Book Review Greenspans Bubbles: The Age of Ignorance at the Federal Reserve William A.

Fleckenstein, with Frederick Sheehan McGraw Hill, 2008 There could be no more timely book than this, now that the United States subprime mortgage crisis has brought things down so resoundingly around everyones heads, including the heads of those outside the United States. It is a short book, easily readable in that it is not given to technical or mathematical explication; and it makes an important and provocative contribution by going so stoutly into the lists to joust with the erstwhile knight-in-shining armor Alan Greenspan, who for almost 19 years presided (one is tempted to say reigned) over the Federal Reserve System of the United States. The value lies entirely in Fleckensteins main thrust, which is that Greenspans near-constant predilection for easy-money and faith in unregulated financial markets led to bubbles that were bound to end, as they did, in disaster. (He sees Ben Bernanke, Greenspans replacement as Chairman of the Fed, as a bird of the feather.) That in itself provides plenty of grist for the readers attention. Unfortunately, the main thrust is not accompanied by depth of analysis or appreciation for intellectual context. The result is that much that is relevant and important is left unexplored. William Fleckenstein is the president of Fleckenstein Capital, a money management firm in Seattle, and is a financial columnist for MSN Money. Frederick Sheehan, who is also an author and someone experienced in the world of finance, did the research for the book. The information recited by the book gives a good capsule summary of American financial history during the past few years. Fleckenstein points out that the stock market bubble began in 1995 when the Federal Reserve pursued a policy of continually cutting interest rates. This bubble collapsed in 1998, causing the Fed to lower interest rates to a mere 1 percent. Then as the threat of the millennium bug of Y2K (the turnover of the calendar to the year 2000, with vast potential computer complications) came nearer, the Fed aggressively increased credit in late 1999, to the extent that the monetary base exploded by an annualized rate of 44 percent over the last ten weeks of the year. This was followed by as many as 13 rate cuts in and around 2001. . In that context, internet stocks rose to incomprehensible levels, peaking in March 2000 before collapsing by 84 percent in the following two and a half years. Fleckenstein dates the real estate bubble, which he considers to have been even more dangerous than the earlier stock bubble, as occurring in 2000-2007. It came along in time to help bail out the deflating equity [stock] bubble. The shock from the atrocities of September 11, 2001, exacerbated the economic situation, to be sure, but werent the root cause of the real estate bubble, which, among other things, was driven by rates as low as 1 percent, the magic of financial innovation, adjustable-rate mortgages, and the use your house as ATM mentality. [The latter is a reference to the automated teller machines from which people can withdraw money, just as people were able during the real estate bubble to borrow ever-increasing money secured by the rising value of their homes.] The stock market began to recover in early 2003, again prompted by massive monetary and fiscal policy stimulus. Then the Fed did an aboutface when in 2004-5 it quadrupled the interest rates in a series of 17 hikes, from 1 percent

to 4.5 percent. The real estate house-of-cards fell when home values stopped rising and even fell. People had been funding their home loans out of debt made possible by rising values, not out of sufficient income to make their payments. And as this is written, a crisis born out of over-borrowing against credit cards remains as a bomb that has yet to explode. Fleckenstein appropriately points to several pathologies that contributed to the turmoil: Changes in accounting allowed the creative expression of earnings, overstating them. There was an absurd tax treatment of stock options. Real estate lending standards fell to an absurdly low level. Deregulation (which Greenspan had championed) led not only to the abandonment of sound lending criteria, but also to the rise of what Greenspan has described as new financial products such as derivatives, asset-backed securities, collateralized loan obligations, and collateralized mortgage obligations. We have said, however, that the book suffers from a lack of deeper reflection and of intellectual context. Fleckenstein is not a deep or systematic thinker about the problems he describes so vividly. Here are some of the voids as we see them: There is no hint that the economic crisis suggests, as well, a profound intellectual crisis, which of course it does. Since the abandonment of the gold standard, with its selfadjusting mechanism that included forcing economic downturns as needed, the modern economy has relied on managed-money through the central bank. The economist Milton Friedman proposed that instead of leaving monetary policy to the central banks discretion, there be a preestablished rule that the money supply be increased by a small increment each year to match economic growth. This was not adopted, and a policy of incremental adjustments to economic conditions, made through changes in the interest rates instead of by watching the quantity and velocity of money, has prevailed. We could call this the wise man at the helm approach to monetary control, since it has counted on insightful guidance in a continuum of changing conditions, making small alterations in direction, to keep all going well. Now, with the collapse in late 2008, the time has surely come when economists must once again check their premises to see where we go from here. Monetary policy as a whole needs reexamination. This must consider, in addition to other factors, the effect of financial globalization on the ability of central banks to control events. It is worth keeping in mind that a sound monetary system is a crucial ingredient of a market economy. Given the dubious basis for the wise-man policy, it would be in order for Fleckenstein to show some compassion for the predicament of the man (here, Greenspan) who was for so long given such a role. According to Fleckenstein, Greenspan rationalized the credit expansion on the ground that computer-driven technology had revolutionized the world of productivity, creating real rather than merely paper values. Fleckenstein treats this as self-evidently wrong, and gives Greenspan no credit for thinking rationally about it. It seems to us that the situation was not nearly so clear as the author makes it out to have been. Was a central banker to ignore the advent of a radically new world of technology and global markets? True, a bubble was being funded; and those who saw the economy in the old terms could see that. But it hardly seems unreasonable to have thought that unprecedented real values were being created that called for a monetary base to support them. A feature of the recent American economy that has hardly received mention in the flood of writing about the 2008 crisis is that the inflating of the supply of money and credit was made politically possible by the fact that major new forces were at work to suppress

