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On 31 January, Alan Greenspan stepped down after 18½ years as Chairman of the Fedeal Reserve. This paper offers a Washington based assessment of his legacy, especially on the objectives of low inflation and transparency in central bank procedures.

He will also be remembered for having responded to major financial crisis – from the October 1987 crash in the stock market to Russia’s 1998 default – by easing monetary policy in an effort to provide liquidity to financial markets. This has met with some resistance in Europe.

But inflation is no longer the devil; the asset price bubble has taken its place. This is now the challenge for Greenspan’s successor Ben Bernanke. The new Fed Chairman has to solve one puzzle in particular: to establish the link between the recent escalation in property values and the US current account deficit, and decide on interest rates accordingly.

This past week in Washington, the press has been filled with accolades and anecdotes. President Bush hosted a dinner party that included the Who’s Who from the American political and financial community. Why? Because an era has come to an end. America’s monetary monarch – Alan Greenspan – has stepped down after 18½ years on the throne of the Federal Reserve.

How the world has changed in those 18½ years! Consumer price inflation rose more than 4 per cent over the year that ended in August 1987 – the month in which Greenspan arrived at the Fed. America’s battle with high inflation in the late 1970s and early 1980s, during which annual inflation topped 13 per cent, is well-known. Also well-known is Paul Volcker’s success at changing the Fed’s monetary policy procedures and bringing inflation down. But lest we forget, when Greenspan took over from Volcker as Chairman of the Fed, the low inflation environment we see today had not yet been achieved. We were on our way there, but our arrival was far from sure. Greenspan secured that arrival for us, in his leadership of the Fed and its policy-making body, the Federal Open Market Committee (FOMC), and in his interpretation of the economy and events. He gave us a way of thinking about the role that monetary policy plays in the economy: that low and stable inflation is necessary so that producers and consumers do not think about inflation when making their decisions and planning for the future. When such low and stable inflation is achieved, the economy can grow at the highest rate possible, given the available technology and inputs to production. And not only did Greenspan explain policy to us, he delivered in terms of economic outcomes too. In only one year since 1991 have consumer prices in the United States risen in excess of 3 per cent. We have had robust growth in real GDP year after year or very nearly so, and from the spring of 1991 until the spring of 2001, we enjoyed for 120 months – the longest business cycle expansion in US post-war history.

Greenspan’s interpretation of the role of monetary policy came before every central banker in the world could chant the price stability mantra and before the Reserve Bank of New Zealand adopted a regime known as inflation targeting. Today’s central banks and their monetary policy look nothing like what they did when Greenspan arrived on the scene which, by the way, was more than five years before the UK’s Ken and Eddie show.

Greenspan’s interpretation was useful too because the Fed’s legal objective is a confusing one that combines goals for inflation with goals for unemployment and interest rates.2 If there is no trade-off between unemployment and inflation in the long run – a view held by probably every economist today – then the best a central bank can do is achieve price stability. Greenspan, in discussing the Fed’s objectives the way he did, made clear that the FOMC was aiming at price stability and that that goal, once achieved, would be associated with full employment.3 Although this was remarkable progress early on, in later years Greenspan dodged opportunities to refine the Fed’s mandate. Legislation introduced in 1995 would have eliminated the ambiguity in the Fed’s statute and charged the central bank with achieving price stability; subsequent legislation went further and paved the way for an inflation target.4 In no case did the bills progress very far through the legislative process. Chairman Greenspan did not support them, perhaps because he didn’t want the US Congress to pick the price index or the numerical definition of stability, perhaps because he preferred discretion, perhaps because he just didn’t want to change.

As other central banks around the world evolved – and evolve they have done in the last twenty years – many adopted inflation targeting regimes and most became much more transparent about their decisions and practices. The Fed became more transparent too, but in a way that suggested that perhaps it didn’t want to. For example, since January 1994, the FOMC has announced any change in policy immediately following the conclusion of its meeting. But the circumstances in 1994 that prompted this were not a concern for the effective communication of monetary policy to the public. Rather, following a bruising battle with the US Congress in the autumn of 1993 over the timely release of information during which Greenspan revealed that the Fed staff had kept historical meeting transcripts, the FOMC sought to avoid further complaints and publicity. Greenspan and his committee became more open over time, but the Fed’s practices generally lagged behind those of other major central banks.

The new Fed chairman, Ben Bernanke, is well schooled in transparency and in its close relative, inflation targeting. So it will be interesting to see how long he waits before suggesting such a change and how he would do it. There are hurdles to be leaped in terms of Congress if inflation targeting is implemented formally, but economic thinking – even among American politicians – has probably evolved enough to withstand an amendment to the Federal Reserve Act. By more clearly defining what the Fed is supposed to do, inflation targeting would make us less reliant on icons like Greenspan to run the place. We would still need competent policy-makers, but we would not need to deify them.

