August 13, 2002


Give Greenspan's Fed Its Share of the Blame (William Greider, August 13, 2002, Washington Post)
For most of the past 20 years, the central bank continued to fight the last war -- inflation -- and did so by restraining economic growth artificially. Its brake produced many years of higher unemployment than was necessary, thus ensuring stagnant or falling real wages for ordinary working people. [...]

In the run-up to the current debacle, Greenspan's first pivotal error occurred back in 1996, when he and other Fed governors first recognized a price bubble forming ominously in stock markets. Then-governor Lawrence Lindsey (now the president's economic adviser) urged the chairman to act promptly. Raising margin rates would tighten stock-market borrowing -- the easy credit investors use in a speculative binge -- and ring a loud warning bell for giddy investors. But Greenspan waved off Lindsey's prescient plea. A few months later, the chairman did speak once of "irrational exuberance," but the markets reacted badly. He dropped the subject. [...]

But Greenspan's second great error was joining the celebration himself. He suggested that rising productivity had opened a glorious new era of ever-upward prosperity. His ebullient remarks sounded very similar to the self-congratulations expressed by the Federal Reserve in the late 1920s. Then and now, the Fed's happy talk excited stock-market plungers, large and small.

The third error was the Fed's belated attempt in early 2000 to get some control over frenzied events -- an error because it did so by hammering the real economy with interest-rate increases, rather than restraining the financial system directly. Greenspan claimed to detect a phantom price inflation in goods and services. Actually, the only price inflation was in the stock market. The obvious injustice was punishing the many for the excesses of a relative few, driving the broad economy into recession in order to calm down the out-of-control financial system.

Greenspan overdid it and was compelled to reverse himself abruptly, cutting interest rates dramatically to revive economic activity. Having cut rates so deeply, the Fed is now dangerously close to zero -- that is, to running out of arrows. Yet Wall Street once again is clamoring for a big rate cut to salvage the deflating stock market. This time Greenspan should ignore the bankers and brokers and allow the stock market to find the "bottom" on its own. The Fed and the White House should prepare a substantial, well-timed package of monetary and fiscal stimulus designed to kick-start the real economy of goods and services. Financial markets will follow.

William Greider, whose Secrets of the Temple: How the Federal Reserve Runs the Country is the best popular book ever written about the Fed, gets more right than wrong here. The first error he speaks of is more technical than I'm capable of discussing intelligently. The second error he cites is actually probably true and may eventually be proven to be one of the main reasons (along with globalization/free trade) why there is no inflation. But the third error he cites is exactly right. The Fed kept raising interest rates as if inflation were right around the corner when in fact we were in a long deflationary cycle. In effect, the Fed caused this economic slowdown.
Posted by Orrin Judd at August 13, 2002 7:25 PM
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