Bailout Nation by Barry Ritholtz Page B

the following year. However, placing this into the context of Greenspan’s tenure as Fed chairman, one gets a very different impression. This was standard operating procedure for Greenspan throughout his Fed career. Targeting asset prices is seen consistently throughout the 1990s. Even his nickname, “the Maestro,” came about due to the way he skillfully “conducted” the markets.
    The Fed’s power to change interest rates as a way to promote and protect asset prices is the key to understanding the Greenspan era. Indeed, it is the crucial economic element that was the precursor to the late 2000 bailouts. Rather than seeing markets as a sign of the economy’s health, the Fed chair tended to see asset prices as an end unto themselves. What this led to was the treatment of symptoms, rather than underlying causes. The markets’ health, rather than the economy’s, seemed to be what was of paramount importance.
    Nobel laureate Paul Krugman, writing presciently in U.S. News & World Report in April 1991, 8 noted the sticky issues that the Fed would be facing in the near future:
    Even if the U.S. economy begins to recover soon, the current recession will leave a lasting legacy in economic policy making. The downturn has undermined public confidence in the Federal Reserve Board because the Fed missed the slump’s early warning signs. A weaker Fed will now find it harder to resist political pressures to keep interest rates low and growth high. (emphasis added)
    Krugman was way ahead of the curve: The public faith in the Fed didn’t falter until after the market crash was well under way (2000-2002). And Greenspan’s reputation didn’t really unravel until the credit crisis and housing collapse were in full bloom (circa 2006-2007). By 2008, the man formerly known as the Maestro saw his reputation in tatters.
    But the key to our tale was the low interest rates. Whether it was a result of political pressure or by his own hand, the story of the Federal Reserve under Greenspan is a tale of acquiescence to those pressures. By February 1994, it had been five years since the Fed had last tightened rates. 9 It was a preview of what would occur a decade later—only the rates would be taken even lower, and the economic damage would be immeasurably greater.
    The tail was just starting to wag the dog.

    O ver the next few years, numerous events would test the bull market that began in 1982. After the recession of 1990-1991, the next major wobble would be the bankruptcy of Orange County, California, late in 1994. That story is yet another book—try Big Bets Gone Bad by Philippe Jorion (Academic Press, 1995)—but for our purposes, we need only note that it caught the Fed’s attention.
    Two weeks later Mexico devalued the peso.
    Markets shook off the bad news. The Dow ended the year under 4,000, but began rising shortly after the calendar flipped. By the middle of 1995, the blue chips were well over 4,500—more than a 13 percent gain in half a year. But concerns about Mexico’s stability and its currency issues began to catch up with the indexes. Markets began to stall in midsummer (see Figure 5.2 ).
    On July 6, 1995, Federal Reserve Chairman Alan Greenspan reversed the string of seven rate increases of the prior 12 months and cut the federal funds rate 25 basis points. The Fed would follow with another 25 basis point rate cut in December and yet another in January of the following year.
    The Fed justified the July and December rate cuts as done to “decrease slightly the degree of pressure on bank reserve positions.” The January 31, 1996, rate cut was put forth because “moderating economic expansion in recent months has reduced potential inflationary pressures going forward. With price and cost trends already subdued, a slight easing of monetary policy is consistent with contained inflation and sustainable growth.”
    Wall Streeters saw it as Alan Greenspan