It is difficult, from today’s vantage point, to recall all of the events that had not yet occurred when Greenspan arrived at the Fed. In August 1987, the US had not yet weathered the stock market crash that came two months later when the Dow Jones Industrial Average dropped 23 per cent in a single day. We had not yet experienced the crisis in our savings and loan industry, repealed the Glass-Stegall legislation that set barriers between commercial and investment banking, or witnessed the productivity miracle of the late 1990s or the technology bubble in stock prices that burst in the spring of 2000. In August 1987, Japan’s asset price bubble had not yet peaked and we could not yet know the recession and deflation that would follow. Mexico had not yet been hit by the Tequila crisis. The crises in Asian emerging market countries had not yet occurred. Russia and Argentina had not yet defaulted.

Starting with the October 1987 crash in the stock market, Greenspan’s Fed responded to many of these events by easing monetary policy in an effort to provide ample liquidity to financial markets so that these markets would not seize up but would instead continue to function properly. By taking this approach, the Fed ensured that the fall-out from a particular event would not spill over into the real economy and thereby engender recession. Witness, for instance, the FOMC’s one quarter percentage point cut in its target for the federal funds rate in September 1998 following Russia’s default on its government bonds. The Fed also presided over the rescue of Long-Term Capital Management (known as LTCM) that September, a large and prominent hedge fund that hovered on the brink of bankruptcy after Russia’s default led to heavy losses on its sovereign bond portfolio. In October and November the FOMC voted further cuts in interest rates, and by November the funds target was 100 basis points below where it had been the previous summer.

The events listed above certainly suggest that most of the crises or challenges in the world economy since 1987 have arisen in financial markets and been propelled further by them. Perhaps that is the legacy of the widespread financial deregulation and globalization that have taken place around the world over the past two decades. But what is the role of monetary policy in that environment? Should monetary policy always respond immediately to such crises, dispensing liquidity and mopping it up later? Does that sort of policy, once it is anticipated, generate some sort of moral hazard whereby financial market participants have an incentive to take on too much risk precisely because they know the Fed will step in at the key moment and cut interest rates to keep the economy from collapsing? Would it not be preferable for monetary policy to do something pre-emptively to reduce the size of market overvaluations or asset market bubbles and thus lessen the likelihood of a crisis? For instance, does it help if the central bank issues warnings about 'irrational exuberance’, as Greenspan did in 1996? Or, going further, should monetary policymakers take asset prices explicitly into account when formulating settings for shortterm interest rates? These are the questions that are plaguing central banks today. Inflation is no longer the demon – the asset price bubble has taken its place.

To be sure, we do not know all the answers yet. But, interestingly, the Atlantic Ocean seems to be the dividing point for different perspectives on this issue. Central bankers to the east of the great pond think that asset prices should be considered explicitly and separately when deciding monetary policy, with interest rates set slightly higher when markets have over-extended themselves than would be justified purely on the basis of the real economy. Here on the west side of the Atlantic the central bank believes that asset prices are only important insofar as they help to predict future inflation and output, and that monetary policy cannot take pre-emptive action against a bubble, only mop up the mess afterwards.

As the new monarch assumes the Fed throne, we are now faced – both in the US and in many other countries – with a substantial run-up in housing prices. America also faces an unprecedented deficit in its current account, the broadest measure of its trade in goods and services with the rest of the world. Precisely how and by what magnitude the escalation in property values, on the one hand, has affected the current account deficit, on the other, is not completely clear. However, it seems likely that activity in the housing market has provided the necessary wealth for a consumption boom, and that that boom has fed into spending on imports. These two issues, and their unwinding, are a legacy of the Greenspan era. What will Ben Bernanke do? We do not yet know, but the world economy awaits his action.

Ellen Meade, Chatham House February 2006

Ellen Meade is an Associate Professor of Economics at American University in Washington, DC. Previously, she was Senior Research Fellow in the Centre for Economic Performance at the London School of Economics, Senior Economist on President Clinton’s Council of Economic Advisers, and for many years a Senior Economist at the Federal Reserve Board.

1 ‘Banzai’, a Japanese word used to greet the emperor and to cry in battle, is translated as ‘May you live ten thousand years.’

2 The Federal Reserve Act specifies that the Fed and its FOMC should attempt to ’promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates’. See Purposes and Functions, Board of Governors of the Federal Reserve System, Washington, DC, 2005,  p. 15.

3 Full employment is achieved when unemployment is at its natural rate.

4 Senator Connie Mack and Congressman Jim Saxton introduced HR 2445 in 1995 that would have changed the Fed’s mandate and established a numerical definition of price stability. On several occasions subsequently, Saxton introduced legislation that would refine the mandate and initiate inflation targeting. For a list of these legislative initiatives, see Brian Higginbotham and Kurt Schuler, ‘Price Stability and Inflation Targets: A Legislative History’, Joint Economic Committee Study, July 2004, www.house.gov/jec/fed/07-14-04.pdf.

Chatham House (The Royal Institute of International Affairs) is an independent body which promotes the rigorous study of international questions and does not express opinions of its own. The opinions expressed in this paper are the responsibility of the author.

© The Royal Institute of International Affairs, 2006. All rights reserved

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