In an Uncertain World (46 page)

This thought was very much on my mind when issues about corporate governance came to the fore with the scandals at Enron, WorldCom, and elsewhere. Our system of corporate governance is based on oversight by directors. But if a board meets several times a year for a full day of substantive discussion, even a board member who also sits on a couple of committees and prepares diligently for meetings is unlikely to spend more than two or three hours a week immersed in a company's issues. Some insist that this limitation is an argument for the kind of system that exists in Europe, where directors are much more active and constitute a second layer of management. More active directors may be able to ferret out problems more readily, though Europe has had its share of corporate governance problems over time. In any case, the European system also has real drawbacks, the biggest being that what is in some measure management by committee leaves companies less agile and adaptable, less willing to experiment and take risks, and less decisive.

On balance I much prefer our system of corporate governance—a strong CEO and outside directors with a more limited involvement. There are many who feel that under our system, especially as strengthened by the Sarbanes-Oxley Act of 2002, there is a flow of information to the board that is as effective as under the European model. But even if that is not so, and the potential for undetected mismanagement and corporate disasters is somewhat greater, I still think the benefits of our system greatly outweigh the costs, in terms of overall economic performance over the long run.

The decisive factor in Nasser's eventual departure was the mounting evidence that major problems at Ford did not seem to be improving. A year went by and Nasser still had strong answers, but the cumulative negative evidence seemed weightier. Given more time, Nasser might have turned Ford around and accomplished the much-needed changes, but the risk was that more time would pass without his doing so. Weighing the risks on both sides, the board decided to change direction and make Bill the CEO.

When Bill had said he was prepared to take over the chief executive job himself to get the company back on the right track, I told him I thought the board would be fully supportive. But then I asked him, “Have you thought about how you're going to frame what you're doing in the press?” I warned Bill that the media might depict this change in all kinds of negative ways. “And you won't have two months to get the story right,” I said. “You'll have one day.”

Bill had to walk a fine line on his message. On the one hand, he was stepping in because he was concerned about the company—this wasn't some kind of power grab. On the other hand, he didn't want to focus attention on the company's problems or make them sound worse than they really were. That was another illustration of the principle that providing the prism through which the issue is seen is critical, whether the issue is deficit spending versus tax increases or strengthening Ford versus Ford in trouble or a boardroom coup.

My advice to Bill was to focus very carefully on crafting his message and on a strategy for getting it across in the media. He had to present a constructive view of the future under new leadership and not focus unduly on problems or on past conflict that might make Ford look like a troubled company. I told Bill about my having asked Tom Donilon to help me plan this kind of communications strategy when I had left Treasury, and I suggested that he do something similar. It wasn't that Bill lacked sensitivity to these issues, just that people in corporate life don't tend to develop that kind of political awareness, despite its relevance to their jobs. As it turned out, Bill handled the transition well—both in the media and inside the company—very much helped by Jac's constructive and gracious attitude. And Bill has clearly taken hold as CEO.

   

AFTER I'D BEEN back in New York for some time, Judy and I spent a week traveling around Sicily by boat with six old friends, including Diana and Leon Brittan, who after our days together at Yale Law School had gone on to serve as home secretary under Margaret Thatcher. One day when we were hiking onshore, Diana observed that some British politicians she knew were unable to let go when their time was over and sought to hang on in one way or another, always hoping to re-create what they once had had.

I said I had the same impression about some American political figures. In a similar vein, Richard Holbrooke, who served with great distinction in a variety of high-level foreign policy posts in the Carter and Clinton administrations, once said to me that some people have a sense of self that is so dependent on what they were in Washington that they forever define themselves by that earlier position. Others, Dick added, look back at their time in government as a very special experience, but remain focused on what they're going to do in the future.

The point both Diana and Dick made was an extension of something I'd often observed. People who are heavily dependent on a job for their sense of self become hostage to the job and to those who have power over them. Someone whose identity is not job-dependent, on the other hand, has the ability to walk away, which creates a sense of psychological independence.

In my own case, I can remember back to my early days at Goldman Sachs, when I certainly didn't have the financial freedom I had when I entered government but nonetheless had that same feeling of being able to leave and lead a whole other kind of life. That made it easier both to be independent and candid in my views and to function in a high-pressure environment.

