When Alan Greenspan attended his first Washington Nationals baseball game at the start of this month, he received a hero’s welcome. Federal Reserve Security guards urged the Federal Reserve chairman to sit in an one of the air-conditioned executive suite but Mr Greenspan, a true baseball fan, chose opted for a seat in the stands in the heat of the Washington summer. The 79-year-old central banker, who for 18 years has presided over the setting of US interest rates, was cheered as he arrived. People seated nearby asked him to autograph their tickets. From further back there were shouts of “Go Alan!” and “Yeah, Alan, keep ’em low”.
The Fed chief is due to step down at the end of January, when his term on the central bank’s board of governors expires. As the baseball crowd’s reaction bears witness, suggests, he is the most widely known and indeed the most popular chairman during of the Fed’s 90-year history. At the end of this week, central bankers and top academic and market economists from around the world will gather for the Fed’s summer retreat in Jackson Hole, Wyoming, to give their verdict on the Greenspan era.
Mr Greenspan took over at the Fed on August 11 1987 – two months before “Black Monday”, August 19, when the Dow Jones industrial average dropped 22.6 per cent; the largest daily fall in the history of the US stock market. Mr Greenspan’s immediate response, saying he the Fed would pump money into the financial system to maintain liquidity, helped to put an end to worries about how the central bank would fare after the departure of Paul Volcker, his predecessor.
Since then US economic growth has averaged about 3 per cent a year and the annual rise in the consumer price index has also averaged about 3 per cent. Unemployment has averaged slightly more than 5½ per cent. Mr Greenspan has cemented the Fed’s anti-inflation credibility but his reputation has been built on the flexibility he has shown. demonstrated when unusual times called for unusual measures. There are a number of challenges for his successor, but The overriding challenge for his successor will be to match Mr Greenspan’s record of getting the big calls right.
Mervyn King, governor of the Bank of England, points in an interview points to his counterpart’s deep thinking, flexibility, communication skills and judgment. , as well as the special spin the Fed chairman puts on his tennis serve. He refers to a piece of writing by John Maynard Keynes, the founder of macroeconomics, on another British economist, Alfred Marshall: “Keynes, in his obituary of Marshall, said that a great economist must possess a rare combination of gifts: mathematician, historian, statesman, philosopher. Alan Greenspan embodies that.”
Throughout its 90-year history, the Fed has had strong chairmen: even those who had poor reputations outside the building managed to dominate the policymaking Federal Open Market Committee. made up of the Fed’s seven Washington-based members of the board of governors and the 12 regional Fed presidents. Mr Volcker defeated the inflation of the 1970s, establishing firmly – as unemployment rose above 10 per cent – that, while the Fed has a dual mandate of promoting price stability and full employment, controlling inflation is the priority. primus inter pares. , driving the unemployment rate above 10 per cent. Mr Greenspan has secured the peace. There has been no doubt that controlling inflation has been the primary goal of the FOMC.Mr Greenspan made clear from the outset that he wanted to see lower inflation than the 4 per cent rate he inherited.
Yet it is simplistic to call him a mere inflation hawk. The anti-inflation credibility he earned made it possible to pursue low unemployment. This can be seen in the recent response to oil prices reaching a record high in nominal terms. Because inflation expectations have remained contained, the Fed has not had to act aggressively. Mr Greenspan has been prepared to tolerate higher “headline” inflation at times when it was clear this was not feeding into higher “core” inflation. In the late 1990s, Mr Greenspan he was prepared to test the waters by holding hold rates lower than the conventional wisdom suggested, believing on the basis of his view that a renaissance of US productivity growth had improved the underlying performance of the economy and that globalisation would prove a disinflationary force. There have been times when Mr Greenspan , a master of maintaining a consensus on the FOMC, persuaded his colleagues to raise rates faster than they wanted to – but also times when he has persuaded the FOMC to hold off. In sum, he is better described as an activist than a hawk.
Alan Blinder, who was Princeton professor who was vice-chairman of the Fed from 1994 to 1996, says: “Volcker’s task required iron will and determination. Greenspan faced more subtle and differentiated challenges: what to do about accelerating productivity growth, 4 per cent unemployment, financial crises and a stock market bubble. His calls, for the most part, were terrific.”
Mr Greenspan has been a student of studied the US business cycle since the late 1940s. giving him almost 40 years experience as a forecaster before he became a central banker. At the Fed he has demonstrated shown a mastery of the data, drawing not only on government statistics and proprietary data series developed by the Fed but also on company reports and anecdotal evidence. Allan Meltzer, professor at Carnegie Mellon University and historian of the Fed, says: “He takes in information from a wide variety of sources and distils it rather accurately. I don’t know of any other Fed chairman who has paid so much attention to the daily, weekly, monthly events, in thinking about what they mean and mostly getting it right.”
