clared in his acceptance speech at the Republican convention: "Read my
lips: no new taxes." It was a memorable line, but at some point he was going
to have to tackle the deficit—and he'd tied one hand behind his back.
People were surprised by the thoroughness with which the new administration
replaced Reagan appointees. My friend Martin Anderson, who had
long since shifted out of Washington back to the Hoover Institution in California,
joked that Bush fired more Republicans than Dukakis would have.
But I told him it didn't bother me. It was a new president's prerogative, and
the moves did not affect the Fed. Besides, the senior economic team com
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ing in—Treasury Secretary Nicholas Brady Budget Director Richard Dar-
man, CEA chairman Michael Boskin, and others—were longtime professional
acquaintances and friends of mine. (Jim Baker, of course, moved
up to become secretary of state.)
My main concern, shared by many senior people within the Fed, was
that the new administration attack the deficit right away, while the economy
was still strong enough to absorb the shock of cuts in federal spending.
Big deficits have an insidious effect. When the government overspends, it
must borrow to balance its books. It borrows by selling treasury securities,
which siphons away capital that could otherwise be invested in the private
economy. Our deficits had been running so high—well over $150 billion a
year on average for five years—that we were undermining the economy I
highlighted this problem just after the election, testifying before the National
Economic Commission, a bipartisan group Reagan had set up in the
wake of the 1987 crash. The deficit was no longer a manana problem, I told
them: "The long run is rapidly becoming the short run. If we do not act
promptly, the effects will be increasingly felt and with some immediacy."
Unsurprisingly, because of Bush's no-new-taxes pledge, the commission
ended in a stalemate, with the Republicans arguing that spending should be
cut and the Democrats arguing to raise taxes, and it never had any effect.
I quickly found myself in the same public conflict with President Bush
that we'd had during the campaign. In January, I testified to the House Banking
Committee that inflation risks were still high enough that Fed policy
would be to "err more on the side of restrictiveness rather than stimulus." The
next day with reporters, the president challenged this approach. "I do not
want to see us move so strongly against inflation that we impede growth,"
he said. Normally such differences would get aired and resolved behind the
scenes. I'd been looking toward building the same collaborative relationship
with the White House that I'd seen during the Ford administration
and that I knew had existed at times between Reagan and Paul Volcker. It
was not to be. Great things happened on George Bush's watch: the fall of
the Berlin Wall, the end of the cold war, a clear victory in the Persian Gulf,
and the negotiation of the NAFTA agreement to free North American
trade. But the economy was his Achilles' heel, and as a result we ended up
with a terrible relationship.
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He faced a worsening trade deficit and the politically damaging phenomenon
of factories moving overseas. The pressure to cut the federal deficit
finally forced him; in July 1990, to accept a budget compromise in which
he broke his no-new-taxes pledge. Just days later came Iraq's invasion of
Kuwait. The ensuing Gulf War proved to be great for his approval ratings.
But the crisis also threw the economy into the recession we'd been worried
about, as oil prices rose and uncertainty hurt consumer confidence. Worse
still, the recovery, which began in early 1991, was unusually slow and anemic.
Most of these events were beyond anyone's control, but they still made
"the economy, stupid" an effective way for Bill Clinton to beat Bush in the
1992 election, despite the fact that the economy during that year had
grown by 4.1 percent.
Two factors greatly complicated the economic picture. The first was the
collapse of America's thrift industry, which put a big, unexpected drain on the
federal budget. Savings and loans, which had been instituted in their modern
form to finance the building of the suburbs after World War II, had been
failing in waves for a decade. The inflation of the seventies—compounded
by mismanaged deregulation and, ultimately, fraud—did hundreds of them
in. As originally conceived, an S&L was a simple mortgage machine, not
much different from the Bailey Building and Loan run by Jimmy Stewart
in It's a Wonderful Life. Typically, customers would deposit money in passbook
savings accounts, which paid only 3 percent interest but were federally
insured; then the S&L would lend out those funds in the form of
thirty-year mortgages at 6 percent interest. As a result, S&Ls for decades
were dependable moneymakers—and the thrift industry grew huge, with
more than 3,600 institutions and $1.5 trillion in assets by 1987.
But inflation spelled doom for this tidy state of affairs. It drove both
short-term and long-term interest rates sharply higher, putting the S&Ls in a
terrible squeeze. For the typical S&L, the cost of deposits soared immediately,
but because the mortgage portfolios turned over only slowly, revenues
lagged. Soon many S&Ls were in the red, and by 1989 the great majority
were technically insolvent: if they'd sold all their loans, they wouldn't have
had enough money to pay off all their depositors.
Congress tried repeatedly to prop up the industry but mainly succeeded
in making the problem worse. Just in time for the building boom of
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the Reagan era, it increased the level of taxpayer-funded deposit insurance
(from $40,000 to $100,000 per account) and relaxed the restrictions on
the kinds of loans S&Ls could make. Before long, emboldened S&L executives
were financing skyscrapers and resorts and thousands of other projects
that in many cases they barely understood, and they were often losing their
shirts.
Others took advantage of the loosened rules to commit fraud—most
notoriously Charles Keating, a West Coast entrepreneur who was ultimately
sent to prison for racketeering and fraud for having misled investors through
sham real estate transactions and the sale of worthless junk bonds. Salesmen
at Keating's Lincoln Savings were also said to have talked unsophisticated
people into shifting their savings from passbook accounts into risky,
uninsured ventures controlled by him. When the business collapsed, cleaning
up the mess cost taxpayers $3.4 billion, and as many as twenty-five
thousand bond buyers lost an estimated $250 million. The revelation in
1990 that Keating and other S&L executives were major contributors to
Senate campaigns made for a full-blown Washington drama.