In that same conversation, Diana Brittan also mentioned a friend who held a distinguished British title and had been very successful in business. He had so much, but he had never succeeded in fulfilling his lifelong ambition of becoming a member of the House of Commons. Rather than reflecting proudly on all he had accomplished, he always looked back with great regret on the one distinction he didn't have. That reminded me of a story about Robert Jackson, a distinguished Supreme Court justice who, despite the enormous respect in which he was held, was always consumed by his desire to be chief justice, an ambition that was never fulfilled. Even extremely successful people always seem to want something beyond what they have. Inner needs drive external accomplishments but can never be satisfied by those external accomplishments. Which is merely to say that, for some people, the inability to be satisfied is a chronic condition.

   

MY OWN TIME back in the private sector has been a mix of positives and negatives. First of all, it's been nice to be home again. And in many ways, my arrangement with Citigroup has worked out considerably better than I hoped. I've immersed myself in a set of fascinating substantive and management issues, and I've been at the center of a remarkable institution without having to shoulder operating responsibility. Outside Citi, I've had the good fortune to be deeply involved in public policy issues I care about and institutions that matter to me, including the Harvard Corporation, LISC, the Council on Foreign Relations, and Mount Sinai Medical Center. I don't miss the activities or the perquisites of government, though I do miss the people I worked with and disagree with the direction our country has taken on many fronts.

On the other hand, I've not owned my own time as I thought I would. To some extent, I simply misread myself. Some people seem to be good at moderating their level of engagement, but I've never functioned that way. My post-government experience has reinforced something I've long believed: you take yourself with you wherever you go, so you had better know who you are.

CHAPTER TWELVE

Greed, Fear, and Complacency

WHEN I RETURNED TO NEW YORK in July 1999 and reimmersed myself in the world of markets and finance, I realized in a more palpable way how much had changed in the six and a half years since I'd left. My son Jamie, who was at that time working at the investment firm of Allen & Co., told me that even though I felt I'd kept current, the changes were greater than I thought—partly because of the Internet and technology. Once I began to focus more deeply on what was happening, I realized what Jamie meant.

I started to understand the technological aspect of the change more fully when Arthur Levitt, who was nearing the end of his tenure as chairman of the Securities and Exchange Commission, asked me to sit on an informal task force he had set up to discuss market structure. Arthur and others felt the new technology should enable better, more efficient ways of doing business, and in fact, some market participants were already beginning to do business differently. This study group afforded some insight into the battles waged by the New York Stock Exchange to preserve its traditional advantages and the changes major firms and innovative newcomers were advocating in their own self-interest. The Levitt group wasn't intended to develop firm conclusions, but the debate did help me to understand the technological and other factors that were transforming the financial marketplace—and that continue to do so.

One element was the new scale of activity. I knew that daily trading volumes on the major exchanges had increased by a factor of five—for example, from 211 million shares traded on NASDAQ on my last day at Goldman to 1.1 billion the week I returned to New York. But you had to be around the financial services industry to get a feel for what that increase really meant. The business of private equity, for instance, had mushroomed with the growth of the market, as had hedge funds. In 1992, a hedge fund that managed $100 million in assets would have been considered large. In 1999, many funds exceeded $1 billion, a few ran more than $5 billion, and the number of funds had doubled.

In New York, the social consequences of the boom mentality were everywhere. People had made a ton of money in the market and had increased their spending just as sharply. I heard about couples who instead of getting married in New York City would fly their entire wedding party to Europe. People were building immense houses—often second or third residences. Real estate prices were crazy. Judy and I were thinking of moving out of the co-op we'd lived in since the early 1970s, and we saw an apartment we liked. So we made a bid, well below what seemed to us a bloated asking price, but in our broker's judgment a reasonable offer. Then someone made an offer above the asking price. We gave up looking for a new apartment. What was happening just seemed bizarre.

Several years into the stock market boom, many people seemed to think we'd reached a kind of economic Nirvana. In late 1999, dot-com and telecom stock prices were still increasing rapidly. That summer when I arrived back in New York, the NASDAQ was trading at a little over 2,500—it would hit 4,000 before the end of the year and a high of 5,049 on March 10, 2000. The comments one heard called to mind the fate of Irving Fisher, an eminent economist at Yale in the 1920s. A week before the Crash of 1929, Fisher famously said stock prices had reached a “permanently high plateau.” It was always possible that the world really had changed in the way the market imagined—but a better bet was that the market had gone a bit crazy. I remember a chart I saw in a financial magazine that depicted the historical relationship of the market capitalization of all publicly held stocks to the U.S. gross domestic product. Until 1996, the value of the stock market had never risen above our GDP, which is, after all, the value of all goods and services produced in the United States. In fact, the average since 1925 is a little over 50 percent; at the market's 1929 peak, the ratio was 81 percent. But by March 2000, it had hit 181 percent. The price-earnings ratio of the NASDAQ had risen even more drastically. During the 1980s, it averaged 18.5. In March 2000, it peaked at 82.3. At that point, information technology stocks provided around 16 percent of the earnings of the S&P 500 but represented over twice as much—around 36 percent—of its market capitalization.