One product of the Fed chairman’s past experience as a business economist before he became a central banker is a suspicion of the false precision of complex economic models and forecasts that assume that the past is a reliable guide to the future. “The first signs that a relationship may have changed is usually the emergence of events that seem inconsistent with our hypothesis of the way the economic world is supposed to behave,” he told the American Economics Association last year. Often Mr Greenspan’s judgment seems to be informed by powerful accounting identities and simple arithmatic - for example, price equals cost plus profitlooking the pattern of cost increases and profit margins in assessing inflation pressures - which, unlike parameters in an econometric model, are unchanging over time. His early realisation that underlying productivity performance was improving in the 1990s – before it showed up in the official data – rested in part on the observation that profit margins and hourly wages were rising but prices were not, which suggested an improvement in output per hour.
In his speech to the AEA, in which Mr Greenspan gave giving his most detailed explanation of his policymaking approach. He described said the central challenge was decision-making decisions in a highly uncertain economic environment, saying the Fed must consider not only the most likely path for the economy but also a range of risks to growth and inflation, an approach he called “risk management”. The FOMC, he said, must take into account not only the benchmark forecast but also low-probability risks that would have a large impact on the economy. In 2003, for example, the Fed judged it worthwhile to take took insurance against the relatively remote chance that the economy would suffer a debilitating bout of deflation by cutting rates to an unusually low level.
Over the period since 1987 as a whole, the Fed has followed a highly predictable approach. The “Taylor rule” – introduced by John Taylor, of Stanford University, in the early 1990s and developed by other economists – offers a good overall guide to monetary policy in the Greenspan era. It provides an equation which that describes Fed monetary policy as reacting to changes in growth that diverges from the economy’s potential rate, and to inflation relative to a presumed inflation target.That kind of reaction function approach gives a good guide to Fed interest rate changes in the Greenspan era, but not to the nearest quarter point or half point change. in interest rates. And However, there were periods when there were showing large gaps large discrepancies between the Fed’s decisions and what such a policy rule would have suggested. Larry Meyer, founder of the consultancy Macroeconomic Advisers, who was a Fed governor from in 1996-2002, says: “The chairman played by the rules in normal times. There is often this notion that he has a seat-of-his-pants, ‘you can’t write it down’ approach, but the Taylor rule fits extremely well most of the time. What distinguished the chairman was when he had to depart from the rules.”
Many economists believe Mr Greenspan’s crowning achievement was his response to signs of the productivity boom of the 1990s. He understood the change early and acted upon it, allowing the economy to expand faster than many economists thought prudent and unemployment to fall lower than many economists thought was possible without stoking inflation. Common estimates at the time put the non-accelerating rate of unemployment , one of the workhorse models of macroeconomics, at the time put it at about 6 per cent. Mr Greenspan ultimately allowed unemployment to fall below 4 per cent in 2000, and inflation did not take off. Aside from the gains in output from letting the economy grow faster, there were other benefits: wages increased for those with lower incomes down the income scale and companies needing skilled workers invested more in training. Other central bankers, wedded to their traditional models, might have taken a far more conservative approach.
He has distinguished himself in crisis management. In his response to After the crash of 1987 he ignored advice that he should wait and gauge the impact on the economy. He also Mr Greenspan pumped increased liquidity into the market in 1998 after the Asian financial crisis and Russia’s default, he took the same approach, helping to calm the markets, and again in 2001 following after the September 11 terrorist attacks. , when the priority was to ensure adequate liquidity to enable the functioning of the financial system. The way the Fed should deal with a financial crisis is now well established, although ; but there is a wide scope for judgment on how much easing is required in response to a financial disturbance. But While this can be can be explained in terms of risk management, it can also seen as the exercise of typical Greenspan ian discretion.
For example, there is no doubt that Russia’s default in 1998 led to a flight from risk that could have led to greater problems in the US than the near-collapse of Long Term Capital Management, the hedge fund. At the same time, there was little sign of an impact on the US economy. when the Fed cut rates that autumn. The Fed had already left interest rates lower than it might otherwise have done owing to because of the Asian financial crisis and its role as the de facto global central bank, though that is not the mandate Congress gave it. The rate cuts following Russia’s default were just what emerging market countries needed. Mr Greenspan exercised his discretion and the subsequent steady improvement in emerging markets suggests he exercised it well.
