Can We Bank on the Federal Reserve?

Was Greenspan a bubble blower? Should Bernanke stay the course? Five experts judge the powers and perils of the world's mightiest central bank.

Brian Doherty from the November 2006 issue

Earlier this year, the Federal Reserve—that citadel of inscrutable power, able to goose conspiracy theories as quickly as interest rates—lost a chairman. Alan Green¬span, whose tenure lasted almost two decades, is the most celebrated Fed chief in the bank's nearly century-long history. His successor, Benjamin Bernanke, has big shoes to fill—and many possible hazards to sidestep.

Established in 1913, the Federal Reserve is America's central bank, run by a board of seven governors who are nominated by the president and confirmed by the Senate; they supervise a system of 12 regional Federal Reserve Banks, with many branches around the nation. The Fed has the power to expand or contract the money supply through various means, most of them opaque to the general public, thus adding to the institution's aura of mystery.

One method is "open market operations," that is, buying and selling U.S. government securities. Another is regulating the amount of its financial reserves a bank must hold, as opposed to being able to lend out. Yet another is setting the federal funds discount interest rate, also known as the overnight rate—the rate at which Fed branch banks loan money to each other (generally overnight). The federal funds rate affects the amount of money banks lend to the public, and it influences other interest rates, such as those for mortgages, home equity loans, and consumer credit.

Adjusting interest rates is the chief method the Fed uses to manage the national economy these days. That's why nearly all the public chatter about Fed activity involves interest rates, and hardly any deals with the money supply per se. The Fed also serves as chief regulatory overseer for the nation's banking system and the "lender of last resort" that can be relied on to bail out other big systems if their own money supplies get too low.

Greenspan, former chairman of President Gerald Ford's Council of Economic Advisers, served as head of a Social Security reform commission during the first Reagan administration, then took over the Fed from the great inflation buster Paul Volcker. Greenspan became chairman less than two months before the stock market crash of October 1987, when the Dow Jones Industrial Average lost 23 percent of its value in a day. He proved his mettle early, calming turbulent markets by vowing that the Fed stood ready to provide all the liquidity—i.e., extra money—the economy might need.

Greenspan marched from victory to victory, enjoying a reputation as the greatest wizard of finance the world has ever known. His 19-year reign saw 72 percent growth in GDP, 31 percent growth in employment, and a quadrupled Dow average. Greenspan helped guide the U.S. economy through two of the longest economic expansions in its history, his record tarnished only by two mild recessions, lasting just 16 months combined.

Greenspan collected a Presidential Medal of Freedom here, a British knighthood and a French Legion of Honor there. But not everyone admired his performance. He is often blamed for being too indulgent toward what in retrospect was clearly an unsustainable bubble in stock prices in the late '90s. The Economist lamented on his departure that his legacy—even, or perhaps especially, his reputation as a deft manager of crises—may be harmful to the economy in the long term: "Investors' exaggerated faith in his ability to protect them has undoubtedly encouraged them to take ever bigger risks and pushed share and house prices higher." That reputation wasn't entirely deserved: Greenspan didn't deserve all the credit for taking the decisive policy lead in navigating such crises as the Mexican peso collapse of 1994, the East Asian bust of 1997, and the failure of Long-Term Capital Management in 1998.

Now all the power and peril inherent in the Fed's ability to control the money supply lies in the hands of 52-year-old Ben Bernanke, a former member of the Fed's board of governors (from 2002 to 2005), former chairman of the economics department at Princeton, and, like Greenspan, former chairman of the president's Council of Economic Advisers. Bernanke initially continued Greenspan's policy of raising interest rates by a quarter point at every meeting of the Federal Open Market Committee. This pattern had been followed steadily since the federal funds interest rate bottomed out at 1 percent in 2003 and 2004; the Fed ratcheted the rate up to 5.25 percent, stopping only (so far) in August of this year. Broadly speaking, higher interest rates mean less demand for new loans, less new money in the economy, and less inflation; raising interest rates is supposed to help "cool down" the economy.

Bernanke has vowed to be more open than the famously enigmatic Greenspan. He already has caused one minor (and temporary) stock slump by confessing at a White House dinner to CNBC's Maria Bartiromo that the markets seemed to be misinterpreting a statement of his to mean he was done raising interest rates.

As men whose every utterance can make paper wealth form or dissolve, Federal Reserve chiefs demand serious attention. In August, Senior Editor Brian Doherty asked several Fed watchers to assess the Greenspan era, to speculate about the Bernanke era, to address the question of how important the Federal Reserve really is to the U.S. economy, and to offer their views of what the Fed chief ought to do.

Milton Friedman is a Nobel Prize–winning economist. His monetarist ideas—in particular, the belief that price inflation is caused by increases in the money supply—have been a major influence on Fed policy since the Volcker era.

Rep. Ron Paul is a libertarian Republican representing the 14th District of Texas. His 10 years on the House Financial Services Committee have involved a fair amount of sparring with Federal Reserve chiefs, and he fears Green¬span has led us to the edge of an economic precipice.

James Grant is a columnist for Forbes and the editor (since 1983) of the financial advice newsletter Grant's Interest Rate Observer. He frequently warns his readers of the looming ill effects of Fed policy.

Bryan Caplan, an associate professor of economics at George Mason University, was a student of Bernanke's at Princeton. He is impressed with the new chairman's intelligence and acumen.

Jeff Saut is chief investment strategist for the investment firm Raymond James Financial. He fears that Greenspan's seemingly excellent record built hazards into the economy of which investors need to be wary.