced.
— Friedrich Engels (1894)
As the millennium turns, central banks are in apotheosis. Never has their
prestige, their authority, or their independence — indeed, their mystique —
been greater. But the appearances are deceptive. The volcano rumbles under
Olympus and fissures are visible on the slopes. The unprecedented volatility in
the markets — stock markets, bond markets, foreign exchange markets —
demonstrates that instead of settling down, the postmodern financial system is
acting up. Central banking in the twentieth century, especially as practiced by
the Federal Reserve System in the United States, is one of the great stories in
economic history, and no one can understand the present policy dilemma
worldwide (the need, as former Treasury Secretary Robert Rubin put it, for a new
financial architecture) without understanding that story. In a world where tiny
changes in interest rates can produce rapid and vast change in the prices of
financial instruments and the viability of national economic policies, the
decisions the central banks must make are exquisitely important. They had better
know what they're doing. We had better know what they're doing.
The touchstone has to be October 1998. It very nearly all came apart in October
1998. As they do in two of every three years, bankers and central bankers,
financiers and finance ministers came to Washington by the thousands in the
first week of October 1998 for the annual meetings of the International Monetary
Fund and the World Bank. It turned out to be an experience they will never
forget as long as they live, a weekend of pure terror, as though an asteroid
were descending on Earth, much worse than the riotous and riotously publicized
protests at the smaller Interim Committee meeting eighteen months later. David
Komansky, CEO of Merrill Lynch, the prototype of the jolly fat man, said that he
woke up on Saturday morning an optimist, and that night he wanted to crawl under
the bed to hide.
This was far from a normal experience at the Bank/Fund meetings, which have
usually been a kind of reward for their participants, divided by age. Seniors
enjoy their importance in various caucuses formed for self-congratulation and
finger-pointing at others outside the caucus. They eat and drink the very best,
decorously, at parties in venues like the Corcoran Gallery and the Folger
Library. Juniors, drafted during the day to provide an audience for the big
shots at the plenary sessions in the enormous ballroom of the Sheraton Park
Hotel near the National Zoo, party vigorously late into the night at the
expense of various publications and suppliers to the finance community. All the
182 countries that belong to the Bank and the Fund are represented, usually by
both finance minister and central bank chairman (all expenses paid by the Bank
or the Fund), and all the world's two hundred largest banks are there (at their
own expense), sometimes with delegations of thirty and forty people.
Not much work is required. Some of the pleasantries in the corridors will turn
into deals, and everybody's Rolodex grows larger. But the closing
communiqués are in large part ritual, and where in fact real decisions
must be made, the terms if not the details are arranged before the first
limousine takes the first delegate from Dulles Airport to his or her hotel. "The
deputies" have already met, in Paris or Tokyo or Rome, and written the draft of
the communiqué, which will be presented in Washington to selected
representatives of the outliers of globalism, noblesse oblige, before the
public meetings begin on Monday. If disagreements persist, they are resolved on
Saturday, when the finance ministers of the seven big financial powers (the
list includes Canada, but not China or Russia) meet as a group.
The official meetings are only part of the show. Perhaps the most important
side event is a Monday morning conference sponsored by the Group of Thirty, a
think tank established in the late 1970s with help from the Rockefeller
Foundation. The anointed Thirty in 1998 included active executives of the Bank
for International Settlements in Basle, the Banque de France, the European
Central Bank, the Bank of England, and the Bank of Israel, plus former chief
executives of the Federal Reserve, the Bank of Japan, Danmarks Nationalbank, the
International Monetary Fund, and the Federal Reserve Bank of New York; half a
dozen academics; and present or recently retired senior executives of Citibank,
Dresdner Bank, Deutsche Bank, Goldman, Sachs, Industrial Bank of Japan, Merrill
Lynch, J. P. Morgan, and Morgan Stanley. When the Bank/Fund meeting is in
Washington, the Group of Thirty affair occurs at the Pan-American Union or in
the top-floor meeting room of the Federal Reserve's Martin Building.
Beneath the practiced mallet of Paul Volcker, a former Fed chairman, the
conference proceeds in an orderly fashion for three hours through presentations
by a dozen speakers (it always, miraculously, ends on time). Private bankers,
finance ministers, and central bankers — since 1987, the list has always
included Federal Reserve chairman Alan Greenspan, early in the proceedings —
present their views on the world's financial situation and respond to a few
questions from the audience. In 1998, the usual list of the great and the good
— the finance minister of Italy, the chairman of the Bank of Japan, a senior
executive from Deutsche Bank, and so on — was supplemented by George Soros,
who had just lost $2 billion in Russia.
But for once the context of the meeting had been set not by its own eminent
speakers but at another meeting two days before, when Deutsche Bank, the
largest by some margin of the German banks, presented the report of its Global
Markets Group. Volcker also chaired this meeting, which was held in the
downstairs ballroom of the Omni Hotel near the Sheraton. Each member of the
audience was presented with an 83-page large-format coated-paper pamphlet on
Global Emerging Markets, tastefully illustrated on the cover with a
drawing of the Titanic sinking in an iceberg field and a bunch of
lifeboats seeking to escape. Next to the illustration was the sentence: "The
real problems lie below the waterline."