Some people I greatly respect do not share my skepticism about many of the widely accepted views about the stock market. One is Steve Einhorn, whom I had worked with at Goldman Sachs, where he had been head of our investment policy and stock selection committees, and later head of global research. For several years, Steve, a top-ranked equity strategist for more than a decade by
Institutional Investor
magazine, has been vice chairman of a large hedge fund in New York. When I sent him a draft of this chapter for comment, Steve reminded me of our first encounter. In his third week at Goldman, he had gotten into a big dispute with me over an arbitrage question about a merger. After being advised by the partner he worked for that this was perhaps not a smart way to start his career at the firm, he came to my office to apologize. He says I told him not to apologize—and to please keep disagreeing with me in the future. A bracing clash of opinions has characterized our relationship ever since. Steve thinks that long-term investors should usually have most of their assets in equities, which have historically outperformed other kinds of investments. He did not think the market levels of the late 1990s reflected collective insanity. Given the strong underlying economic conditions and the low-interest-rate environment, Steve argued that stock prices in the late 1990s, while very high by historical standards, were not demonstrably irrational outside of the tech sector—and therefore subject to normal correction.

My view is that the late 1990s were but one example of the periodic episodes of financial excess that have occurred all through the history of markets. I remember well several of the more recent: the euphoria about conglomerates, whose stock prices went to vast multiples of their earnings in the 1960s; the so-called nifty fifty in the early 1970s—growth stocks such as Polaroid and Avon Products that had innovative products or marketing and were thought to have a limitless future of high growth; the “energy darlings” of the late 1970s; and the southwest real-estate bubble in the early 1980s. The early 1990s saw a biotech boom that foreshadowed another biotech boom at the end of the decade. Excess flows of credit produced by a similar kind of mind-set were at the heart of the Asian financial crisis.

But people involved in markets don't seem to learn from past episodes. They always think,
This time it's different, and here are the reasons why.
Often those reasons are based on genuinely constructive developments, but investors extrapolate too much from the developments and provoke a market overreaction. And that overreaction can endanger the strength of the underlying economy. You might think people would learn from the collective financial experience of mankind. For some reason, they don't.

I expressed something of my view about the seeming inevitability of periodic excesses at the London School of Economics in February 2000, at what turned out to be the eleventh hour of the stock market boom. I said that what had struck me after returning to New York was the pervasive assumption that everything would always be well and that any interruptions in the advance of prosperity would be temporary and mild—solvable, in any case, by the Federal Reserve Board. I was surprised that relatively few others were concerned about historically extreme stock market valuations and other imbalances in the U.S. economy. But even though I was no longer Treasury Secretary, I still had to be careful, on the chance that a comment of mine might affect markets and because I'm mindful of the fact that nobody is very good at predicting the markets' short-term behavior. So I didn't say I thought stocks were overvalued. I said that risk premiums were at historic lows and that discipline tends to get lost in good times.

A number of the people I went to seeking career and financial advice shared my opinion that the market had gone to excess, perhaps badly so. But few were prepared to act in the face of the upward momentum of stocks and the experience of the previous eighteen years. One of the very few who both agreed and acted on that view was Warren Buffett, whom I had known since the 1960s. When we met for breakfast at The Mark hotel in Manhattan, he defended his skepticism about the market.

“Assume today's stock prices are right,” Warren said. “What kind of earnings growth would companies need to warrant those prices?”

The number, extended out to the future and calculated as a share of GDP, was implausibly large. At that point, Buffett's Berkshire Hathaway fund, which had avoided high-priced technology companies, was substantially underperforming the market for the first time in thirty years. People had started to write that Buffett had enjoyed a great career as an investor but hadn't kept current. They said he just didn't understand the fundamental changes taking place.

Others I met with had an interesting duality of view. One of the first people I went to see in New York was Michael Steinhardt, whom I'd known since I'd first gone to work at Goldman Sachs in the late 1960s. Michael had been an extremely successful hedge fund manager for more than thirty years with a reputation as a shrewd and energetic investor.

