Fed maestro sleeps easy

That entry will need little artificial enhancement. Greenspan’s critics may disagree — more on that later — but there is little doubt that he exits to applause from his fellow central bankers, politicians of most stripes, the financial community and, unusually for a central banker, the public, among whom “he enjoys almost rock-star status”, according to The Economist. The “almost” will not cut too deep, since Greenspan is inured to critics who rank him not only below rock stars, but below his illustrious predecessor, Paul Volcker, revered for slaying the inflation dragon and undoing some of the damage inflicted on the economy by Jimmy Carter.

Ravi Batra, professor of economics at Southern Methodist University, contends that “the real impact of Greenspan’s influence (was to) unwittingly effect ... a global crash and spread economic misery on our planet”. Greenspan, in Batra’s view, leaves in his wake millions without health insurance, mountains of consumer debt and a record number of personal bankruptcies.

Less strident critics complain that Greenspan has handed his successor, Ben Bernanke, a poisoned chalice. By their reckoning, he has kept interest rates too low for too long, and pumped so much liquidity into the economy that Bernanke will have to be adroit to avoid a recession.

The reasoning of Greenspan’s critics goes something like this: by refusing to curb, first, share prices and then house prices, Greenspan has allowed asset bubbles to form by keeping interest rates so low that, in the case of houses, consumers refinanced their mortgages, and used the released equity to shop until they dropped. Except that they didn’t drop: they kept shopping, buying so many imported goods that America’s trade deficit ballooned to an allegedly unsustainable 6+% of GDP.

The US sends foreigners pictures of its presidents printed on green paper, and they send back their manufactured products. Then, not having much use for dollars in Beijing, Tokyo and Riyadh, the foreigners use their dollars to buy the flood of Treasury IOUs issued to cover the federal deficit — the second of the financial “twin towers” that, critics say, will tumble down just as their Trade Center counterparts did. These foreign purchases of our bonds and notes kept long-term interest rates low (low interest rates are the flip side of high bond prices), throwing petrol on the bonfire of consumer spending.

All of this because Greenspan hesitated to raise interest rates to deflate house prices, which even he admits are “frothy” in some regions. Never mind that economists cannot agree that there has been a house-price bubble. After all, the underlying fundamentals dictate a robust market. Demand from baby boomers for second homes, immigrants for starter houses, and increasingly wealthy Americans for bigger homes pressed on a supply limited by planning restrictions. Little wonder that prices headed up.

The critics also ignore the fact that the trade imbalance might be due, in part at least, to the massive savings surpluses in such countries as China, where consumers, acutely aware that the communist regime provides no social safety net or health insurance, save some 50% of their incomes. Add to that the sluggishness of the leading continental European economies, and the consequent low level of demand for imports from America, and you have an explanation of the trade deficit that locates the villain of the piece abroad, rather than in the boardroom of the Fed.

Greenspan’s detractors also stumble over the fact that he has racked up three notable successes. The one of which he claims to be most proud is weaning the Fed off its devotion to economic models. These, he contends, project past relationships into the future, and are only useful when those relationships hold. But in a dynamic economy they often do not — witness what has come to be called the productivity revolution, and globalisation.

Greenspan worked out that the American economy was experiencing a productivity revolution, with workers producing more and more goods in each hour. This made a nonsense of arguments that interest rates must be raised as soon as labour markets tighten, lest wages be bid up and trigger a round of inflation. What Greenspan saw long before others was that employers were finally reaping the benefit of investment in high technology, enabling workers to produce more each hour, allowing compensation to rise without driving up labour costs or prices. Raise compensation, but raise output even more, and costs and prices need not rise.

Greenspan also saw that models based on data from pre-globalisation days were not particularly useful forecasting tools. Globalisation has tripled the potential supply of unskilled and even some skilled labour. For Greenspan this meant that tightness in the American labour market no longer could trigger inflation. Goods made by overseas workers, or by immigrants legal and illegal, were flooding world markets and preventing employers from increasing prices.

No model can capture such changes. Ruptures in the historic relation between labour input, and product output — what we broadly call productivity — and globalisation of markets are too recent to be reflected in historic data. But economic models are based on the assumption that historic relationships hold, and would have forced a rise in interest rates at the first sign of a tightening of the labour market. Greenspan captured what was going on in American factories and markets far more accurately than did the standard econometric models, leaving him free to avoid triggering a slowdown by raising rates, and the Fed with a legacy of scepticism about models.

Greenspan’s second success is less obvious but equally important: he preserved the political independence of the institution he headed. It is easy to forget that his first act as chairman was to raise interest rates, to the displeasure of the man who appointed him, Ronald Reagan, a president who wanted rapid economic growth to produce the promised “morning in America”.