Lumping together the five nations devastated by the Asian financial crisis, the
Deutsche Bank researchers concluded that "While it is difficult to argue that
governments are insolvent...under most scenarios, the ability of the government
to service its debt in the short run is questionable." Turning attention to
Russia, the German bank's experts argue that "there is a very high risk that
Russia will not be able or willing to repay its foreign debt" — ever. Latin
America might have a chance because most countries had large enough reserves to
ride out a long storm, but "failing to stay on course might have very costly
and lasting consequences." And the main speaker in the Latin American part of
the program, Professor Guillermo Calvo of the University of Maryland, thought it
would be wisest to abandon hope. Then David Folkerts-Landau, "Global Head" of
Emerging Markets Research, formerly director of capital markets research for
the International Monetary Fund, presented his paper on why the current behavior
patterns of the international banks and their supervisors, especially
in the creation and valuation of derivatives, made crises worse. Volcker called
everybody's attention to Folkerts-Landau's paper, both at the Deutsche Bank
meeting and at the Group of Thirty conference the following Monday.
Russia had defaulted in August, telling foreign investors in its government
debt that they could go whistle for their money. Long Term Capital Management
(LTCM) of Greenwich, Connecticut, the biggest of the "hedge funds" — the
engines of great wealth that only the rich could ride — had collapsed ten days
before the Deutsche Bank presentation. The second biggest such fund, Julian
Robertson's Tiger, was bleeding money in the billions of dollars from a wrong
bet on what would happen to the Japanese yen. The old market-savvy trading firms
made their money in times of high volatility, because they had antennae all over
the market and felt the shifts in sentiment. But the new computer-oriented
trading firms relied on statistical distributions and normal curves, and
advertised that they didn't take risks in the market because they understood the
probabilities of all the price movements and placed their bets scientifically.
Volatility meant that the probabilities did not hold, and destroyed them.
Because they had said they weren't risky, they had been able to borrow 98, 99,
100 percent of the money they bet, some of it from banks, some from securities
houses. They were incorporated in places like the Cayman Islands, and nobody in
any financial center, including the Federal Reserve System, knew what they were
doing. But if they really smashed and defaulted on their borrowings, a lot of
big institutions might be ruined.
Secondary effects hit harshly in the world of borrowers. In September 1997,
Brazil had been able to borrow money on the international market for the rates
on U.S. Treasury paper plus about 4 percentage points; in September 1998,
Brazil could borrow money internationally only by paying the U.S. Treasury rate
plus 22 percentage points. Japan was mired in recession, longing to export its
way out of trouble but constrained by the knowledge that such a policy would
devastate the rest of Asia, unable to think of anything else to do. In the
United States itself, bonds issued by companies without a large asset base were
selling to yield three times as much as bonds issued by the best corporations,
and the market for initial public offerings — first issues of stocks (or bonds)
by new businesses — had dried up completely. Though the publicized indices had
not been so hard hit, the average share in a traded American corporation was
down more than a third from its early summer highs. The closer you lived to the
financial world, the greater the panic. Everybody knew there was bad trouble in
Asia; in Washington, bankers, central bankers, and finance ministers from
around the world — especially from Europe, whence the bankers and ministers had
come to the meetings interested only in themselves and their shiny new money —
were learning that if they hadn't felt the pain yet, it was because they were
off the beaten track.
One of the last speakers at the Group of Thirty conference was William
McDonough, president of the Federal Reserve Bank of New York, a pleasant,
calculating former Chicago banker, usually a rather gray man, who said that
what he saw around him was the greatest financial crisis of his lifetime.
Everyone here, he said, is a banker or a bank supervisor. If you're a banker, go
out and lend — you don't have to dot every i and cross every t. If you're a
bank supervisor, don't criticize your banks for making loans even if they're
loans you might not have approved just a little while ago. Get the money out;
the world needs the money.
Later that same week, the Federal Reserve Bank of Chicago held a symposium
jointly sponsored with the International Monetary Fund (IMF) on the causes and
consequences of the Asian crisis. I was among the speakers. On Friday morning,
arguing that it was time for her to get away from her usual companions from
universities and governments and see what real capitalism looked like, I took
the U.S. executive director of the IMF across the street to the Chicago Board of
Trade, where futures contracts for agricultural and financial commodities are
bought and sold in open outcry markets. We went up to the upper level of the
visitors' gallery and looked out on the "pit" where futures contracts for U.S.
Treasury bonds are traded ($100,000 face value per contract). It is a large,
dark wood, octagonal structure, with seven steps from bottom to top; almost
three hundred traders were crammed onto the rings of steps, shouting and waving
their trading cards in the air to get the attention of the others. Against the
wall behind the pit are row on row of desks where the clerks sit at the
telephones, taking the buy and sell messages from the outside world, wig-wagging
them down to the brokers in the pit, who are in constant interaction with the
"locals," the traders for their own account. The important traders, making the
most motions, are on the top step, where they can see the whole pit and all the
clerks. ("A good place to stand," the most successful bond trader of the 1980s
told novices in a lecture, "is where the locals that drive the nicest cars and
make the most money stand.") Sealed off behind the glass, visitors can hear the
roar.
