The Man Who Knew: The Life and Times of Alan Greenspan (Penguin Press, 2016), won the 2016 Financial Times and McKinsey Business Book of the Year.
Smick: Your new book is a unique achievement. Instead of the normal black-or-white biographical approach, you present former Federal Reserve Chairman Alan Greenspan in shades of gray. No decision ever lacked unintended consequences. Mistakes were put in context. But what is it about us that we can't resist from time to time creating a superman? In this case, a maestro?
Mallaby: A gridlocked political system, as exists in the United States, creates frustration, and that frustration breeds a hunger for supermen who will cut through the gridlock, rise above politics, and act as the saviors.
Smick: Would the average person reading this book conclude that central banking is a bit of a confidence game? It tries to create the impression that a small group of policy officials in Washington, D.C., really know more than the rest of the market. The central bankers are disastrous at predicting asset prices. They're poor at identifying bubbles until it's too late. They can't seem to decide whether we are reflating or disinflating. Is your book essentially is an indictment of the profession?
Mallaby: My book is a warning against the specific superman about whom I write. Greenspan's reputation did overshoot, which not only created a false impression which then had to be corrected, painfully, for him. It also lulled traders and banks into a false sense of security that they could take excess leverage because a maestro was in control of the system. That was an unhealthy impression.
The message at the end of the book is that fighting bubbles and financial instability is extremely difficult and we shouldn't bet that either regulation or monetary policy can reliably head off future instability.
You asked whether central banking is a confidence game. Well, central bankers have three sources of power. One is early access to data. The second is a fairly formidable team of model builders and forecasters. I doubt there's any other center of analysis of the macro economy, whether it's a bank like JPMorgan or a university, that really rivals the engine room of the Fed.
Advantage number three is that the central bank can create money, and it traditionally has used that power to conduct open market operations and peg the short-term interest rate. It has demonstrated more recently that it can do the same thing via quantitative easing on longer-term interest rates.
Traders need to think about what the central bank is going to do. Some hedge funds, for example, go to great lengths to understand who is the big elephant in the marketplace--who is the big institutional investor whose selling might move the price of the stock. The central bank is that, but on steroids. Its activity in the government bond markets, traditionally at the short end but sometimes also at the longer end, will move the price. To that extent, central bankers really are powerful.
Where they are not so powerful or omniscient is in understanding the relationship between the interest rates that they do set and other parts of the yield curve. A constant theme in my book is that the Fed would do something at the short end, and then be surprised about what happened at the long end. Greenspan described the flat yield curve at the end of his tenure as a "conundrum," but it was not new. The same thing existed in the 1970s. My chapter, "The First Housing Conundrum," describes how the expansion of Fannie Mae and Freddie Mac meant that longer-term borrowing rates, particularly for mortgages, were not responding to monetary policy as they would have done before. Just as in 2004 and 2005, the Fed was hiking short rates but longer rates were not responding.
Equally, the Fed was completely wrong in 1994 when it thought that a hike in short rates would cause long rates to remain calm. The theory was that the hike in short rates would signal seriousness about inflation, which would mean lower inflation expectations, which would mean lower long-term bond rates. Instead, long-term rates went up sharply, the bond market crashed, and hedge fund manager Michael Steinhardt and other traders suffered enormous losses. That uncertainty about the yield curve is one way in which central bankers are not powerful.
The way central bankers think about their tools and their objectives changes rather rapidly. If at any given moment we hear central bankers speak as if they are the possessors of the golden key, the truth is they're redesigning their key all the time so it can't be golden. It's not right to think of central banks as having a fixed and settled understanding of what they're doing. They're constantly improvising.
Smick: You called Alan Greenspan a "manipulative genius." You say he was very good at developing a fawning press that played its part in the confidence game. You describe the television reporters fixating on the size of his briefcase, for example. How much of that manipulation was a sideshow? Weren't there powerful global forces at work, particularly after the fall of the Berlin Wall, that had an effect on long-term interest rates and the mispricing of financial assets?
Mallaby: In some sense, Greenspan was less good at controlling the economy than he was at controlling the perception that he could control the economy. The "manipulative genius" lay in shaping how people saw him and the awe in which he was held, even as his real power over what was going on in the macro economy was less than people thought.
To be fair, Greenspan understood that those powerful secular forces were in operation. More than anybody else, he understood that globalization and the China effect would mean that import prices were being held down, contributing to disinflation. He understood that technology was taking pressure off prices. In his 2007 book, The Age of Turbulence, the last chapter is devoted to an acknowledgement that he presided in an extraordinary time when these tailwinds of technology and globalization were helping him.
Even so, Greenspan still achieved a lot. People forget how, during the first George Bush Administration from 1989-1993, Greenspan was under huge amounts of political pressure. The Fed's independence was not yet established. Both the Reagan Administration and the Bush Administration were perfectly happy to put pressure on the Fed. The idea that then-Chairman Paul Volcker established the Fed's authority is not quite right. There was more to be done. Greenspan did it, partly by refusing to cave to pressure from the Bush White...