That low CPI and maximum employment take precedence over controlling irrational exuberance has been a fundamental tenet of Greenspan's policies – one that now looks to have been profoundly mistaken.
By J. Bradford DeLong, Professor of Economics, U.C. Berkeley, and Research Associate, NBER
For more than a decade now, I have been a believer in and a propagandist for Greenspanism – the doctrine promulgated by former Federal Reserve Chair Alan Greenspan that central banks should ignore what is going on in asset markets and focus on low inflation and full employment instead, for central banks are not especially good judges of whether there is an asset bubble, and if asset markets do succumb to a bubble followed by a crash, it will be cheaper to clean up the mess afterwards than to have stamped out the bubble by raising unemployment, and discouraging investment and accumulation through tight monetary policy beforehand.
For more than a decade, I have been a believer in and a propagandist for Greenspanism. A year ago, I was as true a believer as you could find. I held that the failure of the post-internet bubble recession (2000 to ’01) to gather strength was evidence that Greenspanism was correct. As Greenspan said in 2004 at the Federal Reserve Bank of Kansas City’s Jackson Hole conference, looking back at the recession and the recovery that had followed the collapse of that dot-com bubble:
The sharp rise in stock prices and their subsequent fall were, thus, an especial challenge to the Federal Reserve. It is far from obvious that bubbles, even if identified early, can be preempted at lower cost than a substantial economic contraction and possible financial destabilization – the very outcomes we would be seeking to avoid.... The notion that a well-timed incremental tightening could have been calibrated to prevent the late 1990s bubble while preserving economic stability is almost surely an illusion…. [W]e chose… to focus on policies ‘to mitigate the fallout when it occurs and, hopefully, ease the transition to the next expansion.’… There appears to be enough evidence, at least tentatively, to conclude that our strategy of addressing the bubble's consequences rather than the bubble itself has been successful…[i]
The underlying idea, supported by the small size of the internet bubble recession, is that the first priority of the central bank is to maintain low consumer price inflation; the second priority is – given low current and forecast consumer price inflation – to maintain maximum employment and purchasing power; and the third priority of the central bank is that there is no third priority.
Opposed to Greenspanism is a doctrine that I call Mussaism, after former IMF Chief Economist Michael Mussa. Mussaism holds that there are not one but two constraints on central bank activity to pursue maximum employment, purchasing power, and growth. The central bank must insure that:
1. Interest rates are kept high enough to maintain confidence in price stability and to
stamp out any incipient inflationary spiral in wages and consumer prices.
2. Interest rates are kept high enough to stamp out any incipient asset market bubble
before it gets to be large enough that its collapse would cause macroeconomic
distress.
Only after it has successfully achieved these two higher priorities can it then even begin to worry about:
3. Maintaining maximum employment, purchasing power, and growth.
Consider this typical example written by Mussa for the Peterson Institute of International Economics at about the same time that Greenspan was congratulating the Federal Reserve for its wisdom in not acting preemptively to damp down the dot-com bubble:
Policy interest rates are exceptionally low.... The very low level of policy interest rates is an imbalance… [that] poses an important challenge for the future conduct of monetary policy.... [T]hese situations tend to be associated with high valuations of equities, real estate, and long-term bonds, which can become fertile ground for large, unsustainable increases in asset prices.... [I]f monetary policy remains too easy for too long… large asset price anomalies may develop before corrective action is taken. The monetary authority would then confront the grim choice of trying to keep an unsustainable asset price bubble alive or trying to combat the collapse of such a bubble without a great deal of room for monetary easing... [ii]
And, Mussaites argue, the collapse of such a bubble can create a grim situation indeed – all the problems of Irving Fisher’s debt-deflation without the initial consumer price deflation.[iii]
The Greenspanist reply to the Mussaites – a reply I believed 99 percent a year and a half ago, 90 percent a year ago, and 60 percent last March – is that creating unemployment and idle factories because you are scared of what might happen when irrational exuberance dies away and asset prices collapse is an error. Modern central banks are powerful. Modern central banks can successfully manage whatever crisis is provoked by the end of an episode of irrational exuberance when it happens, and not before. It is easier to sweep up after the elephants have gone through than to try to stop them, especially when stopping them requires the destruction of millions of jobs.
After the forced fire-sale mergers and liquidations of Bear Stearns, Merrill Lynch, Wachova, and WaMu; after the bankruptcy of Lehman Brothers; after the nationalizations of AIG, FHLMC and FNMA; after the transformation of Morgan Stanley and Goldman Sachs into bank holding companies to put them under the Federal Reserve’s clear regulatory wing; after the jokes about how the Swiss government might be able to recapitalize UBS but then who is going to recapitalize Switzerland; after a Treasury-Eurodollar spread of 3.6 percent per year; after a year of non-standard monetary policy that has left Treasury bill interest rates under 0.4 percent per year and the Federal Reserve with only US$ 18 billion in Treasury Bills in its portfolio; after Federal Reserve Chair Bernanke’s and Treasury Secretary Paulson’s urgent request for the power to issue US$ 700 billion in Treasury securities and use it to buy up mortgage-backed securities on whatever terms they deem acceptable – after all of this, it is very hard to believe in Greenspanism. The magnitude of the financial chaos surrounding us and its likely consequences in heightened unemployment appear likely to be more distressing than would have been the cost of higher interest rates and greater regulatory controls on mortgage lending earlier to head off the episode of irrational exuberance.