And then the roar stopped. The men stopped waving their arms in the pit, and
they all just stood, arms at their sides. At 11:45 in the morning, the price of
the T-bond futures contract had dropped $3,000, which was the maximum move in a
single day. The market had closed "lock limit down" for the first time since
Saddam Hussein invaded Kuwait. The traders stayed in the pit, because any bid
above the current price would reopen trading; but there was no such bid. We
returned to the Federal Reserve Bank of Chicago, and in the anteroom ran into
Michael Moscow, president of the bank, a tolerant economist who does one thing
at a time. We told him what we had seen across the street, and he nodded
soberly. "Yes," he said. "There are no bids for anything. There is no money."
On Sunday, October 11, I flew off to Geneva, where I was to be one of four
"experts" to help the member states of UNCTAD — the United Nations Conference
on Trade and Development — think about "standstill agreements" that might
permit everybody to draw breath after a banking-cum-currency crisis left a
country unable to finance its imports or pay its debts. Monday, I met with Dr.
Yilmaz Akyuz, UNCTAD's Turkish-born chief of macroeconomic and development
policies, who thought the jig was probably up for economic development financed
by cross-border flows of capital. As always, banks had lent short-term money
for long-term purposes, and now the loans had to be rolled over, and the banks
very clearly weren't willing to do it. Delegate after delegate told me he
expected that his country would be in default on its obligations before the
middle of 1999. To represent UNCTAD at UN headquarters in New York, Akyuz had
just hired Jan Kregel, a very smart and knowledgeable young American economist
with the brush mustache of a British grenadier, who taught at the University of
Bologna. On Tuesday, after the conference standstill discussions, I had dinner
with Kregel, a protégé of the great post-Keynesian economist Hyman
Minsky, and he laid out a scenario based on an anticipated deep world recession
in 1999. There was no money internationally; nobody was prepared to bid for
anything.
Then, on Thursday, October 15, at 3:04 in the afternoon, a press release from
the Federal Reserve Board informed the world that Chairman Alan Greenspan,
acting on authority given him by the Federal Open Market Committee after a
conference call with the members of that committee, had told the system's
trading desk in New York to put enough new money in the banks to lower the "Fed
Funds" rate, the interest banks pay each other for overnight loans, by 25
"basis points," one-quarter of 1 percentage point.
The timing was fascinating. The bond markets had closed for Thursday,
eliminating the small but real danger that bond traders, seeing Greenspan's
action as an abandonment of the fight against inflation, would push up
long-term rates while he was pushing down short-term rates. And the next day
would see the monthly expiration of a set of exchange-traded options contracts
on stocks — contracts each of which gave their holder the right (but not the
obligation) to purchase or sell one hundred shares of the specified stock at a
preset "strike price" that might be above or below the market price. If not
exercised, these contracts for this period would expire worthless at the close
of trading on Friday. People who had written contracts that gave their purchaser
the right to buy stocks tomorrow at yesterday's prices would have to worry that
Greenspan's action would send the market soaring, and they would therefore have
every reason to buy the underlying stocks as soon as possible to limit their
losses on the contract. This need for the players in the options market to cover
their positions immediately (because "in-the-money" options would definitely be
exercised the next day) would further strengthen the upward pressure on stock
prices Greenspan's announcement was sure to cause. From three o'clock Thursday
afternoon to four o'clock Friday afternoon, the stock market rose more than 7
percent. Roughly $1 trillion was added to the world's wealth, on one man's
say-so.
In a world where the Russians and the educated fools of Long Term Capital
Management and the crony capitalists of Asia had changed everybody's estimate
of the risks undertaken by investors in the capital markets, where there was a
gap of 12 to 20 percentage points between the interest rates on foreign bonds or
low-rated domestic bonds and the interest rates on U.S. government paper
(perfectly safe by definition, because the U.S. government can print legal
tender to redeem it), one-quarter of 1 percentage point was not in itself a
noticeable, let alone a commanding, move by the authorities. But you had to
consider — or you thought you had to consider — who was doing it.
In private conversation a couple of weeks before his October 15 intervention,
Greenspan had noted with weary regret that the whole world seemed to believe
that the Fed was in control of what happened to the economy. Of course, he
said, the Fed could strangle the economy by pushing real interest rates beyond
the level honest enterprise could pay — which is roughly what his predecessor
Paul Volcker had done in the early 1980s — but its powers for stimulus were
very limited. Nevertheless, on October 15, he went out on centerstage with his
top hat and pulled a rabbit out of the hat. It wasn't Bugs Bunny or Roger
Rabbit; it was a pretty scrawny little rabbit to which nobody really had
to pay attention; and there wasn't anything else in the hat. But the magician
concentrated the attention of the world on his rabbit, and the crisis eased.
Someone, the magician seemed to be saying, was now in charge. The markets had
desperately wanted to believe that someone was in charge; and they believed.
The reasons Alan Greenspan gave for his coup du théâtre
explain much of how the world works today, and how the chairman of the Fed must
think about it.
