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.
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 Greenspan, 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 Greenspan 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.
Responses should be sent to letters@reason.com.
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.
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 Princeton, 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.
Reason: Bernanke famously apologized to you, Professor Friedman, on behalf of the Fed, at your 90th birthday celebration in 2002. He was on the Fed's board of governors then, and he apologized for the Fed's role in exacerbating the Great Depression by letting the money supply deflate by nearly one-third, which was one of the themes of your work on monetary policy and history with Anna Schwartz. Was this big news, or is it now conventional wisdom?
Friedman: I think there is very little disagreement that, whether the Fed caused the Depression or not, it made it much worse than it otherwise would have been. It deserves a large part of responsibility for there being a Great Depression rather than a major recession—or even a minor recession. But the important point is that the role of money in respect to inflation has become conventional wisdom not only in the U.S., not only at the Federal Reserve, but in every central bank in the world.
Reason: Bernanke has been promising to be a more transparent Fed chairman than the famously Delphic Greenspan. Has he been more open? Should he be?
Friedman: The more the public knows about what the Fed is doing, the better.
Saut: I think the stock market likes an opaque Fed chairman more than clarity. Greenspan was famous for the quatrains he spoke in, like Nostradamus. You could sit and listen to him talk and when he'd finish, you'd say, "What did he say?" He didn't come out and say, "Look, I'm gonna raise interest rates until a financial accident occurs," which has been the history of the Fed since 1970.
Reason: Especially in the Greenspan era, people have attributed an almost wizardly control over the U.S. economy to the Fed chair. How powerful is the Fed chief, or the Fed itself? How important are his actions to the overall heath of the U.S. economy and to individual well-being?
Saut: The Fed chair's power is largely a delusion. The only power he has is over interest rates, and interest rates ceased to be so important when businesses were no longer dependent on borrowing from banks.
Greenspan left a pile of shit in Bernanke's lap. I think he has inherited a very difficult environment to navigate. The government keeps two sets of books: the one we hear the most about that says there was only a $318 billion deficit in 2005, then the one that comes out from Treasury [following standard accounting rules, not special government ones] that no one talks about, which shows a deficit of $760 billion. And if you include Social Security and Medicare liabilities…
We are piling on debt after debt, and we are depreciating our currency. Under Greenspan the dollar lost 50 percent against other currencies, and I think that's going to continue.
Friedman: All elements other than the behavior of the money supply and price level are outside direct Fed control. But those in turn have further effects. I attribute the greater stability of the last 20 years, and the low level of unemployment of those years, to the stability of the price level, the fact that the Fed stabilized prices and reduced uncertainty and therefore allowed entrepreneurship to be devoted more fully to productive activity. The Fed indirectly influences every aspect of the American economy, but directly the only thing it can really influence is the quantity of money and through that the level of prices.
The U.S. economy is capable of very good growth provided the government keeps its hands off. Unfortunately, there's a strong propensity for the government to do things that are harmful rather than helpful. For example, Sarbanes-Oxley [the post-Enron law attempting to curb accounting fraud] is very unfortunate. It tells every entrepreneur in America: Don't take risks. That's not what we want. The function of the entrepreneur is to take risks, and if he's forced not to take risks and to spend on accountants rather than products, the economy is not going to expand or grow.
Paul: If you didn't have an accommodative Federal Reserve, Congress' deficits would cause very high interest rates. Because we run up the deficits, and if we couldn't borrow money and the Fed wasn't there, interest rates would respond by going up until we could find the money we need. The Fed spoils Congress into getting away with deficit spending. But in the long run it's devastating, because that destroys the value of the currency, and that destroys the middle class, destroys investment, creates malinvestment and bubbles. Then you have the collapses.
The bad effects are so much worse than the short-run so-called good effects of letting someone have a low interest rate so they can buy a house.
Reason: Analysts often complain that Greenspan did nothing to help solve our low savings rates and our trade deficits. Is the Fed relevant to these problems? Are they problems at all?
Friedman: I do not think you or I can say what the right savings rate is or should be. There's nothing wrong with a person, family, or country saying, "We have high enough income. We don't need more. We're going to spend it all." We can have a perfectly prosperous and active economy along those lines. I don't think it's helpful to ask, "Is this rate right or wrong?" Instead we should ask, "Have we adopted polices that reduce incentives to save?"
In that respect, there's a great deal to be done. The tax system distorts the incentive to save, sometimes pro-saving and sometimes anti. Government should ask itself how best to maintain institutions under which you have an undistorted market in savings.
So far as foreign balance of payments is concerned, we have to let the dollar float. You shouldn't try to control the price of foreign exchange any more than you should try to control the price of other things. The country seems to have learned that price controls are not good.
