Since the 1980s, speculation in U.S. financial markets has been supported by first the Greenspan “Put” and then the Bernanke “Put.” These puts – informal promises by the Federal Reserve Bank to protect the value of stocks and bonds and prevent destructive crashes, will come to an end if the Fed stops buying housing bonds and allows interest rates to rise this fall.
The wealthiest 1% of Americans, who own about 33% of the total value of stocks and bonds on Wall Street, are upset about the amount of risk they face without the Fed pouring money into the economy.
PART I To understand why the stock market jumps up and down depending on what Ben Bernanke says, you have to understand the Greenspan “Put.” In the 1970s, the post-WWII golden age of American prosperity came to an end. The combination of staggering oil price increases, fierce competition from foreign imports, and resistance to wage cutbacks by unionized workers led to “Stagflation” – an unhappy world of slow growth and high inflation.
Profits for non-financial corporations were squeezed by these trends; in the late 1970s the rate alternated between 2% and 4%, less than half the profit rate of the 1950s and one third of the profit rate of the mid-1960s.
In response to intense competition from modern factories in Germany, France, and Japan, U.S. industrial firms began what Barry Bluestone and Bennett Harrison wrote about in their ground-breaking book The De-Industrialization of America. In a process that now seems commonplace to us, many companies closed old, unionized factories in the northeast and mid-west, moving them first to the south and then overseas.
Other manufacturing firms were purchased, their assets sold for cash, and the shell of the company then allowed to go bankrupt. The blockbuster movie Wall Street captures the ruthless scramble to turn factories into cash in the 1980s.
With investment in tangible production assets becoming more risky and less profitable, American banks and investors began turning to financial speculation as a way to maximize their returns. The newly elected Reagan administration was eager to help, persuading Congress to loosen regulatory restrictions on the savings and loan industry and stocking the government with regulators who looked the other way when new financial instruments like “junk bonds” appeared on Wall Street.
The explosive growth in these new financial products was fueled by a rapid and costly defense build-up which led to federal deficits of 6.1% of GDP in 1983, 5.2% in 1985 and 5.1% in 1986 – the largest peace-time deficits in U.S. history. These deficits led to wild speculative excesses on Wall Street, vividly captured in Tom Wolfe’s novel Bonfire of the Vanities.
Alan Greenspan, formerly Chairman of Gerald Ford’s Council of Economic Advisors, was appointed chairman of the Federal Reserve in August of 1987, at a time when the roaring stock market had soared 44% in just one year. Then, on October 19, 1987, a day after the Hong Kong the stock market collapsed, Wall Street stumbled into full financial panic, losing 22.5% of its value in a single day. Greenspan immediately stepped in, providing large loans to banks and lowering interest rates. He announced that the Fed “affirmed today its readiness to serve as a source of liquidity to support the economic and financial system.”
Greenspan, over the course of five terms as Fed chairman, would demonstrate again and again that the Federal Reserve was ready to pump money into the economy any time the financial markets got into trouble. This guarantee of support became known as the Greenspan “Put.” In the world of finance, a “put” is a contract that gives its owner the right to sell a stock or bond at a certain price regardless of whether the market is falling – essentially a guarantee against severe losses.
With the Greenspan “Put,” banks and investment companies could take more risks. In response, they began inventing the world of derivatives, hedge funds, sub-prime mortgages, and securitization of loans that proved so unstable in 2000 and 2008.
Next week in Part II, I will look at two examples of the Greenspan “Put” and then show how Bernanke has done even more than Greenspan.
Postscript: Front page headline in the Wall Street Journal on Friday the 11th, the day after I put up this post: “Stocks Surge to Fresh Highs: Skittish Investors Gain Courage From Fed Chief’s Reassurance on Easy-Money Policy.”