Mr Greenspan has contrasted his risk-management approach with the standard academic economist’s confidence in economic models and policy rules. The presumed favourites to replace him – Martin Feldstein of Harvard, University, Glenn Hubbard of Columbia and Ben Bernanke of Princeton – are academic economists, though the White House has made clear said it is considering other candidates including business and Wall Street figures. Henry Kaufman, the Wall Street economist and financial consultant, says: “It is very helpful to have a broad-based individual who knows financial markets.”
Probably the most prominent economist that has ever been chairman of the Fed was Arthur Burns, who came to that assignment with extraordinary academic credentials. But he will not go down in history as one of the great chairman of the Federal Reserve.” The three favourites all have experience of government and forecasting: Mr Feldstein was chairman of the Council of Economic Advisers in the Reagan administration, Mr Hubbard held the same job under George W. Bush, and Mr Bernanke was an influential Fed governor until he was recently appointed CEA chair. OPT CUT REST OF PARA I THINK Don Kohn, the Fed governor and former top staff economist at the Fed, is widely regarded as very close to Mr Greenspan - and someone who has the best understanding of Mr Greenspan’s idiosyncratic approach - is not a political figure, which makes his appointment unlikely. But many economists think the Fed chairman should keep out of political matters unrelated to monetary policy.
Mr Greenspan has been criticised for dabbling too much in politics. He is not a particularly partisan Republican – he supported the Clinton administration’s tax increases of the early 1990s as well as the Bush tax cuts of this decade – but he has an overriding belief in the power of market forces and the benefits of unfettered capitalism. Left to themselves, he believes, financial markets will help to reduce imbalances in the economy.
The most prominent example was his approach to the stock market bubble of the late 1990s. Mr Greenspan’s determination that it was better to deal with the consequences of the stock market bubble, rather than trying to burst it, has largely been borne out by subsequent events. In his AEA speech in January 2004, Mr Greenspan said there was tentative evidence that the approach had been a success. Addressing this week’s At Jackson Hole this week symposium, he is likely to draw a more confident conclusion.
Following After the end of the stock market bubble in 2000, and the a collapse in companies’ investment spending the US suffered a short recession in 2001. Since then, expansion has continued without interruption, in spite of a series of shocks: that have hit the economy: terrorist attacks, the wave of corporate governance and accounting scandals and the Iraq war. “The talk at the Jackson Hole summit in August 2001, just before 9/11, was whether the Fed would go below 3 per cent. No one thought it would go to 1 per cent,” says David Hale, the Chicago-based economist. The FOMC cut the federal funds rate to 1 per cent by summer 2003 mid-2003 and left it there for a year.
Monetary policy in the 2000s in this decade the new millennium has been gives another example of Mr Greenspan’s activist approach and judgment. While some economists feared the US would fall into a Japanese-style deflationary trap, – and Fed economists studied Japan’s experience intensely – the US has remained the engine of world growth. The period also illustrates another feature of the Greenspan era: the Fed’s move towards greater transparency, which started slowly but has gathered pace. in recent years. Mr Greenspan established the federal funds rate as the bank’s tool of policy, although it was not until 1994 that it started announcing the target. During the past two years the FOMC has given guidance on the likely course for the federal funds rate, since June of last year raising the federal funds rate by a quarter-point at each meeting and saying each time that . The committee has said on each occasion time that it expected to continue raising rates at a “measured” pace. This year, the Fed accelerated the publication of began publishing FOMC minutes sooner, making them a more timely guide to the committee’s thinking. started releasing the minutes of the FOMC in-between meetings rather than after the next meeting, making them a more useful guide to the committee’s thinking. The new early publication of the FOMC’s minutes provides greater insight into their deliberations. Previously, the minutes did not come out until after the FOMC’s next meeting. , making them a far less useful guide to its thinking.
Many economists argue that say the next logical step is for the Fed to provide give greater more detail on its medium-term inflation target. That or, in a softer form, an objective or definition of price stability. Inflation targeting, the approach is common approach to policy outside the US is favoured by most academic monetary policy experts. and the Fed has already moved close to inflation targeting. approach. In 2003 it made clear that it did not want to see its preferred core inflation measure move lower – in effect setting the floor for the desired rate at 1 per cent. The view propounded by Mr Bernanke – a leading advocate of inflation targeting – while he was at the Fed that the FOMC has a “comfort zone” of core personal consumption expenditures of 1-2 per cent range has become the rule of thumb inside and outside the Fed. When, beginning in February, the FOMC released forecasts for the next two years, a period over which monetary policy would be expected to influence the outcome, it made clear that its members wanted inflation in the top half of the 1-2 per cent range.