I do not believe that [mass foreign holding of U.S. securities] is something to be feared. The only reason [a widespread loss of will to buy U.S. Treasury securities] would happen is if our central bank followed inflationary policies that made it undesirable to hold American securities, and that's our fault, not theirs. I think the concern that has been expressed about foreign balance of payments is in large part mistaken and in large part reflects the defects of statistics available.
If you have a foreign owner of a bond or stock who loses confidence in the American economy and sells, whom do they sell it to? They have to sell it to people with a stronger confidence in the U.S. economy who are willing to hold on to it. If the foreigners dump bonds or stock and use dollars to buy other U.S. assets, there's no net effect. If they use them to buy consumer goods, then that means an increase in balance of payments, a plus on income accounts.
Grant: Before he went to work for the federal government, Greenspan was a great exponent of the classical gold standard, in which a country could not run up its debts to foreign creditors indefinitely. You can't over-issue such a currency, because people start to lose faith in it and want the gold that stands behind it, and eventually there's no more gold.
Under the pure paper, or faith-based, system we have now, people continue to lend to particular governments when it seems expedient, so the U.S. continues piling up debts, principally to foreign central banks. In the dear dead days of the gold standard, this would have been literally unimaginable. From the point of view of American consumers, this is lovely for as long as it continues. What can change the trend might just be one day that one of our seemingly dollar-insatiable Asian creditors will just not raise its hand to purchase the extra U.S. Treasury securities and will start a series of events that will cause the dollar to drastically weaken and finally result in significantly higher interest rates and weaker dollar exchange rates.
By way of full disclosure and confession, I've been saying this for what seems like 100 years, and the dollar is still the world's top monetary brand.
Reason: What would you do if you were in charge of the Federal Reserve?
Caplan: Ideally, I would see if I could do a transition to free banking [defined by the economist George Selgin as "banking without government deposit insurance or a lender of last resort and free of legal restrictions on interest rates, bank portfolios, branch banking," plus "private and competitive" currencies]. Economists and policy makers fear free banking because they think it's safer if the government is able to do something about the economy doing badly. But what about all the bad things caused by government in the first place? It's all about what psychologists call an "illusion of control." Even if a risk is low but outside of their control, people somehow feel worse about it than a higher risk that they can do something about.
I think that's what a lot of government intervention is about: wanting to be able to do something. A classic example is the Fed itself. It was adopted because people were unhappy with what happened to the bank system in the panic of 1907. In the decades after the Fed's founding there were two banking panics that were quite a bit worse, the panic of 1920–21 and the Great Depression. It seems likely we'd be better off with government not able to do something, or not as much. People felt safer once government could do more, but that also meant it could make bigger mistakes.
Paul: I would either resign or cease all my activities. Maybe just be a clearinghouse. I would not resort to interfering with interest rates. Which might make markets get hysterical. They wouldn't know what to think without somebody there as lender of last resort.
So there is a short-run benefit to the Fed in that respect. It is not really my position to close the Fed down. It would require too much adjustment to do that overnight. I advocate competing currencies—to legalize another currency that we can work in. That means repealing legal tender laws and repealing all taxes on gold and silver. If people want to use another money, then they can, and if not they can use paper.
Even the Fed chairmen, Greenspan and Bernanke and Volcker, never deny that they look at the price of gold. I was in Congress when Volcker was chairman, and I had a breakfast meeting with him. I had gotten there early, and when Volcker came in, he didn't say good morning, he went right to his staffer and said, "What is the price of gold?" That was the most important thing on his mind because people buying gold were voting no confidence in the dollar, and his job was to protect the dollar.
There's still a lot of confidence now. But when gold hits $2,000, people will become more alert to what is happening.
Grant: As an alternative to Federal Reserve management, you might say the international gold standard. Has there ever been anything so exquisite in theory, so solicitous in practice, so elegant? No, there never was. But that was another time, a time of economic liberalism. When central banks didn't monetize government debt, and people didn't expect central banks to make their 401(k) appreciate. So I'm stuck on ways to improve the current system, until my forecast of its inevitable comeuppance is validated. If things keep on going as they have been, which is OK economic growth and more than OK appreciation of household net worth despite an immense outpouring of new debt, who's going to want to change that? What's broken?
Friedman: I would prefer the Fed to follow a much simpler course: to take as its operating magnitude not the federal funds [interest] rate but the quantity of money. Pick whatever definition it wants—M2 [one of many measures of the money supply, including currency, savings, demand deposits, and certain liquid time deposits] is a good definition. I'd just as soon the Fed announce it will increase M2 by 5 percent per year, year after year, month after month. But they are not going to do that.
Reason: Why won't they do what you suggest?
Friedman: They don't want to become irrelevant. It's human nature. You would do the same thing if you were there, and I'm afraid even I would.
Reason: But it would be preferable to abolish the Fed entirely and just have government stick to a monetary growth rule?
Friedman: Yes, it's preferable. And there's no chance at all of it happening.