the cost of living by bringing in goods and services that were made inexpensive by cheap labor: a flood of imports, as witness the many years of trade deficits; outsourcing and the moving of production out of the country; and vast immigration. Fleckenstein sees this passingly when he says an absolutely essential component of the late-1990s stock bubble was a well-behaved rate of inflation. What felt the brunt of inflation was anything that was not import substitutable, things like health care and college tuition. If those cheaplabor sources are to be continued, thought needs to be given to how they fit into monetary policy and the total economy. It should also be mentioned that while the cheap labor provided cover for the monetary inflation, the easy credit in its turn facilitated and provided cover for the hollowing-out of American manufacturing and of the jobs that went with it. Taken in its entirety, the program was one that fit nicely into globalist ideology, but that ill-served the national interests of the United States. Fleckenstein doesnt explore these facets, even though they would have provided him much fodder for his criticisms of Greenspan (who was, of course, a major figure, among many others, in the long process of deindustrialization). The return to the drawing board on monetary policyand on economic policy in a much broader sense even than thatmust surely be accompanied by a severe reexamination of the ideological hardening-of-the-arteries that has in recent years come to calcify much of the economic profession. There has long been a tension in free-market thinking between those (such as this reviewer) who have favored a market economy but who have thought that to function properly it must enjoy an extensive framework of law and ethics, and those who have argued that economic man is a rational man who, if left to pursue market processes as he will without government interference, will produce not only profit for himself but an optimum result for society at large. The 2008 collapse puts this latter view, which had become the overwhelmingly predominant view, to the test. It is true that there was a certain amount of government intrusion, most conspicuously to force the making of loans to minority borrowers without their meeting sound loan standards (something even the George W. Bush administration promoted); but it is also evident that the real estate loan market was marked by a combination of a damn the torpedoes, full speed ahead profit-taking mentality on the part of those who made lots of money from the making and sale of the low-quality loans and an incredible lack of due diligence on the part of financial institutions and global investors who wound up as the ultimate purchasers of the securitized loan packages. Rational actors, indeed. Unfortunately, the problem goes even deeper than an absence of the putative rational actors. In a society in which many prescient observers have long perceived a mushrooming decadence, the question becomes whether the United States any longer has the resources of morality and competency that a dynamic society and its economy require. The market economy has become transmuted into crony capitalism; the political system has come to be ruled by lobbyists and special interests; individuals and pressure groups clamor to maximize their own short-term gain; experts have fallen into strait-jackets of ideology; and the educational system turns out masses of dullards along with the minority who have the gumption to excel. Fashioning a theory that will work wonders with such materials will require true genius. There are additional important points that Fleckenstein doesnt discuss, but that would go into a complete analysis. One of these has to do with how the money supply is to

be maintained in the environment of a bursting bubble. Milton Friedman, we recall, laid the principal blame for the Great Depression of the 1930s on the Federal Reserves having allowed the money supply to fall drastically. The book under review stops short of making recommendations about how such a crisis should best be met. And although he does discuss the Fed and its chairman, he has nothing to say about the role of the Securities and Exchange Commission (the SEC) in overseeing securities marketssomething that was far-too-little addressed as new forms of speculative securities came into being. Perhaps Fleckenstein would respond that his goal was just a limited one, and that an author isnt to be faulted for not seeking to write a broad treatise. Indeed, the reason to comment on these things is not to find fault with him, but to alert the reader to the need to think much more expansively. Dwight D. Murphey