No Controlling Authority
The economy is too complex for even Alan Greenspan to handle.
Throughout the 1990s, Federal Reserve Chairman Alan Greenspan basked in the glory of a strong economy—and a strong stock market. Greenspan-worship perhaps never reached the ridiculous heights chronicled by disgraced journalist Stephen Glass, who in 1998 penned a fictitious article for The New Republic about an investment bank that actually created a shrine to Greenspan. But Glass' fabrication, which included tales of traders celebrating Greenspan's birthday with cake and song, wasn't so ridiculous that people didn't believe it at first. "As far as the financial markets go, [Green-span's] more powerful than God," the honest-to-god, real-life chief market strategist for the investment banking firm Ferris, Baker Watts effused to the Baltimore Sun in 1998.
Today, with the economy slowing, the NASDAQ tanking, and the Dow Jones Industrial Average sliding sideways, Green-span is coming in for criticism. "Alan Greenspan is out of control," wrote Fox News Channel's Bill O'Reilly earlier this year. "Take that to the bank. The guy messed up big time and now will not explain himself." More recently, the famously irritable talk-show host has been lambasting Greenspan on the air, decrying the Fed head's general unwillingness to talk in anything other than the most inscrutable terms.
Yet if Greenspan were ever to explain himself clearly, O'Reilly wouldn't like what he'd hear. Neither would all those people who desperately want a single person to be in "charge" of the economy, making sure that stock portfolios remain flush and jobs secure. Hard-truth time: As skillful as he may be, Greenspan has never managed the U.S. economy. "The Fed didn't cause the boom," says Lee Hoskins, who served as president of the Cleveland Federal Reserve Bank from 1987 to 1991. "The slowdown in economic activity wasn't caused by monetary policy."
"If the Fed is trying to steer the macro economy, it has an impossible task," adds Lawrence H. White, the F.A. Hayek Professor of Economic History at the University of Missouri's St. Louis campus. All the Fed controls, after all, is the money supply. To be sure, that's no small matter. "If it gets things wrong," cautions White, "it can drive the economy through business cycles, and through its history the Fed has done that many times. If they get things right, they avoid being a source of disturbance, but they don't affect the real growth of the economy. The best the Fed can do is avoid being a source of disturbance."
Yet even among those who know better, it is widely assumed that the Fed sets interest rates. As the Ferris, Baker Watts market strategist told the Baltimore Sun back in the late '90s glory days: "Greenspan controls interest rates….Interest rates control the money flow. And money makes the market go." Actually, the Fed sets only the discount rate, the interest rate at which it lends to other banks. As for other interest rates, it attempts to affect them by either buying or selling bonds, which either sucks money out of the economy or puts money into the banking system.
But the Fed can't force banks to lend. And it can't force companies and individuals to borrow. Sometimes it can't even affect, let alone determine, other rates for money borrowed over longer periods of time. Although the Fed started cutting its discount rate last December, the yield on the 10-year government bond actually increased from 4.75 percent to 5.09 percent since March. "Real interest rates, adjusted for inflation, have natural values that are independent of monetary policy," says University of Georgia economist George Selgin. "The Fed has no ability to set real interest rates. None."
Is Selgin overstating his case? Consider that Greenspan was unable to gradually moderate the stock market's tech bubble, which he first addressed back in late 1996 with his famous comments on how escalating security prices may be the result of "irrational exuberance" among investors. At the time, the Dow was at 6,300 and the NASDAQ stood at 1,600. As long as the market was going up, no one much cared that Greenspan was powerless to pull the indexes down to earth. In fact, as late as September 2000, a source as sophisticated as The Financial Times of London declared that Greenspan had achieved the much-coveted "soft-landing," as if he were in fact piloting the economy. Now that the NAS- DAQ has dropped more than 60 percent from its peak, people may care more than ever about what Greenspan has to say. But that doesn't mean he's any more able to pull us out of the current doldrums than he was to ease us out of our mind-blowing bubble.