Greenspan said that what convinced him he had to move was the gap that had
opened between the price of the current "on-the-run" 30-year U.S. Treasury bond
and the price of the bond issued the year before. In October 1998, new 30-year
bonds were selling to yield one-third of a percentage point less than the 1997
bond. As investments, the two are essentially identical; there is no
fundamental reason why two long-dated bonds with only a year's difference in
their maturity should not offer purchasers very similar yields. In October,
however, the bond that had been issued in August is still mostly in the hands of
dealers and hedge funds, which are busily playing all their little arbitrage
games of stripping the coupons off the bonds and selling the parts, then putting
the coupons back on the bonds and selling the whole. That meant that the market
was liquid, and a purchaser could count on being able to get out fast at a
reasonable price if it turned out that she needed cash. The bond issued in
August of the year before, by contrast, had mostly disappeared into the vaults
of the insurance companies and pension funds and bond mutual funds. They had
acquired this paper pursuant to longer-term strategies. They're rarely in the
market to add to their holdings of "seasoned" government bonds.
Thus a purchaser of a bond with twenty-nine rather than thirty years to go ran
a slightly greater risk that she would have to cut her price substantially when
she wanted to sell. In October 1998, there was no money and there were no bids,
and a professional purchaser of a one-year-old 30-year bond had to worry that
he could be locked in, paying interest to fund his holdings that might exceed
his earnings on the bond. Indeed, the only way out might be to sell a futures
contract on the Chicago Board of Trade, and then to deliver the bond in
satisfaction of the contract when it expired. When the bond-futures pit closed
lock limit down, even that chance seemed to be foreclosed.
On October 15, 1998, the world was in fact swimming in excess liquidity. The
Bank of Japan was frantically pumping yen into the stagnant pools of its
economy, and in the United States all the measures of money supply were rising
rapidly. But as the gap between new and seasoned long-term bonds demonstrated,
the appearances were deceptive. Money supplies were rising because participants
in the markets wanted cash rather than securities. The banks, which could be
called on to repay their depositors at any time, were keeping the liquidity for
themselves, fearful that those who funded them would take their money out.
Indeed, the Japanese banks, agents of a country with literally hundreds of
billions of dollar-denominated reserves, were being forced to pay a "Japan
premium," a higher interest rate, when they went to market to borrow dollars
from other banks.
There are many discussions in many venues of what numbers central bankers
should watch. The Wall Street Journal is fixated on the price of gold:
if gold goes up, its editors believe, there are inflationary pressures abroad in
the world, and if gold goes down, the danger is deflation. Milton Friedman and a
rapidly diminishing band of acolytes want the central banks to create money at
a steady pace of 3 percent a year, which will give the economy room to grow at
stable prices — indeed, Friedman sometimes seems to believe that it will
force the economy to grow at stable prices. The Maastricht Treaty of
1991 that wrote a framework for the European Central Bank calls for it to
maintain "price stability." The "wise men" who guide the Bank of England in its
new independent existence target an inflation rate, elaborately calculated. The
Humphrey-Hawkins Act in the United States requires the maintenance of high
employment. In the real world, Mr. Greenspan monitors the spread between the
interest rates on this year's and last year's 30-year bond.
Political Washington, a junior minister in the British Foreign and Commonwealth
Office once told me, is a place where information, not knowledge, is power.
Alan Greenspan's Fed is devoted to information beyond the imaginings of
enterprise America or, indeed, the executive branch of the federal government;
he drives his staff crazy with demands for disaggregated data. When he was a
consultant in private practice, he once said that what he did for a living was
"statistical espionage." But he has been extraordinarily adept at finding those
pieces of information that can in fact create knowledge.
One more aspect of this remarkable story should be considered. At the depth of
despair in the financial world, Greenspan gave a speech to a convention of
retailers in which he suggested that the best thing they could do for the next
week was throw their daily newspapers into a dresser drawer, unread. Disasters
are the best stories; the chairman expected a whirlpool of news attention that
would suck public confidence to the depths already reached in the financial
world. But in fact, with the single exception of Thomas Friedman of The New
York Times, who wrote a column on the op-ed page incorporating an all-caps
scream of "BUT HAVE WE GONE NUTS???", the press ignored the crisis. The fact
that the T-bond contract had closed lock limit down in the middle of the
trading day, for the first time in eight years, was never reported in the
Times or The Washington Post, and simply appeared as part of the
usual roundup piece about financial commodities on Monday in the Wall Street
Journal. For newspaper editors, a story about bids drying up in the bond
market is what William Safire was the first to call a MEGO (for My Eyes Glaze
Over); for television producers, there is absolutely no redeeming social value
in trying to tell about a financial crisis that has not yet punished telegenic
people.
So the news that the world was passing through the worst financial crisis since
World War II never got into the papers at all. Few beliefs are so widely held
as the idea that an informed public helps decision makers do the right thing,
but it's not guaranteed. Greenspan's rabbit might not have been so all-absorbing
if newspaper readers had known there was blood in the streets. A little
learning, Alexander Pope argued, is a dangerous thing. Looking out at the world
from their eagles' nests, central bankers must feel once again that a little
ignorance is a necessary evil.
* * *
Central bankers have always believed, and in their hearts most of them still do
believe, though their tongues say something else, that what the people don't
know won't hurt them. Historically, no occupation has been more secretive. The
monetary economist Karl Brunner once described central banking as
"traditionally surrounded by a peculiar and protective political mystique...The
possession of wisdom, perception and relevant knowledge is naturally attributed
to the management of Central Banks...The mystique thrives on a pervasive
impression that Central Banking is an esoteric art. Access to this art and its
proper execution is confined to the initiated elite."
