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Greenspan and rise of the central banker

For all his reputation as a monetary magician, the exit of Alan Greenspan Tuesday from the global financial stage calls attention to a deceptively simple fact: He is replaceable.

It's true that Mr. Greenspan achieved the rare status of a Washington oracle, with policymakers and global investors hanging on each of his carefully intoned pronouncements. And although he has his share of critics, his record as Federal Reserve Chairman has elicited not merely praise but awe.

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Yet Greenspan's legacy after nearly two decades goes well beyond his skill in statistics or his personal influence.

Under his leadership, the Fed has built up a reservoir of public confidence - effectively a vault full of credibility on which it can draw in future battles against inflation. Equally important, the Greenspan years were part of a broader trend toward improved monetary policy that goes beyond the man himself.

"It's a worldwide shift," says Alan Blinder, a Princeton University economist and a former Fed vice chairman. "It started before Greenspan, it was furthered by Greenspan, and it will continue after."

In many ways, this was not merely the Greenspan era but the era of the central banker. The furrow-browed "maestro" was cast in the lead role, and his performance made him an icon.

Yet the vanquishing of inflation during the past two decades was a worldwide trend. The progress stemmed in part from benign forces beyond any official's control, such as generally low oil prices. But a vital factor, economists say, was also better policy.

Increasingly, the job of central banker has become a post for professional economists, not former bankers or businessmen. And those economists "no longer divide at all along party lines on monetary policy," Dr. Blinder says.

Consensus on monetary policy

A consensus now exists on many elements of monetary policy - the role that central banks can play by supplying more or less money to the economy.

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The convergence has been bolstered not just by academic theory but by practical experience - notably that of Greenspan's predecessor, Paul Volcker.

Among the basic points:

• Monetary policy can defeat inflation. In the 1970s, policymakers and the public saw that controls on wages and prices failed to curb inflation. But when Chairman Volcker squeezed the money supply in the 1980s, prices finally stabilized.

• Expectations matter. If people don't believe the Fed will maintain a stable price level, they'll inadvertently fuel inflation by acting on those expectations. This made Volcker's job much tougher, and served as a reminder that maintaining credibility is half the Fed's battle.

• Price stability is Job 1. Congress has given the Fed a mandate to seek both stable prices and full employment. In the long run, those goals don't conflict. But in the short run, they can. Volcker's war on inflation cost many their jobs, but the economy finally returned to solid footing.

"The way to get higher growth is to have lower inflation," says Allan Meltzer, an economist and a historian of the Fed at Carnegie Mellon University in Pittsburgh. "The success of the Fed and the Bank of England has done much to convince people that that's the way to go."

Debates remain about many issues in monetary policy, but this larger unity is significant.

"There's a much broader consensus about the importance of keeping one's eyes on the longer-term objectives ... keeping inflation low," says Carl Walsh, an economist at the University of California, Santa Cruz.

Greenspan, he says, helped cement the Fed's reputation for delivering a degree of price stability.

Once a central bank has credibility on that front, he adds, it gains more freedom to adapt as needed to temporary shocks.

The Fed was able to ease its policy, for example, to calm world markets after the combination of a Russian debt default and a giant hedge-fund collapse in 1998. No one worried that Greenspan was going soft on inflation.

Greenspan departs the Fed after Tuesday's policy meeting to launch a consulting business. He leaves behind an enviable record that includes only two brief recessions (in 1990-91 and 2001) during a tenure that lasted from August 1987 through Tuesday.

Dr. Meltzer ranks one achievement as foremost: giving proof "that the economy can have long expansions without inflation." The 10-year period from March 1991 to March 2001 was the US economy's longest recorded period of growth - and far longer than any other peacetime expansion.

Tuesday, for the first time in more than half a century, a Fed chairman will hand over the reins with the "misery index" - the sum of the inflation and unemployment rates - below 10.

A common lament, however, is that Greenspan leaves behind little in the way of a playbook for future Fed chiefs to repeat that performance.

Indeed, if the job is part science and part art, Greenspan embodied the creative side of Fed policymaking. Unlike his successor, economist Ben Bernanke, he does not support the idea of announcing a target rate of inflation. A former jazz saxophonist, Greenspan was known for culling through reports on factory inventories or scrap-steel prices for clues on the economy.

His methods triumphed in the late 1990s, when he detected a hidden surge in productivity. His correct reading of this trend allowed the Fed to let the unemployment rate fall to a level that many said would spark inflationary pressure. Instead the productivity boom acted as a shock absorber against inflation, and joblessness fell to unheard-of lows.

Not without his critics

At various times, investors and politicians criticized his interest-rate policies. The elder President Bush, for instance, reportedly blamed Greenspan for not cutting rates aggressively enough in 1991, something that might have improved the economy - and his prospects for reelection. His most controversial moves, however, may have involved words rather than deeds. Greenspan's support for the Bush tax cuts in 2001, for example, raised questions about his independence from the political process. And some argue that his 1996 remark about the possibility of "irrational exuberance" represented too weak a verbal effort to confront a stock market bubble that finally burst in 2000.

Despite these criticisms, most observers acknowledge the steady hand Greenspan kept on the tiller of the American - and by extension, global - economy. "What if the US had not been managed well?" Raghuram Rajan, chief economist at the International Monetary Fund, asks in an interview by e-mail. "I suspect the world economy would have been worse off."

Potential lessons for Greenspan's successor

Greenspan's admirers, including Princeton economics professors Alan Blinder and Ricardo Reis, say his record provides a host of lessons for future Fed chiefs.

Among them:

• Avoid policy reversals. When adjusting the Fed's interest rate, Greenspan tended to move in small increments - 0.25 percent at any given meeting.

One benefit of this approach: The Fed is less likely to be forced by events to make a dramatic change in the direction of rates, a reversal that can rattle financial markets and erode the credibility of its decisions.

• Ask "What if we're wrong?" The Fed's policymaking committee, led by Greenspan, tempered its consensus on the "best" policy by factoring in what dangers might arise if that policy proved wrong.

Would the greater risk be in tightening too far or easing too much? In 2003, this risk- management view led the Fed to keep its interest rate low to make sure deflation didn't materialize.

• Keep your options open. While aiming to maintain a consistent and predictable policy, the Greenspan-led Fed allowed a place for discretion as well as rules.

Janet Yellen, president of the Federal Reserve Bank of San Francisco, emphasized this in a recent speech. A systematic approach has been highly successful, she says, yet "it has by no means been a straitjacket for policy during the Greenspan years."

• Look at "core" inflation. With the 1970s oil-price spikes fresh in memory, Greenspan guided policymakers to gauge risks by looking at the core inflation rate, with volatile food and energy shifts stripped out. This view diminishes the risk of driving the economy into recession by tightening interest rates in response to a one-time surge in energy prices.

For the past decade, the core inflation rate has hovered around 2 percent a year. Though prices are rising somewhat, the jump is not so fast that businesses or consumers are lying awake at night wondering about the purchasing power of their dollars.

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