Bailout Nation by Barry Ritholtz Page A

than 40 percent for the year, the first 10 weeks of 2009 saw the markets fall another 22 percent.
    Worst annual decline in eight decades? Down another 22 percent in two months? Geez, how incompetent must a secret market-manipulating organization be before someone gets fired?

    H istory teaches us that the development of Bailout Nation, Wall Street edition, was not done in secret meetings. Rather, it occurred in the very public functions of the Federal Reserve, and the subsequent results of its policy actions.
    The Greenspan Fed created an endemic culture of excessive risk taking. The U.S. central bank created moral hazard not by targeting inflation or the business cycle, but instead by focusing on asset prices. From the squishy focus on psychology, it was merely a short hop to asset prices. After all, when prices go down, it negatively impacts sentiment, right? This was the Fed’s fatal flaw under Greenspan’s leadership. As we shall see, once those in the capital markets realized that the Fed stood ready to protect the downside via monetary reflation, all bets were on higher prices.
    It’s worth recalling that the 1987 crash came mere months into Greenspan’s tenure. The rookie Fed chairman earned high praise for his handling of the situation. There were reports of a mysterious trader entering the S&P futures pits in Chicago to make a large buy order, which helped finally stem the decline; whether that person was an agent of the federal government or just part of Wall Street mythology remains a mystery. But the truth is enough people believed Greenspan’s Fed would approve such an intervention that it helped restore confidence in the markets.
    Indeed, one can make a case that Greenspan learned early on that the solution to every problem was to throw money at it— liquidity in the parlance of central bankers—even though doing so ultimately leads to bigger problems down the road.
    The 1987 crash was unusual, in that it was a market-based—as opposed to an economic—event. After a 40 percent rise in the first eight months of the year, prices had simply gotten way too far ahead of themselves.
    The 1990-1991 recession was a more typical economic event. 6 A variety of macroeconomic factors contributed to the slowdown: The S&L crisis, a real estate slump, the first Gulf War, and a spike in energy prices had all taken their toll. Chairman Greenspan found himself hobbled by a near open revolt of FOMC governors. The Fed “curtailed the authority of its chairman, Alan Greenspan, to reduce rates on his own” in between meetings. 7
    It seems that Greenspan couldn’t help himself: He cut rates half a point just days prior to the February FOMC meeting, despite signs of an economic recovery in the making. This upset the FOMC Board of Governors a great deal.
    Why would a Fed chair risk the ire and support of his board—and only a few days before the next FOMC meeting? Perhaps a chart of the equity markets might provide some insight (see Figure 5.1 ).
    Note: The small circles are quarter-point rate cuts; the large circle is a half-point cut. The last cut in 1990 and the first two in 1991 were intermeeting. There would be seven more quarter-point cuts in 1991, and a half-point “Christmas present cut” in late December 1991. By the end of 1992, Fed rates would be as low as 3 percent—and would stay that low until February 1994.
    One cannot help but notice how unusual this action was: a half-point cut, made by a Fed chair acting alone, mere days before the next FOMC meeting and with the Dow already in rally mode. While one can never know exactly what another person is thinking, Greenspan’s actions certainly have the appearance of attempting to spur the equity markets.
    Figure 5.1 Dow Jones Industrial Average, 1990-1991

    By itself, this action can be in part rationalized by other factors—the economic slowdown, the high price of oil, perhaps even the presidential election