Is Alan Greenspan a fraud? The chairman of the Federal Reserve Board has built a reputation as a miracle-worker. He’s the man, more than any other, who’s given credit for the economy’s impressive performance (strong growth, low inflation). Now comes Bert Ely, a well-known private economic consultant, to assault the conventional wisdom. The “market”–not the Fed–has made the economy hum, he says. Ely’s half right, and his theory is worth examining because it says a lot about how the economy works.
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Private investors, Ely argues, are the main regulators of the economy’s tempo. Any hint of excessive growth or higher inflation, he says, causes them to nudge up interest rates on long-term bonds and mortgages. This slows growth and prevents shortages that would raise inflation. If growth and inflation worries slip, so do long-term rates. Economic growth then improves. Significantly, the Fed doesn’t control long-term rates. It can change only the overnight lending rate between banks. Although this influences rates on bank loans and credit cards, long-term rates matter more to the economy.
The idolatry of Greenspan, then, seems exaggerated. Moreover, the Fed appears to have little to do with many of the other favorable forces that have pressured companies and workers to restrain wages and prices. By now, these forces are familiar: intense competition; the deregulation of various industries; corporate “downsizing”; and the explosion of computer technology. Ely has taken to distributing buttons sarcastically inscribed “All hail St. Alan” to puncture the aura of infallibility around Greenspan.
Case closed? Not exactly. What Ely says is mostly true, but what’s unsaid is equally important. Although the U.S. economy is largely self-regulating, it operates within the bounds of government policies. These policies create an economic climate for good or ill. The Fed’s success–not the market’s–has been to improve the climate by reducing inflation.
Recall the figures. In 1979, the Consumer Price Index jumped 13.3 percent; last year, it rose only 3.3 percent. Although the Fed can’t regulate the economy’s growth from quarter to quarter, it can make or unmake great inflations. In the 1960s and 1970s, it kept interest rates too low for too long and pumped too much money into the economy. Paul Volcker, the Fed chairman between 1979 and 1987, shattered double-digit inflation by squeezing money and credit. Greenspan’s Fed has continued a policy of emphasizing stable prices.
To recite this history, though, is to overlook that inflation–or its absence–affects how we all think and act. What are now described as spontaneous changes in corporate and worker behavior are often invisible responses to low inflation. When high inflation was expected to continue, companies thought they could boost profits by raising prices. Workers expected hefty annual pay increases to stay abreast of surging prices. Companies provided them because (it was assumed) higher costs could be recovered in higher prices.
As a result of low inflation, much has changed.
First, the growth of productivity–efficiency–has improved. To increase profits, companies now have to streamline production or cut costs. Little wonder there’s been so much “downsizing.”
Second, unemployment can drop further without raising inflation. Economists call this safe level of unemployment the NAIRU (the non-accelerating inflation rate of unemployment). A few years ago, most economists put the NAIRU around 6 percent. Now, most would lower it. (Unemployment has been below 6 percent since late 1994.) One reason may be that wages no longer explicitly try to compensate for past inflation.
Each of these changes enhances the economy’s capacity to produce and grow. Greater supply dampens inflationary pressures. And low inflation pays a final dividend. It stabilizes the economy. Business cycles stem from miscalculations. Consumers overspend; investors speculate; markets become saturated; government blunders. Low inflation erases one source of miscalculation–erratic price swings.
All this qualifies Greenspan’s reputation. Ely is correct that we shouldn’t deify him. In effect, Ely asks: Why is Greenspan praised when he’s mostly an economic spectator? Greenspan would surely agree that he’s been lucky. He recently told Congress that the economy’s “exceptional” performance “has been better than most anticipated”–an admission that even he has been pleasantly surprised. That’s also a warning, of course. Just because recent surprises have been pleasant doesn’t mean they will always be.
Whatever happens, the central lesson is the virtue of price stability. This is the main idea animating Greenspan’s Fed, and a lot of his good luck is self-made. When the Fed blunders, as it did in the 1970s, growth weakens and the economy becomes less stable. But when the Fed succeeds, growth improves and the economy becomes more stable. The answer to Ely’s question is: The better the Fed does, the less it has to do.