As important and as interesting as the episode of financial distress created by the end of the 2000s housing bubble is the Federal Reserve and Treasury’s regulatory reaction to it. To call it non-standard monetary policy is not to do it justice. Both the Federal Reserve and the Treasury are attempting things that have never been attempted before.
For more than 170 years, it has been accepted doctrine that the market is not to be trusted in a liquidity squeeze. When the prices of even safe assets fall and interest rates reach sky-high levels because the traders and financiers in the markets collectively want more liquid assets than exist, it is simply not safe to let the market sort it out. The central bank must step in. It must set the price of liquidity at a reasonable level – make it a centrally-planned and administered price – rather than let it swing free in response to private-sector supply and demand. This is the doctrine of the lender of last resort.
For more than half that time – say, 85 years – it has been accepted doctrine that the market is not to be trusted even in normal times lest it lead to a liquidity squeeze or to an inflationary bubble. The central bank must make the price of liquidity in the market a centrally-planned, administered price day in and day out. It must keep the market rate of interest near the natural rate of interest, said the followers of Knut Wicksell; it must offset swings in business animal spirits in order to stabilize aggregate demand, said the followers of John Maynard Keynes; it must keep the velocity-adjusted rate of growth of the money stock stable, said the followers of Milton Friedman – but if you do any one of these things you have done them all, for they are three ways of describing what is at bottom the same task and the same reality.
Thus as social democracy, government guideposts, and centralized planning waxed and waned elsewhere in the economy, social democracy in short-term finance went from strength to strength. First central banks suspended the rules of the free market in liquidity squeezes. Then central banks set the price of liquidity as an administered price in normal times. Then central bankers freed themselves of all but the lightest contact with their political masters: They became independent technocrats, a monetary priesthood that spoke in Delphic terms obscure to mere mortals.
The justification for this system was that it seemed to work well – or at least to work less badly than central banking that blindly adhered to the gold standard or than no central banking as well. This island of central planning in the midst of the market economy was a strange and puzzling feature – and even stranger was that few remarked how strange it was. There were no calls for a 5-percent-growth-of-kilowatt-hours rule as their were calls for a 5-percent-growth-of-M2 rule. There was no Federal Automobile Board to set the price of vehicles the way the Federal Reserve Board set the price of federal funds.
But now it appears that the Federal Reserve and the Treasury believe that the traditional tools are not enough. The price of liquidity has been a price administered by the central banking authority for nearly two centuries. But the price of risk has been left to the tender mercies of the market. Now the price of liquidity has been driven to zero. Yet neither the Federal Reserve nor the Treasury believes that it has done enough.
Our problem today is not that the world economy faces a liquidity squeeze. Far from it: US$ 1,000 face value of two-year U.S. Treasury notes will get you US$ 998 in cash, a lower price of liquidity than has ever been seen before outside the Great Depression and Japan in the 1990s. Yet the risk premiums on non-Treasury assets have soared to barely believable heights: a 5 percentage point-per-year interest rate premium for holding a CD issued by a private bank rather than a Treasury bond issued by a public government. And it is this rise in the risk premiums that threatens to send the global economy into a deep recession, and turn the financial markets from a spectacle of schadenfreude into a malign source of unemployment and idled factories worldwide.
The U.S. Federal Reserve, the U.S. Treasury, the ECB, the Bank of England, and other public financial regulatory entities are being pushed down the road toward a further expansion of their role. Expanding the demand and reducing the supply of these risky assets is a way of manipulating the price of risk. The Federal Reserve and the Treasury are walking down a road that ends with making the price of risk in financial markets as well as the price of liquidity an administered price.
This was how central banking got started in the first place: Letting the market and the market alone determine the price of liquidity was judged too costly for the businessmen who voted and the workers who could overthrow governments to bear. Now it looks as though letting the market alone determine the price of risk is being judged similarly too costly for today’s voters and campaign contributors to bear.
For more than two centuries it has been well known that market economies are very flawed ways of organizing human society, although perhaps much less flawed than the other ways we have tried. The hope has been that these flaws can be compensated for – through progressive tax-and-transfer systems and the public provision of the basic human standard of living and amenities as recommended in Britain’s World-War-II era Beveridge report, and through the use of monetary and fiscal policies in the manners recommended by Wicksell, Keynes, and Friedman to make Says’ Law – the principle that the market guarantees nearly-full employment – true in practice even though it is not true in theory.
Today we once again discover that the global market economy can go awry in ways that have escaped all our forethought and planning.
[i] See
[ii] Michael Mussa (2004), "Global Economic Prospects: Bright for 2004 but with Questions Thereafter" (Washington: Institute for International Economics: April 1)
[iii] See J. Bradford DeLong (1999), “Should We Fear Deflation?” Brookings Papers on Economic Activity
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