In 1989, Alan Greenspan testified before Congress against the idea that the
Federal Open Market Committee (FOMC) should announce its decisions to raise or
lower or maintain short-term interest rates: "it would be ill-advised and
perhaps virtually impossible to announce short-run targets for reserves or
interest rates when markets were in flux" — and even in normal times "a public
announcement requirement also could impede timely and appropriate adjustments
to policy." A couple of years before, the Fed had fought to the Supreme Court
and won a lawsuit in which a Georgetown University law student had tried to
force publication of the decisions of the FOMC. Awful things would happen if the
world knew the instructions being given to the desk that traded Treasury paper
for the Fed, said Governor Charles Partee and senior staffer Steven Axilrod. It
would cost the government more money to sell its bonds because the primary
dealers would have to protect themselves against informed speculators (Governor
Partee estimated a loss of $300 million a year), and the Fed itself might lose
money on its trades if speculators had this information. Verbally, all that
changed in the 1990s; the watchword now is "transparency," and it is only cynics
who feel that the lady doth protest too much. "The word honor in the mouth of
Daniel Webster," said Senator John Randolph of Virginia (on the Senate floor,
too) "is like the word love in the mouth of a whore." I have some of that
feeling when I hear a central banker recommend "transparency."
The world's central bankers meet eight times a year — formerly only those from
the eleven largest Western economies, now with some added starters from poorer
parts — as the directors of the Bank for International Settlements (BIS), a
leftover from the days of German reparations disputes a decade after World War
I. Their meeting place is a handsome round tower in Basle, the highest building
in the city, not in its center but at the railroad station, which was once the
most convenient locus for European conclave. They rarely tell outsiders what
they talk about.
The annual report does not discuss at any length what the BIS did during the
year, but presents the views of the managing director (and his very talented
multinational staff) on what has been happening to the world's economies and
the world's monies. Written brilliantly in English by the curmudgeonly American
economist Milton Gilbert in the 1960s and 1970s, then also in English by the
equally brilliant multilingual Belgian Alexandre Lamfalussy in the 1980s and
early 1990s (before Lamfalussy went off to put the future European Central Bank
on an intellectually stable footing while it was still called the European
Monetary Institute), the BIS annual report has been for decades the world's
best source of information about cross-border banking and national economic
policies. Lamfalussy's successor, Andrew Crockett from the Bank of England, is
still trying, with help from the easygoing Canadian William White, who runs the
BIS research operation, to fill those shoes.
It's not unreasonable for BIS to concentrate on its opinions rather than its
actions, because the BIS has essentially no authority to act. It has some
resources, especially a hoard of gold (it still keeps its own books in "gold
francs"), and the stock trades on the Paris Bourse, essentially as a proxy for
gold. In January 2001, the private stockholders sued to prevent BIS from
forcibly buying in their stock at what they considered an inequitable price.
When big-time packages are put together to rescue this country or that from the
consequences of bad luck or folly (the list includes the United States in 1978
as well as Mexico in 1995 and the Asians in 1997), the BIS has an advertised
part in it, though in fact its contributions are bookkeeping on both sides and
the bank almost never puts up any actual cash. Its most important role has been
to establish forums where issues can be thrashed out among central bankers and
guidelines can be set.
The most significant of these guidelines was a recommendation back in the 1980s
that national central banks should set minimum "risk-adjusted capital"
standards for banks headquartered in their countries that also operated
elsewhere in the world. Banks notoriously buy their assets with Other People's
Money; only the bank's capital is its owners' money. Obviously, a bank that has
all its assets in government bonds requires less capital than a bank making real
estate development loans and speculating in the derivatives markets; hence "risk
adjustment." But the immediate purpose of the capital standards recommended by
Basle, and imposed over the next few years by the authorities in all the major
countries, was to rein in the Japanese banks, which had been rampaging around
the world's markets making loans at rates others could not match, because they
had essentially no equity on which they had to deliver returns.
Unfortunately, the categories of risk were poorly defined — for example,
interbank loans between the banks of countries that were members of the
Organization of Economic Cooperation and Development (OECD), a group that
included Mexico and South Korea, were given a weighting of only 20 percent,
which meant that the same capital could support loans to such banks five times
as large as loans to manufacturing enterprise. Efforts to change the
definitions of risk have foundered, mostly because the Germans want a special
category for their housing bonds. Pending as these words are written is a
proposal by which the banks could make up their own risk schedules with
reference to the published ratings of Moody's and Standard & Poor's — a truly
awful idea, because lending officers at banks and ratings officers at the
ratings agencies tend to be optimistic or pessimistic at the same time. So the
talk at BIS too is about "transparency," letting the markets know what each
central bank is doing, and urging every nation's commercial banks to publish
considerable though significantly incomplete information about their investments
and off-balance-sheet activities.
The transparency push, originated with the world's finance ministers and the
International Monetary Fund, was led by the American Susan Krause, then senior
deputy comptroller for international affairs in the U.S. Office of the
Comptroller of the Currency. Krause, an energetic lady in her forties, with a
casual manner but square shoulders, really did believe (most of the time) that
getting more information out about banks and central banks would make the
regulators' job easier. But the regulators must make a credible commitment:
"[I]f shareholders, creditors and the market in general believe that
governments will allow non-disclosure, partial disclosure or even misleading
disclosure should a bank run into difficulties," she wrote in a paper for the
Basle Committee on Banking Supervision, "they are unlikely to consider publicly
disclosed information credible." She admits that it goes against "the gut
reactions of banking supervision." But, she adds, "Asia illustrated the dangers
of a lack of transparency." It works, she suggests, if you can "think
separately about valuation and disclosure." There are important converts, at
least in public, among them Alan Greenspan.
