and I felt we needed to address them.
In early September I had a long-planned date to speak to an audience
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of business scholars at the University of California at Berkeley. I'd intended
to talk about technology and the economy, touching on productivity, innovation,
virtuous cycles, and the like. But as the date drew near, I decided I
couldn't limit my focus to the domestic economy. Not after what had just
happened in Russia. America's problem was not that the U.S. economy had
run out of steam. It was that the imbalances caused by the technology revolution
and rapidly globalizing markets were straining the world's financial
systems.
In my talk, I noted the impact of the turmoil abroad. Up to now, I said,
all it had done was hold down prices and slow demand for U.S. products.
But I warned that as dislocations abroad mounted, feeding back on our financial
markets, these effects would likely intensify. That dimmed the economic
outlook.
"It is just not credible that the United States can remain an oasis of
prosperity unaffected by a world that is experiencing greatly increased
stress," I said. We could never gain the full benefits of the technology revolution
unless the rest of the world shared in the growth. The standard of
living in every nation we did business with had to be a matter of concern.
For many in the audience who'd been riding the wave of the high-tech revolution,
this probably came as news.
I don't think my "oasis of prosperity" remark made much of an impact
that day. But the idea was meant to have a long fuse. I wasn't talking about
the next six months or the next year. America's isolationism runs so deep
that people still haven't let it go. There's always a presumption that since
America is better, we should go it alone.
I told the Berkeley audience that the Russian crisis had prompted a
major rethinking at the Fed. We'd been so focused on domestic inflation
that we hadn't paid enough attention to the warning signs of a possible international
financial breakdown. This was the part of the speech the media
picked up: Wall Street read my message loud and clear that the FOMC was
poised to lower interest rates.
The threat of a worldwide recession seemed increasingly real to me.
And I was convinced that the Fed did not have the power to cope alone.
The financial pressures we faced were on a global scale, and the effort to
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contain them would have to be global too. Bob Rubin shared this view. Behind
the scenes, he and I began contacting the finance ministers and central
bankers of the G7 nations to try to coordinate a policy response. We argued,
quietly but urgently, for the need to increase liquidity and ease interest
rates throughout the developed world.
Some of our counterparts proved very difficult to convince. But at last,
as the markets in Europe closed on September 14, the G7 issued a carefully
written statement. "The balance of risks in the world economy has shifted,"
it declared. It went on to detail how G7 policy would shift too, from singlemindedly
battling inflation toward also fostering growth. As Rubin noted
eloquently in his memoir, as bland as those ten words may have seemed,
they marked a major change in the global financial picture: "Every war has
its weapons, and when you're dealing with volatile financial markets and
jittery investors, the subtleties of a carefully crafted communique, signed
by the top financial authorities in the world's seven largest industrialized
countries, can make a crucial difference."
None of this did much at first to ease the sense of impending doom.
Brazil became the latest victim of the malaise, and Rubin and Summers
spent most of September working with the IMF to craft a rescue. Meanwhile
Bill McDonough, the head of the New York Fed, took on the challenge
of coping with the implosion of one of Wall Street's largest and most
successful hedge funds, Long-Term Capital Management.
Hollywood could not have scripted a more dramatic financial train
wreck. Despite its boring name, LTCM was a proud, high-visibility, high-
prestige operation in Greenwich, Connecticut, that earned spectacular returns
investing a $125 billion portfolio for wealthy clients. Among its
principals were two Nobel-laureate economists, Myron Scholes and Robert
Merton, whose state-of-the-art mathematical models were at the heart of
the firm's money machine. LTCM specialized in risky, lucrative arbitrage
deals in U.S., Japanese, and European bonds, leveraging its bets with more
than $120 billion borrowed from banks. It also carried some $1.25 trillion
in financial derivatives, exotic contracts that were only partly reflected on
its balance sheet. Some of these were speculative investments, and some
were engineered to hedge, or insure, LTCM's portfolio against every imag
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inable risk. (Even after the smoke cleared, no one ever knew for sure how
highly leveraged LTCM was when things started to go wrong. The best estimates
were that it had invested well over $35 for every $1 it actually
owned.)
The Russian default turned out to be the iceberg for this financial Titanic.
That development contorted the markets in a way even the Nobel
winners had never imagined. LTCM's fortunes reversed so abruptly that its
elaborate safeguards never had a chance to work. Practically overnight, its
stunned founders watched the nearly $5 billion in capital they'd built up
drain away.
The New York Fed, whose job is to help maintain order in Wall Street's
markets, tracked LTCM's death spiral. Ordinarily a business that makes a
fatal blunder ought to be left to fail. But the markets were already spooked
and skittish; Bill McDonough worried that if a company of LTCM's size
had to dump its assets on the market, prices could collapse. That would set
off a chain reaction that would bankrupt other firms. So when he called to
say he'd decided to intervene, I wasn't happy with the idea, but I couldn't
disagree.
The story of how he godfathered LTCM's bailout by its creditors has
been told so many times that it is part of Wall Street lore. He literally gathered
top officials of sixteen of the world's most powerful banks and investment
houses in a room; suggested strongly that if they fully comprehended
the losses they would face in a forced fire sale of LTCM's assets, they would
work it out; and left. After days of increasingly tense negotiations, the bankers
came up with an infusion of $3.5 billion for LTCM. That bought the
firm the time it needed to dissolve in an orderly way.
