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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If you accept that interest rates are the traffic signals of the financial economy, Greenspan said, "Turn them all green." By imposing this 1 percent interest rate, the Fed invited everyone and his brother and sister-in-law to go out and get a new mortgage and take on more debt.

The consequence of all this was one terrific burst of housing-induced prosperity. One economist at Northern Trust, Asha Bangalore, calculated that from 2001 to 2005 or thereabout, 40-percent-plus of job growth was driven indirectly or directly through housing activity. So housing became the motive force in the U.S. economy, and housing was financed through debt, and people who borrowed to buy new houses famously borrowed against the collateral of houses they occupied, so the American home became pretty much like an ATM machine.

For Greenspan, inflation was measured by a very narrow slice of goods and services that omitted energy and food prices, which he believed to be too volatile. To me, inflation is not too many dollars chasing too few goods; it's too many dollars, period. It's variable what they chase. It has been houses for the last several years, and we don't call that inflation. When the dollars chase the stock market, it's called a bull market; it's not called inflation. But with the Fed overdoing it, the consequence will be distortion someplace.

Reason: Congressman Paul, you've tweaked Greenspan about his radical Randian past…

Paul: Shortly after I got back into Congress, about 1999 or so, they had invited us on the House Financial Services Committee to get our pictures taken with Greenspan and say hello. I dug out my copy of The Objectivist Newsletter [edited by Ayn Rand] where he wrote his gold article [in which Greenspan praised the gold standard as a source of economic stability, guarantor of economic liberty, protector of savings, and check on government's power to inflate and spend]. When we started talking I flashed it out and said, "Remember this?" He said, "Yes, I certainly do."

I opened it up to his article and said, "Remember writing this article? Would you autograph it for me?" And while he was autographing it I said, "You want to write a disclaimer on it?" "No, I read it recently," he said, "and I wouldn't change a word."

Toward the end of his reign I brought that up again in a congressional hearing. I was a little more confrontational with him about what he used to think and why it's different now, and he said, "That's a long time ago, and I no longer subscribe to those views." He did put a disclaimer on it. The first encounter was private, and the second was a public statement.

Reason: What can we expect of Bernanke as Fed chief?

Caplan: I was his student for monetary economics at Prince¬ton, and he also supervised my second-year paper in grad school. Overall, I can't think of anyone who had a decent chance that I would have preferred. He knows economic history and not just in a dilettantish way. He takes it seriously, unlike all the other macroeconomists I know.

I really like his writing on the Great Depression. Essentially, he has a very Rothbardian take. One of the major points in [libertarian economist Murray] Rothbard's America's Great Depression was that the cause of high unemployment during the Great Depression was excessive real wages, which were caused by a combination of fairly rigid nominal wages with deflation. Looking at the Great Depression, Bernanke also saw the obvious point: a large increase in real wages and a sudden spike in unemployment—wouldn't supply and demand suggest a connection between the two? But in the minds of people at the time the problem was falling wages. Whereas Econ 101 says no, falling wages are the response of the economic system to unemployment; falling wages are a symptom of bad conditions, but they are also working toward improving conditions.

I expect I'll disagree with a lot of what he'll say or do. He's not a libertarian. He's just a good, competent, thoughtful mainstream economist, which is still a lot better than a typical mainstream politician.

Grant: Bernanke to me is the prototypical academic. He was one of the all-time great economics students at Harvard, one of the most precocious and brilliant Ph.D. candidates at MIT, and the head of the Princeton economics department. He wrote a well-regarded macroeconomics text. He's the kind of guy who knows the answer before he hears the question, which to me is an exceptionally dangerous mind-set for a price fixer.

A price fixer has to be humble in the face of what we don't know and can't know. Bernanke seems to be a true believer in the efficacy of the impossible: of the Fed turning on its computers and caffeinating its Ph.D.s and plucking from thin air the correct interest rate that will let markets clear; will minimize, at not too low a level, the rate of inflation; and will guarantee high employment and prosperity for all.

Paul: Most people who have looked at what Bernanke has written are convinced that when push comes to shove, he will not hesitate to inflate. He has a pretty strong conviction that inflation is a lot less of a danger than deflation and the greatest sin during the Great Depression was that the Fed didn't inflate soon enough. If anything Bernanke is an even stronger believer in inflation, but how can you outdo Greenspan, who took interest rates down to 1 percent? That's gonna be hard to beat.

Friedman: I had minor contact with Bernanke before he became Fed chair, but it was not a close relationship. I have read a lot of his writing, and I think very highly of him as an economist. But the business of being chairman of the Fed requires something more than economics. It has something to do with personality, character, and that can only be found out by seeing how he does.