I had a complicated involvement in this mess not only because of my
job but also because of a study I'd done while still a private consultant.
Years before, at Townsend-Greenspan, a major law firm representing Keating
had hired me to evaluate whether Lincoln was financially healthy
enough to be allowed to invest directly in real estate. I'd concluded that
with its then highly liquid balance sheet, it could do so safely. This was before
Keating undertook dangerous increases in the leveraging of his balance
sheet and long before he was exposed as a scoundrel. To this day I don't
know whether he'd started committing crimes by the time I began my research.
My report surfaced when the Senate Ethics Committee opened
hearings into Keating's connections to five senators, who came to be known
as the Keating Five. John McCain, one of those being investigated, testified
that my assessment had helped reassure him about Keating. I told the New
York Times that I was embarrassed by my failure to foresee what the company
would do, and added, "I was wrong about Lincoln."
The incident was doubly painful for me because it caused trouble for
Andrea. By this time she had become her network's chief congressional correspondent,
and she was covering the Keating scandal. Andrea had always
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THE AGE OF TURBULENCE
taken extreme care to keep what she called a firewall between my work
and hers as our relationship deepened. For example, she never attended any
of my congressional testimonies; she strove to avoid even the appearance of
a conflict of interest. The Keating hearings put this to the test. Reluctantly,
Andrea decided to take herself off the story while the news media explored
my connection to the case.
No one knew how much the final cleanup of the thrift industry would
cost taxpayers—the estimates were in the hundreds of billions of dollars.
As the work proceeded, the drain on the Treasury was perceptible, worsening
the fiscal challenge for President Bush. The job of trying to recoup some
of the losses fell to the Resolution Trust Corporation, which Congress had
created in 1989 to sell off the assets of the ruined companies. I was on its
oversight board, which was chaired by Treasury Secretary Brady and included
Jack Kemp, then the secretary of housing and urban development;
real estate developer Robert Larson; and former Fed governor Philip Jackson.
The RTC had a professional staff, but for me by early 1991 being on
the oversight board was almost like having a second job. I spent large
amounts of time poring over detailed documents and attending meetings.
The vast numbers of uninhabited properties we managed were deteriorating
rapidly from lack of maintenance, and unless we moved quickly to get
rid of them, we would end up with one huge write-off. Moreover, we would
probably have been saddled with a bill to tear a lot of them down. I kept
adding up the cost in my mind. It was not a pretty thought.
S&L mortgages that were still paying interest had sold off readily in the
market. But now the RTC had gotten down to the assets nobody seemed to
want: half-built malls in the desert, marinas, golf courses, tacky new condo
complexes in overbuilt residential markets, repossessed half-empty office
buildings, uranium mines. The scope of the problem beggared the imagination:
Bill Seidman, who chaired both the RTC and the Federal Deposit
Insurance Corporation, calculated that if the RTC sold off $1 million of assets
a day, it would need three hundred years to sell them all. Clearly, we
needed a different approach.
I'm not sure who came up with the creative sales idea. As we finally
presented it, the plan was to group the properties into $ 1 billion blocks. For
the first package, which we offered at auction, we especially solicited the
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bids of a few dozen qualified buyers, mostly businesses with track records
of turning around sick properties. "Qualified" doesn't necessarily mean
"savory"—the groups we approached included so-called vulture funds and
speculators whose reputations could have used a face-lift.
Only a few bids materialized, and the package went for a comparative
song—just over $500 million. What's more, the winning bidder had to
make a down payment of only a fraction of the price, and then pay installments
based on how much cash the properties generated. The deal looked
like a giveaway, and as we'd expected, public watchdogs and Congress were
outraged. But there's nothing like a bargain to stimulate demand. Large
numbers of greedy investors rushed to get in on the action, the prices of the
remaining blocks of property soared, and within a few months the RTC's
shelves were stripped bare. By the time it disbanded in 1995, the RTC had
liquidated 744 S&Ls—more than a quarter of the industry. But thanks in
part to the asset sales, the total bill to taxpayers was $87 billion, far less
than originally feared.
Commercial banks also were in serious trouble. This was an even bigger
headache than the S&Ls because banks represent a far larger and more important
sector of the economy. The late 1980s was their worst period since
the Depression; hundreds of small and medium-size banks failed, and giants
like Citibank and Chase Manhattan were in distress. Their problem, as with
the S&Ls, was too much speculative lending: in the early eighties, the major
banks had gambled on Latin American debt, and then, as those loans went
bad, like amateur gamblers trying to get square they'd bet even more by
leading the whole industry into a binge of commercial real estate lending.
The inevitable collapse of the real estate boom really shook the banks.
Uncertainty about the value of the real estate collateral securing their loans
made bankers unsure how much capital they actually had—leaving many
of them paralyzed, frightened, and reluctant to lend further. Big businesses
were able to tap other sources of funds, such as innovative debt markets
that had sprung up on Wall Street—a phenomenon that helped keep the
1990 recession shallow. But small and midsize manufacturers and merchants
all over America were finding it hard to get even routine business
loans approved. And that, in turn, made the recession unusually difficult to
snap out of.
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Nothing we did at the Fed seemed to work. We'd begun easing interest
rates well before the recession hit, but the economy had stopped responding.
Even though we lowered the fed funds rate no fewer than twenty-
three times in the three-year period between July 1989 and July 1992, the
recovery was one of the most sluggish on record. "The U.S. economy is best
described as moving forward, but in the teeth of a fifty-mile-an-hour headwind"
was how I explained the situation to an audience of worried New
England businessmen in October 1991.1 couldn't be very encouraging, because
