The Bear's Lair: Life after Greenspan

By MARTIN HUTCHINSON  |  July 19, 2004 at 2:19 PM
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WASHINGTON, July 19 (UPI) -- Speculation has begun on the successor to Federal Reserve Chairman Alan Greenspan, due to leave office when his 14-year term as Federal Reserve Board member ends in January 2006. Whoever his successor, he won't have Greenspan's enormous credibility with the markets, so monetary policy will never be the same. This is probably a good thing.

The consumer price index for June, announced Friday, was up 0.3 percent, more than expected, and consumer prices have been rising at an annual rate of 4.9 percent in the last six months. Since wages have been rising at only 2.6 percent -- in other words falling in real terms -- it's not surprising that retail sales were weak in June, and it's very questionable how much longer the current economic "recovery" is going to last.

Contrary to much calming media and analyst speculation, the rise in inflation is not a one-time blip, but the beginning of a long-term trend, caused primarily by excessive money creation over almost a decade. Further, the May inflow of foreign funds into the U.S. economy was also announced Friday; at $54.8 billion, down from $81.2 billion in April, it dropped for the fourth-successive month. As Federal Reserve governor Susan Bies confirmed after the announcement, the growing reluctance of foreign central banks to invest their hard-earned money in U.S. Treasury bonds is going to weaken the dollar, if only to lessen a little the continuing trade deficit, now running at over $550 billion per annum.

Bies no doubt didn't want to add the corollary that if foreign central banks stop buying Treasuries, and the federal budget deficit continues at its current level, then long-term as well as short-term interest rates must rise. This is obvious at another level, too; if inflation is running at 4.9 percent per annum, or even at the 3.7 percent per annum of June's superficially-anodyne figure, then a Federal Funds rate of 1.25 percent is not the beginnings of restriction, it is still wildly inflationary, being minus 2.5 percent or more in real terms.

Now that inflation has stirred, to the 3.4 percent to 4 percent range, the neutral Federal Funds rate is not 4 percent but at least 6 percent. We are a very long way from that level, and as long as we delay getting there, inflation is likely to accelerate rather than slow. This in turn of course will make the equilibrium Federal Funds rate rise further, a vicious circle last seen in the 1970s, at the end of which the Federal Funds rate peaked at 20.06 percent in the first week of January 1981 (and then people wonder why president Ronald Reagan's policies "produced" recession in his first year of office!)

It is therefore likely that in January 2006, a new Fed chairman will be struggling with a renewed bout of price inflation, being forced to push short-term interest rates higher than the state of the economy would suggest, which in turn will produce a sluggish economy or even a recession, and an unpopular Fed. At that point, whoever is appointed may wonder whether Alan Greenspan's 18 1/2-year Fed chairmanship, with the Fed chairman acquiring unprecedented market credibility, has really been worth it. Indeed, the heretical thought may arise: is huge market credibility for an inevitably fallible Fed chairman a good thing?

Fed Chairmen always want market credibility. It helps them hang onto their job, and it gives them great power, as their lightest utterance is analyzed by the entire forces of Wall Street to divine what the future may bring. Administrations who appoint Fed chairmen also want them to have credibility for one very important reason: a Fed chairman with credibility is much more likely to be able to calm the markets in periods of difficulty, and is therefore likely to preside over a lower average level of interest rates than a Fed chairman with less credibility. The lower interest rates in turn are thought likely to produce higher economic growth.

The best example of a Fed chairman without credibility is the unlucky William Miller in 1979; a perfectly competent Jimmy Carter appointee, he was forced out when inflation refused to die down, and was replaced by the draconian but undoubtedly credible Paul Volcker. All in all, credibility in a Fed chairman is seen as a no-lose proposition, having benefits but no costs.