Ascribing dictatorial powers to the Fed chairman is nothing new. Indeed, there was a time when virtually all sophisticates believed the government could control and effectively manage the economy. "In the mid-1960s, a report from the Council of Economic Advisers stated that we had sufficient knowledge to manage the economy and it was incumbent on us to do so," says Hoskins, the former chief at the Cleveland Fed. "That proved to be the big mistake. We started with low inflation and unemployment and sent them both into double digits." This outcome was supposedly impossible according to standard economics of the era.
But then economists have never known much about how the economy actually works from day to day. "Economists do not know the interworkings of the economy sufficiently well to attempt to manage it," says Hoskins. "There are millions, if not billions, of decisions, going on in the U.S. economy every day. Those decisions are made by a couple of hundred million people. There's no way anyone can stamp those decisions out in advance."
Some dismal scientists have long understood the limits to government management of the economy. "We are in danger of assigning to monetary policy a larger role than it can perform," said the supreme monetarist Milton Friedman in 1968. "In danger of asking it to accomplish tasks that it cannot achieve, and, as a result, in danger of preventing it from making the contribution that it is capable of making."
That contribution is not to manage the price of stocks and bonds or to smooth short-term fluctuations in economic output and employment. The contribution that monetary policy can make is to not distort these variables. This is accomplished by keeping a steady price level—or steady inflation—which in turn is accomplished by keeping a steady rate of growth in the money supply. If we want economic growth, then price stability, not economic smoothing, should be the Fed's goal.
In the early 1980s, Fed chair Paul Volker started the stabilizing process by shutting off the money spigot, and inflation dropped from 14.8 percent in March 1980 to less than 4 percent three years later—low by recent, if not historical, standards. Greenspan inherited Volker's legacy when he took over in 1987, and has undoubtedly enjoyed a wonderful run. Save for a brief downturn in 1990 and 1991, which helped cost Bush the Elder his job, the U.S. economy has grown his entire tenure. Inflation, while higher than in the 1950s and the 1960s, has held at a stable 3- percent annual rate. As important, unemployment and growth, two variables on which the economy's average performance was actually worse in the 1990s than in the '50s and '60s, have also remained stable. The 1990s were remarkable, notes Harvard economist N. Gregory Mankiw in a study of monetary policy during those years, for their smooth sailing. There was much less variation in both unemployment and output than in earlier decades. Perhaps this stability was due to deft discretionary monetary policy, or perhaps it was due to other factors. Throughout the '90s, after all, the U.S. economy experienced fewer external shocks than in previous decades, the two most prominent being the Gulf War and the Asian financial crisis.
One might also add the technology investment bubble to the disturbances. It produced our current situation: an economic slowdown led by declining investment. While consumer spending remains remarkably strong, business investment has collapsed, due to more realistic expectations of future economic growth and profit potential. The collapse was not caused by a Fed-induced liquidity crisis—that is, by a tightening of the money supply—but by a reality check among investors and managers. There's plenty of money in the economy, as evidenced by the fact that the Consumer Price Index is increasing to nearly 4 percent. If deflation were occurring, one would expect that indicator to be falling.
So far, outside of the devastated telecommunications and tech sectors, firms have been hesitant to lay employees off, which has helped to keep consumption high. If this holds, the slowdown will be relatively short: Companies will sell off inventories, then start to invest again. Jobs and resources will shift from unproductive sectors to productive sectors of the economy. If employment collapses, consumer spending will likely fall as well, and the current slowdown will take longer to pass.
In either case, it will be natural market forces that end the slowdown, not a blast of money into the economy. That's normal. Says White, the University of Missouri economist, "There's never been a time when monetary policy pulled us out of a slowdown."
If the slowdown is short, Greenspan will retain his demigod status. If it plays out over a longer time frame and stories about rising unemployment hit the papers, he'll suffer more insults from the likes of Bill O'Reilly, Americans will lose their faith in him, and he'll wish he'd called it quits back in June 2000.
Regardless of how the current situation plays out, however, Greenspan's tenure will leave a dangerous legacy. It has done much to revive the notion, as expressed by the Council of Economic Advisers in the 1960s, that wise economists can in fact pilot the economy smoothly or bumpily. In fact, they're passengers, just like the rest of us. When the next person climbs into what he considers to be the pilot's seat, he may just fly us right into a mountain.