“If you accept the basic facts of economic life, namely that a central bank’s main responsibility is to control inflation and that because you can’t do that on a month-to-month or a quarter-to-quarter basis, and that you have to aim at a longer-term target, then you have to have a systematic procedure for doing it,” Mr Meltzer says. “I think the Fed is very close to inflation targeting, but Greenspan has not wanted to be quite as clear that that is what he does.”
Mr Greenspan has said that whether a central bank has an explicit inflation target affects how policy is discussed internally and communicated externally but probably makes little difference to policy outcomes. Mr King, of the Bank of England, who was invited to respond to Mr Greenspan’s speech at the AEA last year, said he agreed that any sensible approach to monetary policy was explicable in terms of an inflation target and response to shocks. to the economy. The question was the willingness to be explicit. about the definition of price stability, with the potential benefits of credibility, communications and anchoring long-term inflation expectations.
Few would argue that Mr Greenspan’s discretionary approach has been anything but successful. A more formal and clearly explained strategy may help a successor to establish credibility. It will not remove the central challenge. “What do you look for in a chairman? A great forecaster and person with extraordinary judgment,” says Mr Meyer. “There is no taking away from Greenspan the fact that he’s a hall-of-famer and he’s exceptional.”
How to be exuberant and rational
In December 1996, when Alan Greenspan made his famous comment on the possibility of “irrational exuberance” in stock prices, the Dow Jones industrial average stood at 6,400. At its peak in 2000, the Dow hit 11,700. In the subsequent collapse, the index never returned to 1996 levels and now stands above 10,500.
Mr Greenspan’s view that the Fed should not try to burst a bubble by raising interest rates when the outlook does not demand it is based partly on the difficulty, for central bankers, of spotting the difference between an unsustainable surge in prices based on speculation and a sustainable one based on fundamentals. But Mr Greenspan believes in any case that market forces should be allowed to play out and that it is the Fed’s job to pursue policies aimed at low inflation and full employment, not to target asset prices. If a market shift threatens the core mandate, its job is to deal with the consequences.
Alan Blinder, the Princeton professor who is giving a paper on the Greenspan era at this week’s Jackson Hole symposium, calls this the Fed’s “mopping up” strategy.
Mr Greenspan has long argued that there is no guarantee that raising interest rates would have allowed a more gradual deflation of the stock market bubble, pointing to evidence that stock prices rose after the end of the Fed tightening cycles in the late 1980s and early 1990s. Of course, if the Fed had raised interest rates high enough, it would eventually have affected the stock market, but that might also have thrown the economy into recession.
“It is far from obvious that bubbles, even if identified early, can be pre-empted at lower cost than a substantial economic contraction and possible financial destabilisation – the very outcomes we are seeking to avoid,” Mr Greenspan told the American Economic Association last year. The short recession the US suffered in 2001 appears to provide vindication.
Mr Greenspan has suggested that the Fed’s success in securing low inflation and less volatile economic growth may itself lead to more speculation in asset markets, as investors conclude that these good times are likely to continue. Part of the next Fed chairman’s inheritance will be a housing market that Mr Greenspan has said is showing signs of “froth” in a number of cities, amid buy-to-let speculation that has resulted in “speculative fervour” in some areas. At their June meeting, the Fed’s policymaking Federal Open Market Committee discussed house prices and came to the same conclusion as it had with the stock market: the Fed should deal with the consequences in the event of a market disturbance.
Henry Kaufman, the Wall Street economist, believes the FOMC is too sanguine: that the housing market poses grave risks for the economy and that the Fed’s assurances that it will raise rates at a “measured” pace have contributed to a household debt-financed consumption binge and to speculative activity by investors. “The new exuberance is in the housing area, and that problem will have to be resolved by the next chairman,” Mr Kaufman says.
ROOM FOR REFLECTION
In Alan Greenspan’s office adjoining the Federal Reserve’s boardroom, the desk is covered with papers – economic reports, memos, company reports, newspapers – and a number of calculators. There are three screens: a personal computer, a Bloomberg terminal and a television on which the Fed chairman switches between news channels.
On one shelf of the built-in bookcase is a picture of his wife Andrea Mitchell, the NBC television reporter; on another is a signed photo of Margaret Thatcher, as well as photos of Mr Greenspan with past US presidents and world leaders. Also on view is a copy of Adam Smith’s The Wealth of Nations and David Ricardo’s Principles of Political Economy and Taxation, a gift from Gordon Brown, the British chancellor of the exchequer.
Close to the desk, a map of the world is displayed on the wall. The US flag stands on one side of the fireplace, the Federal Reserve flag on the other, and on the mantelpiece is a bronze bust of Abraham Lincoln. Resting in the corner is a wooden baseball bat with Mr Greenspan’s signature carved into it.
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