How this unfolded is a sordid tale, with major ramifications for investors. I’ll share with you what I told clients this week: “This entire crisis traces itself back in large part to then FOMC chair Alan Greenspan not allowing markets and the economy to flush themselves clean after the dot-com collapse. It seems that nearly every Fed/government policy action has been a response to the problems that error led to.”
The Fed — unlike most other central banks — has a dual mandate: To maintain full employment and, at the same time, keep inflation at bay. History informs us that these two factors are often at odds: Growth usually begets price increases, and excessive price elevation retards growth. Hence, for the Fed to do its job well, it has a neat balancing trick to perform.
In the 1990s, the Fed drifted away from those mandates when Greenspan began focusing on markets, asset pricing and a nonsensical catch-all he called “investor confidence.” (Others may point you to earlier dates — you might check out Bill Fleckenstein’s book “Greenspan’s Bubbles.”)
With the bull market in full charge, Greenspan watched investor confidence more and more. This is a tough crowd to play poker with, and once traders deduced that Greenspan was concerned about their sentiment, his cause was lost. It became quite apparent that at the first sign of any market spasm, the Fed stood ready to flood the system with liquidity. In just four short years, markets saw massive Fed responses to the 1) Asian contagion (1997), 2) Russian bond defaults and 3) Long-Term Capital Management Collapse (1998), 4) Y2K bug (1999), 5) Dot-com implosion (2000) and 6) 9/11 (2001).
Thus was born the Greenspan put. Investors had determined that Greenspan would not allow stocks to drop appreciably. This led to appreciably more aggressive trading postures, increased usage of leverage and an overall embrace of risk.
There was no small irony in this. Greenspan — Mr. Free Markets himself — had somehow morphed into Mr. Centrally Planned Economy. This was not lost on the Wall Street community, whose bonuses depended on sniffing out the most lucrative opportunities. What was becoming the obvious answer to that question was wherever Fed liquidity was driving asset prices. For the late 1990s, the answer was upward.
Following the Y2K cash infusion on Oct. 22, 1999, the Nasdaq doubled from 2,500 to 5,100 in six months. The 78 percent collapse it suffered overstates what should have been a more typical 50 percent crash (say 2,500 down to 1,250) had the Fed intervention not occurred. (Savvy traders saw parallels to this in August 2010, when the Fed announced QE2.)