The Never Ending Greenspan Story

With Greenspan scheduled to step down at the end of January, there are questions, lots of them.  Who will be the next Fed chair?  What were Greenspan’s greatest successes and failures? What challenges will the new Chair face?  In which direction, towards discretion or adherence to rules, should the Fed go in the future?  Do high oil prices require a deviation from inflation targeting and the Taylor rule?  Is transparency good?  Will the next Chair come from academia or business?  Was Greenspan too political?  Did he exert too much control on the FOMC?  How will the new Chair establish credibility?  Why did he take such bad pictures (I empathize)?  The Financial Times adds to the growing number of articles addressing such questions (see here also):

The activist unafraid to depart from the rules, by Andrew Balls, Financial Times: … Mr Greenspan took over at the Fed on August 11 1987 – less than two weeks before “Black Monday”, when the Dow Jones industrial average dropped 22.6 per cent; the largest daily fall in the history of the US stock market. Mr Greenspan’s immediate response, saying the Fed would pump money into the financial system to maintain liquidity, helped to put an end to worries about how the central bank would fare after the departure of Paul Volcker, his predecessor. … Mr Greenspan has cemented the Fed’s anti-inflation credibility but his reputation has been built on the flexibility he has shown. The challenge for his successor will be to match Mr Greenspan’s record of getting the big calls right. …

Mr Greenspan made clear from the outset that he wanted to see lower inflation than the 4 per cent rate he inherited. … Yet it is simplistic to call him a mere inflation hawk. ... Mr Greenspan has been prepared to tolerate higher “headline” inflation at times when it was clear this was not feeding into higher “core” inflation. … There have been times when Mr Greenspan persuaded his colleagues to raise rates faster than they wanted to – but also times when he has persuaded the FOMC to hold off. In sum, he is better described as an activist than a hawk…

Over the period since 1987 as a whole, the Fed has followed a highly predictable approach. The “Taylor rule” … offers a good overall guide to monetary policy in the Greenspan era. It provides an equation that describes Fed monetary policy as reacting to growth that diverges from the economy’s potential rate, and to inflation relative to a presumed inflation target. ... Larry Meyer, … who was a Fed governor in 1996-2002, says: “The chairman played by the rules in normal times. There is often this notion that he has a seat-of-his-pants, ‘you can’t write it down’ approach, but the Taylor rule fits extremely well most of the time. What distinguished the chairman was when he had to depart from the rules.”

Many economists believe Mr Greenspan’s crowning achievement was his response to signs of the productivity boom of the 1990s. He understood the change early and acted upon it, allowing unemployment to fall lower than many economists thought was possible without stoking inflation. … He has distinguished himself in crisis management. After the crash of 1987 he ignored advice that he should wait and gauge the impact on the economy. He also increased liquidity in 1998 after the Asian financial crisis and Russia’s default, and in 2001 after the September 11 terrorist attacks. While this can be can be explained in terms of risk management, it can also seen as the exercise of typical Greenspan discretion…

Mr Greenspan has contrasted his risk-management approach with the standard academic economist’s confidence in economic models and policy rules. The presumed favourites to replace him – Martin Feldstein of Harvard, Glenn Hubbard of Columbia and Ben Bernanke of Princeton – are academic economists, though the White House has said it is considering other candidates including business and Wall Street figures. Henry Kaufman, the Wall Street economist and financial consultant, says: “It is very helpful to have a broad-based individual who knows financial markets.”…

Mr Greenspan has been criticised for dabbling in politics. He is not a particularly partisan Republican – he supported the Clinton administration’s tax increases of the early 1990s as well as the Bush tax cuts of this decade – but has an overriding belief in the power of market forces and the benefits of unfettered capitalism. …

Monetary policy in this … illustrates another feature of the Greenspan era: the Fed’s move towards greater transparency, which has gathered pace. ... During the past two years the FOMC has given guidance on the likely course for the federal funds rate, since June of last year raising the rate by a quarter-point at each meeting and saying each time it expected to continue raising rates at a “measured” pace. This year, the Fed began publishing FOMC minutes sooner, making them a more timely guide to the committee’s thinking … A more formal and clearly explained strategy may help a successor to establish credibility. …

Mr Greenspan’s view that the Fed should not try to burst a bubble by raising interest rates when the outlook does not demand it is based partly on the difficulty … of spotting the difference between an unsustainable surge in prices based on speculation and a sustainable one based on fundamentals. But Mr Greenspan believes in any case that … the Fed’s job to pursue policies aimed at low inflation and full employment, not to target asset prices… Alan Blinder, the Princeton professor who is giving a paper on the Greenspan era at this week’s Jackson Hole symposium, calls this the Fed’s “mopping up” strategy. …

Mr Greenspan has suggested that the Fed’s success in securing low inflation and less volatile economic growth may itself lead to more speculation in asset markets, as investors conclude that these good times are likely to continue. Part of the next Fed chairman’s inheritance will be a housing market that … is showing signs of “froth” in a number of cities, amid buy-to-let speculation that has resulted in “speculative fervour” in some areas. At their June meeting, the … Federal Open Market Committee discussed house prices and came to the same conclusion as it had with the stock market: the Fed should deal with the consequences in the event of a market disturbance. Henry Kaufman, the Wall Street economist, believes the FOMC is too sanguine: that the housing market poses grave risks for the economy and that the Fed’s assurances that it will raise rates at a “measured” pace have contributed to a household debt-financed consumption binge and to speculative activity by investors. “The new exuberance is in the housing area, and that problem will have to be resolved by the next chairman,” Mr Kaufman says…