The symbol of the new openness is the light that now shines on the work of the
Federal Open Market Committee. In the 1980s, "Fed watchers" at the Wall Street
houses, like Salomon's Henry Kaufman and First Boston's Albert Woljinower,
issued streams of comments on the significance of the Fed's daily purchases and
sales of government paper. Now the Fed publishes before each FOMC
meeting the "beige book" on economic conditions in each of the twelve districts,
which is prepared by the staffs of the district Federal Reserve Banks and will
guide the deliberations of the FOMC. And an announcement is made, during the
FOMC's two-day meetings, in time for the markets to use the information on a
same-day basis, to tell the world whether the Fed will be changing short-term
interest rates — and if so, why; if not, why not.
There is no question that this is Greenspan's doing, though perhaps some credit
should be given to Alan S. Blinder, a Princeton economist who served as vice
chairman through the middle 1990s. Blinder believes completely in transparency
for central banks, arguing that it makes them more effective: "A central bank
which is inscrutable gives the markets little or no way to ground [its]
perceptions in any underlying reality — thereby opening the door to
expectational bubbles that can make the effects of its policies hard to
predict. A more open central bank, by contrast, naturally conditions
expectations by providing the markets with more information about its own view
of the fundamental factors guiding monetary policy. This conditioning ought to
make market reactions to monetary policy changes somewhat more predictable,
thereby creating a virtuous circle...And that makes it possible to do a better
job of managing the economy."
It is not clear that the Fed's staff, which has great influence on Greenspan
(he says much more interesting things on the road than he does when he speaks
from his office), has signed off on the values of transparency. The Fed in
recent years has asked Congress to strengthen bank secrecy laws, increasing, for
example, the penalties on anyone who leaks anything from an examination report
that might indicate that a bank's public statements are less than full or less
than honest. To protect the privacy of his colleagues, Greenspan even misled
the Congress, claiming incorrectly that no transcript was made of the tape
recordings of FOMC meetings, and that the tape recordings were destroyed (the
tape, we were told, was recorded over for the next meeting) once they had been
used to prepare the traditional ritualized summary of the meeting. On the
general issue of putting out information so that "market discipline" could
reinforce the supervisory work of bank examiners, the Fed staff really agrees
with Lowell Bryan of McKinsey & Co. that "market discipline by depositors is
another name for bank panics."
A Fed staff study, "Improving Public Policy Disclosure in Banking," published
in early 2000, notes that "the public policy concern is that disclosure about
individual banks would trigger actions by private stakeholders that would
preempt the efforts of a central bank and supervisory agencies to contain a
systemic threat." The study suggested that Federal Reserve examiners could
"review the public disclosures of large banking organizations as part of their
evaluations of its management." By the time this process was completed, the
intervention of the Fed's disclosure authorities would probably reduce the
quantity of information legally available to the public.
Bank secrecy is in the bones of central bankers. It goes back to a time when
the knowledge banks gathered — about changes in interest rates and foreign
exchange rates, the creditworthiness of borrowers, corporate investment plans —
was available only to banks, which spent a good deal of money gathering it. Bank
income derived not so much from maturity transformation — taking very short
term money like checking account deposits and converting it to loans of some
duration — as from information advantages. Credit in Latin means "he
believes." Banks had a rational basis for belief, because they knew a lot.
Direct lenders or investors, who employed their money without the
intermediation of the bank, knew much less. (Remember Partee's comment that the
Fed would lose $300 million a year in its trading if the speculators on the
other side of its transactions were better informed.) Banks could spread the
costs of gathering credit information over a number of accounts, and use the
information in a number of contexts.
As late as the years right after World War II, more than three-fifths of all
lending in the United States was mediated through the commercial banks. Their
profits came from their exploitation of the information they had and others
didn't. Of course they wanted legal protection of their secrecy.
Which left them sitting ducks for the information revolution and the
development of modern finance economics. Today, for minimal expense, anyone with
a computer modem can know just about everything a bank knows, certainly about
conditions in the money market and probably about the quality of potential
borrowers. The BIS has even suggested that the ratings agencies know more than
the banks. It's Ozymandias — there's a ruined statue in the desert, with a
pedestal boasting of a glorious past when banks called the tune and markets
danced to it.
In the old days, the central bank worked on the economy by influencing the
behavior of the banks; enterprise was dependent on banks, and responded to
their response to the pressure from the central bank; and the market moved
according to participants' perceptions of what would happen to the economy with
the change of behavior and attitude at the banks. Now what banks do doesn't
matter all that much in the United States, and soon in Europe, too (indeed, part
of the problem in the world is that banks still do matter enormously in the less
developed countries and it's hard for the industrial countries to understand
that, especially where there are touted "emerging markets"). Where information
technology has taken hold, the central bank, still charged with keeping the
currency stable and the economy growing, must work its magic through
the markets.