Greenspan also made George Bush senior unhappy by, in the then president’s view, adopting policies that prolonged a mild recession just long enough to allow Bill Clinton to contend that it would take a Democrat to restore prosperity. And the present resident of the White House cannot have been pleased with Greenspan’s criticism of the profligacy of the federal government.

The Fed chairman was also a master at defanging congressional critics at his many appearances before House and Senate committees. Greenspan’s reasoned and precise answers to those who at times urged him to loosen policy, or to tighten, more than he was inclined to, showed respect for their views but an unwillingness to change course to satisfy the political requirements of his critics.

At times, watching Greenspan’s performance, I was reminded of a lawyer friend who once accused me of using language with such precision that it had ceased to be a means of communication. But precision is not obscurantism. There is nothing difficult to understand about “irrational exuberance”, or “Globalisation is changing many of our economic guideposts”, or “The more flexible an economy the greater its ability to self-correct after inevitable, often unanticipated disturbances”.

Greenspan’s third triumph was as a crisis manager. Two months after he was sworn into office Greenspan had to deal with a stock-market crash. During his tenure — he told me he prefers “tenure” to the word I originally planned to use, “reign” — he confronted a collapse of the Mexican peso (December 1994) and of Asian currencies (July 1997), and of the Russian rouble (October 1994 and August 1998). He prevented those crises and the near-collapse of Long Term Capital Management (September 1998) from destabilising the entire financial system. And he saw Wall Street through the fraught period after the attack on the World Trade Center. “At crucial points,” Greenspan said in a speech in 2004, “simple rules will be inadequate.”

The swift injection of liquidity into the system and the successful overall management of these crises enabled the economy to right itself quickly, and to resume what proved to be the two longest expansions on record. Only two very short and very mild recessions (compared with four long and deep ones in the preceding 18 years) blemish an otherwise perfect record that saw the American economy grow at a satisfactory average rate of slightly over 3% during Greenspan’s tenure. This compares with 2.05% in Japan, 2.18% in Germany, 2.44% in Britain, 2.25% in France, 1.67% in Italy and, no surprise, 6.58% in Ireland, which has even lower taxes than America.

Perhaps more important, while leading continental European countries seem unable to bring down double-digit unemployment, the American economy is close to full employment, if not at it. During Greenspan’s tenure the unemployment rate declined to below 5%, as some 30m new jobs were created.

Greenspan would be the first to credit much of the success of his years in the Fed chair to the dynamism, flexibility and entrepreneurial nature of the free-market US economy. And he has fought against policies that would introduce rigidity into the economy — unnecessary regulations, protectionism, taxes that discourage risk-taking and hard work. And, it should be added, what he considers the rigidity of inflation targeting.

It is this that will distinguish Bernanke, an advocate of targeting, from Greenspan, whose approach was characterised by Princeton economists Alan Blinder and Ricardo Reis as “maximum tactical flexibility

... and not much in the way of explanation”. Bernanke has said that at some point people will have to get over the fact that he is not Alan Greenspan, just as they had to get over the fact that Alan Greenspan was not Paul Volcker.

Greenspan preferred the flexibility of not having an explicit inflation. He wanted licence to deploy his vaunted judgment, informed by myriad contacts in the business and financial community, and by masses of data. An explicit target, thinks Greenspan, will force the Fed to raise or lower interest rates when such moves might do more harm than good. Bernanke prefers greater specificity, and an inflation target of 1%-2%, not very different from the informal comfort range used by Greenspan but more binding on the Fed to act.

It is too early to determine whether Greenspan has left a mess for his successor to clean up, or a golden inheritance on which he can build. Bernanke is calmly confident that, come what may, he can handle the job. Good thing, if Bank of England Governor Mervyn King is right that “it is rather unlikely ... the next ten years (will) be as nice as the past ten.”

My own view is that it is impossible to get monetary policy just right, and that when it comes to raising interest rates any Fed chairman has to decide between too little, too late, and too much, too soon. Do the latter and risk recession and deflation, both so difficult to reverse.Raise rates too little and too late, as Greenspan is accused of having done, and you risk a bit of inflation and, it seems, unsustainable increases in the price of assets such as homes and shares. That seems to me the less damaging of the two possible errors, being less likely to throw thousands out of work, and more easily reversible.

So, if the departing chairman has erred, he has chosen the best of the available errors. More likely, the performance of the economy over the last 18 years, and especially in the more recent past, suggests that the honours he wears so lightly are well deserved.

Irwin Stelzer is a business adviser and director of economic policy studies at the Hudson Institute