The old order was failing. Villainous Wall Street was actually losing its dominant position over American finance… The panic of 1907 was an indication of the extent to which the ability to control crises had moved out of the hands of the New York bankers. The balance of power would soon shift to the Federal Reserve.

William Greider
Secrets of the Temple

Before the creation of the Federal Reserve in 1913, the American economy seemed to move in huge waves of prosperity countered by sometimes prolonged stretches of recession/depression. Since lending was dominated by those who came to be known as “robber barons,” prosperity often hung on the boldness or perhaps reckless abandon of a few monied financiers such as J.P. Morgan. It was Morgan who gave his backing to the administration of Grover Cleveland in the gold crisis in 1895, and the same man who quelled the panic of 1907 by publicly announcing his decision to support stocks on the floor of the New York Stock Exchange backed by a $40 million list of buy tickets. Time, growth, and the internationalization of the American economy, however, inevitably led to the collective decision to take the responsibility of stabilization out of the hands of a few financial titans and instead to institutionalize it, in a body which was to become affectionately known as “the Fed.” Never again (the hope was) would America’s economic fate solicitously hinge on the decision of one individual.

This institutionalization of money was effected in much the same way as our government itself was established in the late eighteenth century. Separation of power was promoted by the establishment of a Board of Governors controlling the Open Market Committee, as well as the initiation of 12 separate Federal Reserve districts, each which in theory was to represent its constituents much like our Senators or Representatives in Congress. But power, if not corrupting, eventually condenses and the Fed was no exception. Strong Federal Reserve Chairmen have throughout its history controlled the ebb and flow of monetary policy much like Morgan did in his prime. Eccles, Martin, Volcker and now Greenspan have taken turns at not only capturing headlines but also “saving” the nation, and perhaps the world, from financial and economic calamity. If Fed Chairman is not the second most powerful position in the world as some have claimed, then it is at least close.

But “powerful” and “omnipotent” are two different words, and only the former is distinctly human. Fed Chairmen have never been omnipotent. Funny, then, to hear the brickbats and watch the rotten tomatoes fly in the direction of Alan Greenspan who, at the peak of the market’s exuberance, had been beatified like no other. Despite having warned against the very exuberance that was escalating stock prices to three-digit multiples of earnings or better yet sales, America’s investment clubs and day traders bore him no grudge. It was as if he was there in principle if not in enthusiasm. As long as he endorsed the New Age Economy and its miraculous increases in productivity then what was there to fear? And had he not “saved” the world at least twice during his fourteen-year reign – once during 1987’s crash and again in 1998 by presciently cutting rates 75 basis points in the midst of Asia/LTCM? Why with Saint Alan deftly guiding the American New Age Economy through its New Age rapids, there was truly nothing to fear. Buying the dips and investing for the long term overtook “thou shalt not steal” and “honor thy Father and Mother” on the exalted list of commandments. Greenspan became the new Moses.

Ah would that it were, or ever was. Greenspan is just a man and the Fed is just a well-intentioned institution. As the market players now begin to recognize this, however, there is no need for vilification or rotten tomatoes. For what? Raising interest rates by 100 basis points or so in the face of accelerating inflation that was grinding upward, while at the same time unemployment was notching below 4%? No, surely not. For warning us years ago that stock prices were vulnerable to a fall? No, the only complaint could be one of premature “market timing.” For keeping interest rates too low, for too long during the early 1990s in an effort to reliquefy the U.S. banking system? Well perhaps a ripe tomato for that one, but a rear view mirror is a great critic. For not focusing on asset prices instead of consumer prices during the bubble’s formation? Perhaps, but as Greenspan said, recognizing bubbles is a tricky affair and best accomplished after the fact. Aside from the NASDAQ, how many of you would now argue that the Dow or the S&P 500 represent bubble markets? I might, but I remain, I fear, in the distinct minority.

So lay off the rotten tomatoes will you. I’ll tell you who did us in. I’ll tell you who caused this recession, and who’s going to be responsible for a tepid, sluggish recovery for the next several years. Pick up a mirror. You’re looking at him. If you consider yourself a capitalist, then you’re looking at him. Animal spirits and yes, irrational exuberance did us in, not Alan Greenspan. Aside from the most obvious banner of viewing the markets as an eternal cornucopia of double-digit returns, our biggest mistake was to stop acting like squirrels and to pretend we were lions. Instead of saving nuts for winter or retirement, we became convinced we were the king of all beasts and could pick off a stray zebra just about anytime we wanted. The following chart tells it all.

Personal Savings
Percent of Disposable Income
 
Source: Goldman Sachs

What it says is that sometime around 1992 or so we stopped saving money like we used to. Historically, 7-8% of our paycheck has been set aside for that proverbial rainy day, but as recently as January of 2001 that savings rate had turned into disavings at the rate of –1%. That of course is great while the ride lasts because it pumps up consumption and GDP, but when it ends there’s usually a piper to be paid in the form of a return to historical averages and less than average consumption. When markets head south and unemployment points north, less confident consumers begin to act like squirrels instead of stately lions. Their squirrelly behavior guarantees at least a significant economic slowdown and when combined with pullbacks in business investment and synchronous global excesses, the combination in my view leads to the big R.

Which brings us back to the Fed and Saint Alan and their inexorable quest to lower interest rates to prevent just such an outcome. Too late, I would claim, and mostly beyond their control. After all, how low do they have to go in order to keep Americans spending money they don’t have? And why would they want to? A healthy savings rate is after all, “healthy” in the long term. What Greenspan does want of course is to temper the slide, and to prevent a sudden rise in the savings rate that would smack of Japanese liquidity trap style depression. And so he and his helpers parade and testify in favor of consumers acting “exuberant” at least in the short term. Fed Governor Meyer tells Americans to go out and buy an SUV and Reserve Bank President McTeer cheerleads by saying that “the consumer…has the means to spend. I’m hopeful (they will).” The means to spend? Is he looking at the same savings chart as I am? Not only the consumer but businesses as well are tapped out, as the following chart displays.

U.S. Private-Sector Net Saving*

*Households' and companies' savings minus investment
**To Q3ce: Goldman Sachs

And so we will proceed through 2001 with a combination of interest rate cuts and cheerleading from our less than omnipotent Fed Chairman, Saint Alan, who never claimed to be one and was doing a pretty good job acting like a human being. We will have our recession; we will have our slow recovery; we will have much less exuberance in the future. The bond market has a few good months left, the stock market may even rally as “bargain hunters” step in. But make no mistake, the days of wine and roses are history. We are about to become a nation of squirrels without a star or a saint to show us the way back to that promised land of 20% returns.

William H. Gross
Managing Director