America has had an odd assortment of Federal Reserve Chairmen. It has had tough ones, such as Paul A. Volcker, who crushed inflation mercilessly in the early 1980s. It has had political ones, such as Arthur F. Burns and G. William Miller, who catered to the election needs of the White House. It has had clueless ones, such as Eugene Meyer, who mistakenly tightened monetary policy after the 1929 stock market crash and helped push the U.S. into the Depression. But it wasn't until Alan Greenspan that the nation had a Fed chairman who combined a devotion to fighting inflation with a willingness to let the economy run, unleashing the benefits of higher productivity.
Greenspan's long tenure as Fed chairman will likely end in less than two years, and his legacy is beginning to generate intense discussion (page 94). But a debate about the rights and wrongs of specific policy moves in the 1990s pales in significance to his greatest achievement. Before him, economists saw the Fed as having a single role--to take away the proverbial "punch bowl" at the economic party by raising interest rates when the economy overheated and inflation rose. Greenspan applied a more dynamic analysis to the economy, understanding before most that it had evolved in the '80s and '90s into a more productive, flexible, and elastic system. He then redefined the goal of the Fed as allowing faster growth while guarding against inflation. Greenspan encouraged the rise of a new risk-taking investor class that made the stock market central to raising capital for innovation, and to higher productivity, growth, and prosperity in America.
Along the way, Greenspan broke the Philips Curve, the principle that inflation inevitably rises when unemployment falls. This conventional wisdom led economists to believe that unemployment should not be allowed to drop below 6%. But under Greenspan unemployment fell below 4% and inflation virtually disappeared. To his credit, Greenspan foresaw that information technology in the '90s was raising productivity levels and the potential speed limit of the U.S. economy. He had the courage to act on his convictions against strong criticism among conservative economists both within and outside the Fed, and allowed the economy to grow faster than they thought possible. This lowered unemployment to new levels, generated enormous wealth for the rich and middle class, and created huge opportunities for millions of poor people and immigrants.
THE UPSIDE OF VOLATILITY
And yes, it did lead to a bubble. Yet it is important to note that, despite the recession and such unexpected shocks as September 11 and the wave of corporate scandals, most of the gains of the boom were not lost in the bust. Stock prices measured by the Standard & Poor's 500-stock index remain twice as high today as they were when the boom started in 1995. With the exceptions of the telecom and tech markets, the economic pain from the bursting of the '90s bubble has been substantially less than after previous bubbles in both the U.S. and Japan.
But what of future Fed policy? Greenspan believes the Fed's successful monetary policy has reduced inflation and the impact of recession to the point where people are willing to take much more risk. But the price may be more booms and busts, more bubbles. Greenspan believes this greater volatility is a fair exchange for long-term gains in capital investment, productivity, economic growth, and prosperity. It can be managed by deft policy.
WHAT COMES NEXT?
There is fear in Washington that the Greenspan era will end with Greenspan. Will the next chairman be able to read the entrails of economic data the way Greenspan can? Will the person act fast enough to temper the impact of burst bubbles? No one can be certain, so a group of economists is calling for a post-Greenspan Fed to adopt "inflation-targeting." They want the next chairman of the Fed to publicly set a target range for inflation and report to Congress on how well it is meeting the goal. Inflation targets would ensure that the Fed reins in the economy if inflation heats up, and boosts the economy if inflation falls too low and becomes deflation. Inflation-targeting would put policy on autopilot and reduce uncertainty. It would also, believes Greenspan, force policy into a straitjacket. The Fed would have to act on historical data and ignore significant changes in the economy. We think Greenspan is right on this one.
A second group of economists, the "anti-bubblists," worry about Greenspan's acceptance of bubbles as a price to pay for long-term growth. They want the next Fed chairman to move early against any big run-up in asset prices in stocks, real estate, or even the dollar. They criticize Greenspan for not boosting interest rates or raising margin requirements on stock purchases in the late '90s, when such actions might have prevented a bubble. This group fears that bubbles lead to deadly deflation, and must be fought, not accepted.
Greenspan believes that the price of puncturing bubbles is too high. Better to wait until bubbles burst and manage the consequences, softening the economic blow by loosening monetary policy very quickly. In speeches, Greenspan has suggested that had it not been for unanticipated events--September 11 and corporate corruption--the economy might have already fully recovered from the damage of the bubble popping. Perhaps. Greenspan was right about productivity. It remains to be seen whether he is right about bubbles, though we suspect he is.
Greenspan served as Fed chairman under Presidents Ronald Reagan, George H.W. Bush, Bill Clinton, and George W. Bush. He leaves a powerful legacy of using flexible monetary policy to generate a high-growth, high-risk economy. His keen intellectual curiosity, his economic insight, and his willingness to contradict conventional wisdom will mark his years in office. Whoever replaces him, when the day finally comes, should understand that legacy and the benefits it has bestowed on the nation.