No taxpayer money was spent (except perhaps for some sandwiches
and coffee), but the Fed's intervention touched a populist raw nerve. "Seeing
a Fund as Too Big to Fail, New York Fed Assists Its Bailout," trumpeted
the New York Times on its front page. A few days later, on October 1, McDonough
and I were called before the House Banking Committee to explain
why, as USA Today put it, "a private firm designed for millionaires
[should] be saved by a plan that was brokered and supported by a federal
government organization." The criticism came from both sides of the aisle.
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Congressman Michael Castle, a Delaware Republican, half jokingly said
that his mutual funds and real estate investments weren't doing so well,
but "no one is helping me out." And Congressman Bruce Vento, a Democrat
from Minnesota, complained that we were shielding rich people from the
harsh effects of market forces that often caused misery for the little guy:
"There seem to be two rules," he said, "one for Main Street and another one
for Wall Street."
But telling the banks involved with LTCM that they might save themselves
money if they facilitated an orderly liquidation of the fund was by no
stretch of the imagination a bailout. By facing the harsh reality and acting
in their self-interest, they saved themselves and, I suspect, millions of their
fellow citizens on both Main Street and Wall Street a lot of money.
I was tracking the signs of trouble in the financial world with mounting
concern for how all this might damage the economy. At a speaking engagement
on October 7, after thirty-year treasury bonds hit their lowest interest
rates in thirty years, I threw away my prepared remarks and told an
audience of economists, "I've been watching the U.S. markets for fifty years
and I have never seen anything like this." Specifically, I said, investors in the
bond market were behaving irrationally—paying substantially extra for the
newest, most liquid treasury bonds, even though slightly older but less liquid
ones were equally safe. This rush to liquidity was unprecedented, I
noted, and reflected not judgment but panic. "They basically are saying, 'I
want out. I don't want to know anything about whether an investment is
risky or not. I can't stand the pain. I just want out.' The economists knew
precisely what I was getting at. Panic in a market is like liquid nitrogen—it
can quickly cause a devastating freeze. And indeed, the Fed's research was
already showing that banks were increasingly hesitant to lend.
It took no argument at all to get the FOMC to lower interest rates. We
did so three times in rapid succession, between September 29 and November
17. Other European and Asian central banks, honoring their new G7
commitment, also eased their rates. Gradually, as we'd hoped, the medicine
took hold. The world's markets calmed down, and a year and a half after
the Asian crises began, Bob Rubin was finally able to take an uninterrupted
family vacation.
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The way the Fed responded to the Russian crisis reflected a gradually
evolving departure from the policymaking textbook. Instead of putting all
our energy into achieving the single best forecast and then betting everything
on that; we based our policy response on a range of possible scenarios.
When Russia defaulted, the Fed's mathematical models showed that it was
highly likely that the U.S. economy would continue expanding at a healthy
pace in spite of Russia's problems and with no action by the Fed. Yet we
opted to ease interest rates all the same because of a small but real risk that
the default might disrupt global financial markets enough to severely affect
the United States. That was a new kind of trade-off for us: we judged this
unlikely but potentially greatly destabilizing event to be a greater threat
to economic prosperity than the higher inflation that easier money might
cause. I suspect there had been many such decisions in the Fed's past, but
the underlying decision-making process had never been made systematic or
explicit.
Weighing costs and benefits systematically in this way gradually came
to dominate our policymaking approach. I liked it because it generalized
from a number of ad hoc decisions we'd made in years past. It let us reach
beyond econometric models to factor in broader, though less mathematically
precise, hypotheses about how the world works. Importantly it also
opened the door to the lessons of history: for example, by letting us explore
how the railroad boom of the 1870s might hold clues to behavior in the
markets during the Internet craze.
Some economists still argue that such an approach to policy is too
undisciplined—overly complex, seemingly discretionary, difficult to explain.
They want the Fed to set interest rates according to formal benchmarks and
rules. We should manage the economy, say, to achieve an optimal level of
employment, or by "targeting" a set rate of inflation. I agree that sensible
policies can be made only with the help of rigorous analytic structures. But
too often we have to deal with incomplete and faulty data, unreasoning human
fear, and inadequate legal clarity. As elegant as modern-day econometrics
has become, it is not up to the task of delivering policy prescriptions.
The world economy has become too complex and interlinked. Our policymaking
process must evolve in response to that complexity.
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Isuppose we might have guessed that the last year of the millennium
would be the wildest, giddiest boom year of all. Euphoria swept the U.S.
markets in 1999, partly because the East Asian crises hadn't done us in. If
we'd made it through those, the thinking went, then the future was bright
for as far as the eye could see.
What made this optimism so infectious was that it had a basis in fact.
Driven by technological innovation and helped by strong consumer demand
and other factors, the economy was booming right along. Yet while
the opportunities were real, the degree of hype was surreal. You couldn't
open the paper or read a magazine without encountering stories of the latest
high-tech zillionaires. The head of a major consulting company made
headlines when he quit to start Webvan, a company meant to deliver groceries
ordered over the Internet. It raised $375 million in its initial public
offering. Some London fashionistas I'd never heard of founded something
called Boo.com, an apparel Web site that raised $135 million with a scheme
to become the leading global seller of trendy sportswear. Everybody, it
seemed, had an uncle or a neighbor who'd made big gains on Internet stock.
The Fed, where people are constrained by conflict-of-interest rules from financial
speculation, was probably one of the few places in America where
you could ride an elevator without overhearing stock tips. (Like scores of
other Internet start-ups, Webvan and Boo.com flamed out—in 2001 and
2000, respectively.)
The Internet boom became part of TV news, not just on the networks