To abuse Isaiah Berlin's metaphor one more time, banks are hedgehogs who know
the few things they know very, very well; markets are foxes that roam the world
picking up snippets of fashion. Banks are stuck with their corporate customers,
who owe them money; markets can sell out the stock in a twinkling. The conflict
between the information systems, one deep, one shallow, could not be more
striking. Banks generate and keep information; markets forage for it, publicize
it, and consume it. Banks historically have been confident in their
information, and set a course with it; markets are ready to turn on a dime. As
markets rather than central banks set most of the interest rates that matter and
markets rather than examiners value the banks' investment portfolios, and the
instability of their funding multiplies their risks, banks have become less
assiduous in seeking information, less confident in the information they have,
more willing to go with a flow they and their supervisors only partially
understand. "Do we," asked E. Gerald Corrigan, former president of the Federal
Reserve Bank of New York and chairman of the executive committee of Goldman,
Sachs, "really understand the long-term consequences of the technologically
driven disintermediation of payment flows away from credit-sensitive financial
institutions?" To which the short answer is no; we don't.
The derivatives process, permitting participants to bet on the direction of
market prices rather than on the absolute numbers, enables participants in the
business of borrowing and lending to arrange their affairs so that the actions
of the central bank do not greatly affect them. In the early 1990s, it was
fashionable for economists at central banks to speak of a "financial
accelerator" or a "credit channel effect" that multiplied the effects of the
central bank's raising or lowering of short-term interest rates. Just a touch
on the brakes, raising rates a smidgen, would reduce the value of the paper
borrowers used to gain cash through repurchase agreements, and by increasing
the costs of carrying inventory would reduce profits to damp what Keynes once
called the animal high spirits of businessmen. A touch on the gas pedal would
bring the economy back to speed, Paul Krugman of MIT proclaimed in his role as a
columnist, because "recessionary tendencies can usually be effectively treated
with cheap, over-the-counter medication: cut interest rates a couple of
percentage points, provide plenty of liquidity, and call me in the morning."
But it isn't so. Ingo Fender of the Bank for International Settlements notes
that given the opportunities afforded by derivatives, "firms should not be
expected to accept their fate...like lemmings. Instead, they will implement
corporate risk management strategies that are likely to alter the sensitivity
of the real economy to changes in interest rates." Because the hedging is
necessarily imperfect, he adds, "monetary policy will be increasingly
unreliable when used to affect investment spending and real activity." What
remains is theater, most useful when the threat to be countered is itself
dramatic. Greenspan could master the threat to the world economy in 1998 because
the reason for the disruption was the previously unimaginable default by Russia
on its domestic debt. In January 2001, the decline in economic activity derived
from several years of careless investment (especially, though not exclusively,
in dot-coms and tele-coms) that did not and would not pay out its carrying
cost. Against this backdrop, not even the most startling announcement — half a
point, between meetings of the Fed's rate-setting committee, while
President-elect George W. Bush was meeting with the big businessmen who had
financed his campaign — could do much more than give a temporary goose to the
stock market.
Theory has not yet confronted fact. Theory still says that the effects of
changes in the interest rate play through the attitudes of the banks. The
central bank cares about the real economy and the prices for goods and
services, costs of production and costs of living. Too much "money" in the
system generates higher prices for goods and services and the cost of living.
Too little money denies funds to producers and reduces national product. But the
central bank can't decree how much "money" will be in the economy. It needs
"intermediate targets" that more closely impact the real economy. Those targets
are interest rates and bank reserves (and through bank reserves, "the quantity
of money").
Prior to the last quarter of the twentieth century, banks "set" interest rates:
there was a "prime rate" for the best customers in the United States, a "bank
rate" in England, and their equivalents elsewhere. The central bank by altering
its "discount rate" — the rate it would charge banks for, in effect,
borrowings secured by the banks' best collateral — would influence the banks to
change their prime rate, which would affect business decisions. Rising interest
rates would reduce the market price of fixed-income securities, which
discouraged banks from lending because they felt the decline in the value of
existing investments. If banks have bought 90-day government paper at 5 percent
and the Fed by selling its holdings of that paper raises that rate to 6 percent,
the prices on the 90-day paper the banks own will drop until they sell to yield
6 percent. To create new assets (make loans), banks either have to borrow money
(at the new higher rates) or sell old assets (at the new lower price); the
central bank has given banks reason to think hard before making new loans. Vice
versa with declining rates: existing assets in the banks' portfolio became more
valuable, which encouraged new lending as a way to use the profits.
Others could argue, equally plausibly, that the quantity of bank reserves,
which the Fed could create and extinguish at will, determined the availability
of money to borrowers from the banks. Putting money into the system by
purchasing paper in the market, the Fed increased the banks' lending capacity
and thus their borrowers' spending power. Taking money out of the system by
selling paper in the market, the Fed forced the banks and thus the economy to
cut back. The Fed's actions were always and necessarily pretty small by
comparison with the effects desired, and their effectiveness was explained by
the operation of a "multiplier" inherent in a system where banks had to keep
"reserves" against some fraction of their liabilities. The bank that received
the Fed's "high-powered money" might lend 90 percent of it, and the bank that
received the proceeds of that loan would lend 90 percent of that, producing
deposits in another bank that would lend 90 percent of that, etc. — Big
fleas have little fleas/That come in swarms to bite 'em/And little fleas have
littler fleas/And so ad infinitum.