“I'm a former public servant, coming to seek your assistance,” I said with mock seriousness. “How would you advise this public servant about how to invest his savings?”

Michael laughed. He had disbanded his hedge fund but still actively managed his own not inconsiderable fortune. Karen Cook, whom I had known from the Goldman Sachs trading room, worked with him, reviewing hedge funds as possible investment vehicles. Michael generously offered me full access to Karen's research. He told me he was investing in various stocks and hedge funds.

“But Michael, I don't understand,” I said. “You agree that the market may well be overvalued. And yet you say that you're invested in the market.”

“People like you keep telling me the market is overvalued,” he answered. “But tell me what you think will precipitate a correction.”

“I don't really know exactly what will cause it,” I said. “Won't it just fall of its own weight?”

“But something has to precipitate it,” Michael responded. “And the problem with people like you who keep talking about how overvalued the market is, you can't point to anything that's going to precipitate a fall.”

“Well, it's true,” I said. “I don't have any idea what it will be. But if it's overvalued, it's going to correct. Whatever the proximate precipitator is doesn't matter. It could be anything.”

By 1999, many shrewd investors were in Michael's position. In an analytic sense, they thought the market was overvalued but stayed invested anyway, perhaps on the “greater fool” theory that they could profit from an irrational rise and then sell their positions before it was too late. In any case, the relatively few nonbelievers were irrelevant after an eighteen-year bull market that simply fed on itself. The skeptics among market analysts and forecasters had lost their credibility. Nobody—including me—is particularly good at predicting shorter-term market movement, and if I had been invested in stocks during the later half of the 1990s, I would have sold or lightened up much too early. But it does seem to me that investors should at the least have recognized that many conditions had gone to excess by any historical standards and have given that serious consideration in their decision making.

It was striking during that period not just that financial markets went to extremes but that, when they did, people developed convincing intellectual rationales for those extremes. Those rationales seemed plausible both because they reflected real and positive economic developments and because the ongoing behavior of the market appeared to confirm them. By 1999, after an eight-year boom, many commentators were asserting that productivity growth was going to continue at much higher levels indefinitely and that business cycles were history. Two other widely held views were that the Fed was omnipotent and that the market had misunderstood equities all along, with the result that historical risk premiums—the additional return investors demand to hold stocks rather than “risk free” Treasury bonds—were much too high. While Steve Einhorn is correct that equities have outperformed bonds over any extended period of time historically, some digested this view into the shorthand that stocks simply weren't risky over the long term, or even that short-term declines would always be temporary and that stocks would quickly bounce back.

As an aside, these views provided support for a movement to convert part of the Social Security system into private accounts that could be invested in equities—a political cause that largely faded away after the dramatic market rise of the 1990s came to an end. If this proposal is going to be seriously revived in the political arena at some future time, the very substantial risks attendant to stock ownership should be fully included in the analysis. But it concerns me that the outcome of the debate may be unduly influenced by an ebullient market environment—the only context in which such a proposal is likely to have political viability. Another problem is that there could be irresistible political pressure to make up for shortfalls in accounts for people who retire when market conditions are adverse. This could create additional fiscal problems and skew investment incentives for private account holders. My own view is that we should preserve the guarantee of Social Security, but consider establishing tax credits for savings accounts on top of that, when this is fiscally feasible. If the Social Security guarantee itself needs reform because the system is underfunded, then that is a separate matter that should be dealt with directly.

Each claim about what had changed in the economy reflected some underlying reality. But in most cases, the conclusions for markets were greatly overdrawn. Take the theory that technological advance had led to a structural increase in productivity growth. The issue may not be fully settled, but assume for the sake of argument that the theory's proponents were right. Surely that would be good news for the economy and for stocks. But it was an immense and illogical leap, as some proponents argued, from technological development to permanent and uninterrupted prosperity, with at most brief and mild interruptions. Or consider the view that business cycles had become a thing of the past. It is true that cyclical recessions have tended to become progressively less severe since the end of the Second World War, in part because of various social safety net programs, such as unemployment insurance and welfare, which increase government spending when the economy is weaker, and because monetary policy has become more effective. However, business cycles remain, because the constants of human nature, such as greed, fear, and complacency, have not changed. As for the Fed, it has indeed become a far more important factor in the economy in recent decades, but it is not powerful enough to prevent all slowdowns. Perhaps risk premiums were once too high, but that didn't mean that stocks weren't still significantly riskier than Treasury bonds.