Unfortunately, his victory has been over the 1990-92 recession, not this one. Like a 1940 French general, hiding behind the Maginot line in the face of a newly mobile enemy, he is proving adept at fighting the previous war.
In 1990-92, Greenspan was worried about high and persistent inflation, which had been the problem for Paul Volcker in the recession of 1980-82. Consequently, he held short-term interest rates high, with M3 money supply almost stationary for two years between 1991-93. This would have proved admirably successful in wringing the inflation of 1980-82 out of the economy. Unfortunately, in 1990-92 the problem was not inflation, except to a limited degree, it was a real estate asset price collapse and banking crisis, combined with a hugely costly bailout of the savings and loan industry. A rapid move to lower interest rates would have allowed distressed asset sales to take place more quickly, the banking system to be re-liquefied, the economy to recover and President George H.W. Bush to be re-elected in 1992. Greenspan's policy did wonders for the political career of one William Jefferson Clinton, but nothing much for the rest of us.
On Dec. 4, 1996, with the Dow Jones Industrial Index around 6,400 Greenspan warned that the stock market was in danger of "irrational exuberance" but then did nothing to correct the mania.
Had he been Fed chairman in December 1986, and made the "irrational exuberance" speech ten years earlier, his inaction following the speech would have been appropriate. On Dec. 4, 1986, the Dow Jones index closed at 1,939.68. The market was undoubtedly in an exuberant mood, with the index having more than doubled since August 1982, and being more than 85 percent above its pre-1982 high. There was indeed considerable speculative froth -- to that extent the exuberance was "irrational." At the same time, the market was still in late 1986 trading well within its historical valuation range, substantially in inflation-adjusted terms below its level of the late 1960s. Greenspan's 1996 policy mix, of talk but no action, would thus have been admirably suited to the circumstances of 1986.
In 1996, however, the market was at more than three times its 1986 level, far above any norms of historical valuation, well above the peak of the 1960's boom in real terms. In 1996, deflationary action was needed, and Greenspan did not provide it. The result was a further 39 months of equity prices rising to levels ever more divorced from reality, and only a modest correction in the two years thereafter, and a huge misallocation of investment.
This time around, Greenspan spotted the recession early, three months indeed before it officially began, and moved swiftly to cut interest rates, making a total of eleven reductions in the Federal funds target rate, from 6.5 percent to 1.75 percent, the lowest in the last 40 years.
Had he done this in 1991 instead of in 2001, his policy would have been entirely appropriate to the deflationary recession that was then under way, and would have led to swift recovery. In the two years to December 1990, M3 money supply had increased at an annual rate of only 2.7 percent, below the level of inflation, so a loosening of policy would have been appropriate. Instead, Greenspan tightened; M3 rose only at 0.7 percent per annum in the two years after December 1990.
In December 2000, the situation was very different. Stock prices were still close to an all time high, far above traditional valuation levels, and the housing market had also enjoyed several good years. M3 money supply in the preceding two years had grown at 8.5 percent per annum, well above the prevailing inflation level. The situation was thus very different from that of December 1990, and the solution should have been correspondingly different.
In the event, Greenspan dropped interest rates, and in the fourteen months since December 2000 has allowed M3 money supply to rise by an extraordinary 14.1 percent per annum, at a time when consumer price inflation has been no more than 1 percent to 2 percent.
The result has been further inflation, not this time in consumer prices, nor in stock prices, which absent Greenspan's huge injection of money into the system would surely have crashed, but of the housing market. Mortgage originations and refinancing have both run at record levels through 2001-02, at a time when economic growth has been close to zero, and the consequence has been a further run-up in house prices, a partial recovery in equity prices, a large increase in consumer spending and indebtedness, and a further decline in the savings rate. As a corollary, the U.S. trade deficit has remained at a record level and indeed has shown signs of increasing further, with February's trade deficit of $28.5 billion, announced today, being substantially above analyst expectations.
At this point, Greenspan has painted himself into a corner. He cannot continue to cut interest rates, there is little further to go. Fiscal policy also cannot help him; the huge surplus of a year ago has been replaced by a deficit, which we project to run close to $200 billion in this fiscal year. With long-term interest rates trending upwards, and the consumer surely tapped out, housing, auto sales and consumer spending generally are surely likely to be weak going forward. The trade deficit will at some stage become unfinanceable, particularly as Japan needs to reflate its own economy by lowering the yen/dollar exchange rate -- thus increasing the U.S. trade deficit as their marvelous exporters roar into action. Slowly, eighteen months after it should have happened, the U.S. economy will head into a second, much deeper dip. The road back from the second dip will be long and hard, probably similar to Japan's tribulations since 1990.
As a counterfactual speculation, suppose in December 2000 Greenspan had decided to fight this war instead of the last one. In that case, he would have recognized the speculative excesses that he should have taken care of four years earlier, and would have raised rather than cutting interest rates. The result would have been a very sharp but short recession, with the Dow Jones index reaching its equilibrium level of around 5,000 in a matter of months. By now, with the asset bubble wrung out of the economy, we could be again returning to economic growth, this time on a basis of sound valuation, lower debt and a trade position close to balance. Only a year, or maybe two of peoples' economically productive lives would have been wasted in the unpleasant downturn, compared with close to a decade that is likely to be wasted going forward.
But that would have required Greenspan to fight the war he is actually faced with. Which, like 1940's General Gamelin faced with Germany's Panzer divisions, would appear to be beyond him.
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