The benefits claimed for a credible Fed chairman are those claimed before 1931 for the gold standard: greater credibility of the currency and therefore lower average interest rates. However the gold standard, when things went wrong, imposed unpleasant costs on the economy, in terms of having to reduce government spending, raise interest rates, or suffer through a recession. "Fiat" money (i.e. money whose value and quantity is decided by the government, and doesn't depend on a particular commodity) and a credible Fed chairman, on the other hand, appear to pose no such downside costs; the combination seems to offer truly something for nothing, a gift from heaven.

Of course, there's no such thing as a free lunch. Giving Fed chairmen such credibility ought to raise the question of whether they deserve it. And, on balance, most of them don't. As exhaustively chronicled in Milton Friedman and Anna Schwarz' classic 1963 history of monetary policy, the Fed bore a large share of the responsibility for the Great Depression, and total responsibility for the unexpected second downturn in 1937-38, by keeping money supply too tight at a time of severe price deflation.

It is also unquestionably true that Fed chairman William McChesney Martin (1951-70), while having coined the immortal and very apt quote that the Fed chairman's job was to "take away the punchbowl just as the party gets going," was excessively jawboned by President Lyndon Johnson and didn't actually do so in 1966-69, leaving a ghastly legacy for his successor. That successor, Arthur Burns (1970-77) in turn allowed far too rapid a growth in the money supply in 1970-72, ensuring President Richard Nixon's re-election but that his successor, Miller, would fatally lack credibility when the going got rough. Only Volcker (1979-87), of the Fed chairmen who have served more than a couple of years, deserved the credibility that he had coming into the job, and by the middle of his eight year term, he had earned.

Greenspan gained credibility at the beginning of his term, by pumping money into the system after the October 1987 stock market crash, thus ensuring that the crash was remembered as a blip, not a recession. He then increased his credibility in 1991-92 by mistakenly keeping money supply tight, at a time when modest inflation had been caused by the bail-out of the savings and loan industry, thus prolonging the 1990-91 recession and causing President George H.W. Bush to lose the 1992 election. Since 1994, Greenspan has never seen an asset bubble he didn't like, and has prolonged first the stock market bubble of 1996-2000 and then the housing bubble of 2001-04 by an exceptionally loose monetary policy, with interest rates in 2002-04 at record low levels.

Had Greenspan lacked credibility, he would not have been able to achieve this dubious feat. His monetary laxity in the late 1990s would have been scrutinized much more carefully, his repeated statements that a "productivity feast" enabled him to expand money supply more rapidly than otherwise would have been mocked, and his failure to prevent a historic mis-allocation of America's scarce investment resources in 1998-2000 would have been derided. The result would have been a smaller bubble, much more rapidly corrected, a stock and housing market that by now would not be over-valued, and a current outlook that would be for further sound growth in the U.S. economy. By January 2006, as inflation rises and the economy sinks, the advantages of a non-credible Fed chairman will be even more apparent than they are today.

The pre-1931 gold standard, or any truly fixed-parity system, had the enormous advantage that monetary control is close to automatic. Whether politicians like it or not, the market in such a system rewards saving, both government and private, and punishes profligacy, particularly government profligacy, by causing after a relatively short period a financial crisis that forces a policy reversal. To politicians, a fiat money system with a credible Fed chairman seems to offer the best of both worlds: a low inflation, low-interest-rate environment, and only loose controls over public spending or private consumption.

But like all systems where government seeks to outwit the market, this one in the long run (and I quite grant you, it's had a good innings of almost a decade) simply doesn't work. Reducing the power of the fallibly human bureaucrat, by appointing a non-credible Fed chairman, will produce better results in the long run.

Alfred E. Neuman for Fed Chairman!

(The Bear's Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that, in the long '90s boom, the proportion of "sell" recommendations put out by Wall Street houses declined from 9 percent of all research reports to 1 percent and has only modestly rebounded since. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)

Martin Hutchinson is the author of "Great Conservatives" (Academica Press, June 2004) -- details can be found on the Web site

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