It is by no means clear that this ever worked, past the extraordinary decade of
the 1950s when American banks funded their lending activities by selling the
government bonds the Fed had helped them acquire to finance the war. That was
then, and this is now. Today, Fed decisions that change banks' capacity to fund
loans mean very little, partly because the most significant lending occurs
directly in the markets and partly because the banks don't want to fund loans,
anyway: they want to package their loans into salable "asset-backed securities"
or in more sophisticated form. In the modern world, a bank loan is a bundle of
risks — risk that the borrower won't repay, that interest rates will change,
that the lender will need the cash he has put out before he thought he would
need it. These risks can be separated out, traded, sold, hedged by the creation
or purchase of derivative instruments. This process, writes Henry Kaufman, the
premier Fed watcher of the 1980s, "has had the significant side effect of
dispelling the illusion that nonmarketable assets by nature have stable
prices."
But while the intrusion of market values everywhere in the banks reduces the
confidence of those enterprises, they and the Fed and the markets all take
heart from the often ingenious calculus of probabilities expressed in the new
instruments. The new interplay of borrowers and lenders in the market, Kaufman
writes, "allows the private sector to withstand monetary restraint for a longer
time. As a result, the central bank will need to engineer considerably higher
interest rates — with correspondingly lower asset values — to achieve
noninflationary growth."
These lower asset values will not be restricted to the segments of the bond
market where the Fed sells. Especially at a time when obscure companies can
fund themselves by selling equity — when funding for investment is provided not
through the intermediation of institutions that have continuing relations with
their borrowers but through the presentations of stock salespeople who are gone
the moment the deal is concluded — the Fed must pay attention to the stock
market. 'Twas not always so. In the 1920s, Benjamin Strong — who ran the
Federal Reserve Bank of New York and thus, at a time when the Board of
Governors in Washington was weak, the Federal Reserve System — had occasion to
write to the head of the Federal Reserve Bank of Philadelphia that "if the
Federal Reserve System is to be run solely with a view to regulating stock
speculation instead of being devoted to the interests of the industry and
commerce of the country, then its policy will degenerate simply to regulating
the affairs of gamblers."
In the mid-1930s, when a stock market boom heralded a false dawn of recovery
from the depression, the president of the New York Stock Exchange (then an
unpaid part-time post) made a speech saying that if the market went pop, the
blame should lie with the Federal Reserve, which had loosened money too far;
and Fed chairman Marriner Eccles responded with a statement endorsed by all the
governors to the effect that the rising stock prices had not been financed with
Fed credit and the Fed couldn't do much about it anyway. Roosevelt sent Eccles
a letter warning him against "any statement relating, even remotely, to actual
stock market operations. This is where Coolidge, Mellon and Hoover got into
such trouble. A word to the wise!"
Erik Hoffmeyer, longtime head of the Danish National Bank, observes that
players in markets are motivated by "what they expect the market to do," and
that these expectations "are heavily influenced by the behavior of the monetary
authorities concerned." Still, new economy or no new economy, the values
asserted by the stock market represent the price of an anticipated stream of
future earnings ("even if," as Alan Greenspan rather grumpily told a conference
in summer 1999, "no market participant consciously makes that calculation").
Higher interest rates mean a greater discount in those values looking forward,
and thus lower stock prices today. Once an economy reaches a certain level of
development, with a body of existing debt that must be rolled over periodically,
everybody hates high interest rates, debtors because they have to pay them,
creditors because the market value of their assets falls. Central banks have
been given independent authority over interest rates because high interest rates
are the necessary prophylactic when inflation threatens, and politically there
is no constituency for increasing interest rates even after inflation has taken
hold. The willingness of political leadership to abdicate responsibility for
interest rates has been one of the most remarkable aspects of the postmodern
political economy. As a German cabinet minister said many years ago, explaining
this phenomenon in Germany, "every politician knows that some day he may need a
central banker to hide behind."
To say that central banks must now seek their objectives through the market
rather than through the banks masks the essential change. Securitization,
derivatives, worldwide markets, and the vastly increased liquidity of once
non-marketable assets (represented in the household world by home equity loans
and easy access to margin values of stock market investments) have made the
idea of the "quantity" of money a historical curiosity, like belief in a flat
Earth. Credit may be amorphous, but credit risk is specific, and leverage — the
fraction of the money at risk that the lender or investor or speculator must
repay to his creditors — continues to rise. Henry Kaufman worries that
securitization and derivatives will act as rubber bands allowing the system to
keep stretching as the central bank pulls at it; an equal worry is that the
chaos theoreticians may be right, and that a system where receipts and payments
are tightly bound together may shatter beyond easy repair if a minor event far
away — the Indonesian butterfly's wings feared by the chaos maven — leads
with awesome inevitability to systemic disaster.
As the Asian crisis of 1997 demonstrated, much of this risk remains with the
banks. The finance ministries and the central banks can probably protect them
and their creditors, though there is a lot of work to be done to assure that
government and central bank protections cannot be abused self-destructively by
the participants in the system. But in a market-dominated age, most of the
burden inevitably lies on investors who no longer use banks as their
intermediaries, and who need unprecedented access to information and even more
unprecedented capacity to analyze and use it.
The burden lies on you.
(C) 2001 Martin Mayer All rights reserved. ISBN: 0-684-84740-X
