Now What, Alan?

Greenspan's struggle to rescue the economy and keep the peace with a new president.

Few would disagree with the assertion that Federal Reserve Chairman Alan Greenspan had reached the pinnacle of success as he began a fourth four-year term as head of the U.S. central bank in June of last year. Indeed, until quite recently, most have found it difficult to do anything but heap praise on Greenspan and his fellow Fed policymakers for presiding over a record-long economic expansion, in which real GDP growth was unexpectedly strong, inflation was uncharacteristically subdued, business investment and productivity were surprisingly high, and most impressively, the unemployment rate plunged to a three-decade low.

Suspecting correctly that a permanent surge in productivity growth, arising from a business high-tech investment boom, had lifted the non-inflationary "speed limit" for real GDP growth, Greenspan was more tolerant of rapid growth during the 1996-2000 period than many thought prudent at that time. To be sure, Greenspan tightened the Fed's policy stance in 1999 sufficiently to absorb the extra liquidity provided in 1998 to cope with the global financial contagion. Nevertheless, the Fed Chairman did not begin a series of counter-cyclical rate hikes until early 2000, when he perceived that a wealth-induced surge in aggregate demand growth exceeded growth in potential supply, thereby exerting increased strain on an already fight labor market and threatening an escalation in wages and prices. In all, the Fed hiked rates three times in 1999 and three times in 2000, with the last rate hike in May 2000 amounting to fifty basis points, double the normal size.

In recent months, however, critics have been howling that this earlier Fed tightening was excessive and that Greenspan missed the boat in failing to foresee a particularly sharp plunge in economic growth in the final two months of last year. This rapid loss of momentum reflected the combined effects of declining stock prices, which operated through an attenuated wealth effect to curtail consumer spending, and rising energy prices, which acted like a tax increase on debt-heavy consumers.

Why did the usually prescient Fed fail to foresee that the economy would hit a wall in the final two months of 2000? The simple answer is that Fed officials were too complacent last fall; they were convinced that they could achieve an often-elusive "soft landing" Also, there is every reason to believe that the last thing Greenspan wanted to do, following the bursting of the NASDAQ bubble in early 2000, was to be accused of trying to lend a helping hand to battered stock market participants. In the fall of 1998, stock traders and investors cheered when the Fed eased to fight the global financial crisis; this Fed-induced dose of financial bullishness helped propel the NASDAQ to bubble-like highs. From the Fed Chairman's point of view, a post-bubble rescue mission by the Fed would pose the ultimate moral hazard. Specifically, it would tempt investors to behave in a decidedly riskier manner than otherwise would be the case, on the expectation that the Fed would always be there to bail them out. It is no wonder that a growing chores is now asking the exalted Fed Chairman, "What have you done for me lately?"

Also, concern is growing that there will be considerably more policy friction between Greenspan and the new Bush administration than there was between Greenspan and the Clinton administration, although, in congressional testimony on January 25, Greenspan did Bush a big favor by endorsing a tax cut in principle.

Clearly, Greenspan has achieved celebrity status far beyond that of his predecessors. This celebrity status is evidenced by a recent barrage of books extolling Greenspan's virtues, including Bob Woodward's latest book, Maestro. Moreover, it will be recalled that as far back as January 1993, Greenspan was invited to occupy a highly visible seat of honor between First Lady Hillary Rodham Clinton and Tipper Gore, the Vice President's wife, at President Bill Clinton's first State of the Union Address. More recently, Greenspan's celebrity status was enhanced, as he was the first person George W. Bush visited on his initial trip to Washington, D.C. as President-elect. Underscoring that Greenspan's celebrity status may have reached near-deification, even California's Governor Grey Davis chose to visit Greenspan first on a trip to Washington, D.C. to try to untangle California's misguided regulatory problems and its severe shortage in electrical generation capacity, items about which Greenspan would seem to be able to do little other than perhaps offer his keen insights into the implications of the electricity supply-demand imbalance. The bottom line is that it is widely perceived that Greenspan is the second most important person in our government, and, as the new Bush administration assumes power, no one can challenge Greenspan's authority on economic policy issues.

Greenspan has excelled at his job because he is a policy pragmatist rather than a monetarist ideologue. Rather than focusing primarily on monetary aggregate growth, Greenspan holds that the main job of a modern-day central banker is to read capital markets and react appropriately. Actually, Greenspan got his baptism as Fed Chairman in crisis management, notably in dealing effectively with the 1987 stock market crash. He earned further plaudits as a crisis manager in the 1998 global financial crisis. In his counter-cyclical actions, Greenspan seeks to be first to identify imbalances and to promptly adjust monetary policy to correct them. Moreover, he is prepared to reverse course when necessary. In sum, Greenspan seeks to follow a flexible, open policy approach.

Significantly, Greenspan has been more transparent about Fed policy intentions than any of his predecessors. Typically, in speeches or congressional testimony, Greenspan will signal a shift in policy intentions well ahead of actual Fed policy moves. When Greenspan communicates a shift in policy intentions, financial market psychology will change abruptly, triggering related capital market asset price adjustments (i.e., bonds, stocks, foreign exchange, etc.) well before actual Fed policy moves. Greenspan's commendable efforts at greater transparency represent one of his major contributions to modern-day central banking technique.

