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

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Responses should be sent to [e-mail].

Reason: What is your assessment of Alan Greenspan's record as Fed chief?

Milton Friedman: I think Greenspan did remarkably well. However, I note the same is true for most of the major central banks of the world for the past 20 years. It has been a rather unusual period. It's had declining or relatively stable inflation throughout, very few recessions, and a highly stable economy. And in the U.S. and many other countries—New Zealand, Australia, Great Britain—relatively low unemployment.

This is because the central banks of the world have finally learned the lesson that inflation is a monetary phenomenon, and that they are responsible for inflation when it occurs. That lesson was partly taught by Greenspan, and Volcker as well, by demonstrating that monetary policy could curb inflation in the United States. But also I give a great deal of credit to Donald Brash, the governor of the Bank of New Zealand when New Zealand reformed its monetary system. He was the first one to introduce inflation targeting, and he was very successful; he brought the inflation rate down from a very high level to a very stable level. He was imitated and followed by Australia, which adopted inflation targeting, by Britain, and by other countries, and all of them did well as well.

Ron Paul: If you evaluate Greenspan from a conventional perspective, you'd have to say that he was successful in that he kept the charade going. He fooled people long enough that trust in the U.S. economy's health was maintained. In other words, he was able to manufacture bubbles when they were necessary and get away with it. In the short run that looks beneficial, but in the long run it's very dangerous, just delaying the inevitable.

When you keep interest rates lower than the market rate by creating new money and credit, that is inflation. That's the source of much mischief, and he did this continuously. When the interest rate is 1 percent, you know it's way below the market rate. When it's 6 or 7 or 8, you can't be certain it's not higher than the rate would be if they had a totally hands-off position. But for the most part Federal Reserve chairmen keep the interest rate that they control lower than the market rate, and therefore they are running an inflation machine.

The incentive is always short-run, because Wall Street enjoys low interest rates. They see it as a positive sign psychologically, and it plays a role in keeping stock prices high. The majority of people still believe this is the road to prosperity, that with lower interest rates businesses do better and banks do better and everyone is going to be happy. What the Fed does is just a form of central economic planning that this country and its business community have come to accept and that I reject.

James Grant: Alan Greenspan is one of the most curious and ironic figures in recent financial history. He went to Washington in the mid-'70s as an acolyte of Ayn Rand. She gave a quote to The New York Times, something along the lines of how she and Alan have no delusions that the transformation of the U.S. economy from a statist regulatory regime to perfect freedom of markets will be easy—we know it will be difficult, and it can't happen overnight. A few decades pass, and now Greenspan exits his job as the nation's premier fixer of prices. Greenspan succeeded as almost no one else has done, at least in the public eye, at plucking prices out of the air and imposing them on the U.S. economy, which is essentially what he did as Fed chairman. He made decisions that were invariably expedient and served the purpose of sustaining and prolonging the prosperity that mainly smiled upon his reign as Fed chair.

Bryan Caplan: I'm convinced by what [Harvard economist] Greg Mankiw said, which is that Greenspan probably was better than average, but we tend to give too much credit to the individual as opposed to external circumstances in judging him. Many others considered incompetent might have done as well given the scenario Greenspan inherited. Greenspan came to office with things already improving, so he was bound to look good.

Jeff Saut: Greenspan was in the right place at the right time. Reagan and Volcker set the stage for the greatest bull market of a lifetime. Greenspan was smart enough to keep his hands off it. Anyone would have looked good. I think he did do a Herculean job at managing crises. But his typical response to problems was to throw a bunch of money at them and to lower interest rates, and that caused a series of bubbles. I don't know what the alternative to the bailouts would have been—probably not pretty. But he managed to inflate a bubble in the stock market, and when that burst he managed to inflate a bubble in real estate. Among portfolio managers, certain people have called him a serial bubble blower.

Reason: Do you think Greenspan was to blame for stock and now housing price bubbles?

Caplan: If monetary policy had been less expansionary, it's likely that stocks and housing would have gone up less. Certainly housing, if interest rates had been higher, wouldn't have gone up as much. Those who want to limit the Fed's activity to just price stability can't really criticize the Fed for other things not going well, because Greenspan was doing the things that managed to get price stability. To prevent stock or housing price increases, he would have to have had a less expansionary policy, inflation lower than his general 2 to 3 percent target, and maybe he would have even needed deflation.

Friedman: We've had those bubbles in both stocks and housing for many decades and centuries, and I don't think Greenspan had much to do with it. On the contrary, I give him credit for not letting himself be diverted from intelligent monetary policy by pressure to do things about the stock market boom. It would have been a mistake. The role of a central bank is to provide a stable money, which means a fairly constant level of inflation, preferably zero inflation. That's their function. They should not let themselves be diverted by booms in housing here or in stocks there.

Grant: The benefits of repeated intervention are obvious and pleasing. Greenspan compiled a record of prolonged economic expansions and very short contractions and of unparalleled financial prosperity, and the numbers are hard to argue with—until you begin to consider the unanticipated consequences.

The reason that price controls or price fixing is such an unholy line of business is that prices convey information. They make markets work. They allocate resources and allow individuals to conduct their affairs in the most efficient way in a free economy. And fixing a price distorts the allocation of resources, in this case the vital resource called credit.