One of the most difficult tasks of the modern-day central banker is to manage market psychology in a manner that enhances the monetary policy transmission process. In this delicate and complex effort, Fed officials have sought to come up with a policy directive that avoids exaggerated market responses to policy pronouncements.

In December 1998, Fed authorities declared that henceforth they would announce changes in the Fed's policy bias regarding the likely direction of short-term interest rates immediately, if it represented a significant shift in Fed thinking. During 1999, however, the problem was that financial market participants usually overreacted to the Fed's immediately announced changes in its policy bias while tending to under-react to actual Fed policy moves. In May 1999, for example, the financial markets overreacted in a negative direction to the Fed's announcement of a shift to a tighter policy bias. Yet, in June 1999, an actual Fed move to tighten its policy stance was met with wild rallies in both the stock and bond markets, partly owing to the Fed's misleading shift back to neutral in its policy bias.

In any case, Greenspan sought to solve this problem by establishing an internal committee under Vice Chairman Roger Ferguson that was charged with changing the policy directive to focus on the Fed's views concerning the economic outlook and the balance of risks to good economic performance. These changes were implemented at the February 1-2, 2000 FOMC meeting. At this and each subsequent meeting through November of last year, Fed policymakers perceived that the balance of risks was weighted toward conditions that could produce heightened inflation. However, in a significant shift in emphasis, the monetary officials perceived at their December 19, 2000 FOMC meeting that the balance of risks shifted dramatically toward conditions that could produce economic weakness. This new Fed emphasis helped set the stage for the Fed's subsequent aggressive intermitting easing move on January 3, 2001. On balance, the Fed has arrived at policy directive wording that communicates Fed thinking more clearly to market participants, thereby effectively managing market psychology. This Fed effort to avoid excessive swings in market psychology is crucial in a monetary policy transmission process that increasingly relies on capital market asset price adjustments (i.e., stocks, bonds, foreign exchange, etc.) to influence aggregate demand and ultimately real GDP growth and inflation.

Looking ahead, perhaps the greatest challenge facing Greenspan is whether the Fed will be able to work effectively with the new Bush administration to establish an optimal fiscal-monetary policy mix at a time when the economy is rapidly losing momentum. The administration is, of course, proposing large, across-the-board tax cuts that might jeopardize longer-term fiscal discipline. In the Clinton administration, there was an ideal fiscal-monetary policy mix of increased fiscal discipline and general monetary accommodation, which provided the low-interest rate backdrop for a record-long economic expansion. Greenspan had urged President Bill Clinton to reduce the budget deficit, and the Clinton administration, which had planned to do just that even before Greenspan weighed in, produced a plan that raised taxes mainly on the rich, reduced defense spending, and adhered strictly to caps on non-defense spending. In this regard, Greenspan calculated that the negative impact on the economy from increased taxes and reduced government spending would be more than offset by the positive impact of lower real interest rates arising from increased longer-term fiscal discipline, as turned out to be the case.

As regards the future relationship between Greenspan and the Bush administration, the Fed Chairman now sees, in light of upward revised federal surplus estimates, a near-term tax cut as being compatible with longer-term fiscal responsibility. In arriving at the appropriate future fiscal-monetary policy mix, the necessary calculation must be that the favorable impact of tax cuts in promptly stimulating consumer and business spending more than offsets the negative effect in the form of upward pressure on real interest rates, from reduced longer-term fiscal discipline.

In his congressional testimony on January 25, Greenspan surprised Wall Street observers by declaring that in light of upward revised Federal surplus estimates to a hefty $5.7 trillion for the coming decade, it is possible to use the surplus both for the desirable purpose of paying down Federal debt and to cut taxes in the near-term as well. In addition, the Fed Chairman suggested that, in current circumstances, both further Fed easing and tax cuts were appropriate to try to counter the dramatic slowing in the economy. In sum, despite his exalted status, the Fed Chairman is destined to face major near-term challenges, namely an economy that is far weaker than had been expected and the need to establish in concert with a new administration the optimal monetary-fiscal policy mix to fit both short- and long-term circumstances.

In addition to policy differences, the potential for increased friction between Greenspan and the new administration will hinge importantly on personalities. The good news is that Greenspan has been friends with Vice President Dick Cheney, for whom he has the highest respect and admiration, and Treasury Secretary Paul O'Neill, who worked with Greenspan and Cheney on the senior economic policy team in the Ford administration. The bad news is that Larry Lindsey, Bush's chief economist and head of the National Economic Council, has already clashed with Greenspan on the tax cut issue. In the 2000 presidential campaign, Lindsey, a former Fed Governor and ardent supply-sider, frequently asserted that Greenspan favored tax cuts. Just as frequently, Greenspan corrected Lindsey by stating that the best use of the Federal surplus is to pay down federal debt, but if there is not sufficient political will to do this, the next best use is to cut taxes and the least desirable use of the surplus is to increase government spending. This potential source of friction was lessened somewhat when Greenspan altered his view during his January 25 congressional testimony.

Another potential problem in Fed-White House relations is that the Bush administration lacks a senior economic policymaker with extensive financial market experience in contrast with Wall Street wonder Robert Rubin, Clinton's highly regarded Treasury secretary. Rubin worked effectively with Greenspan to keep the record-long economic expansion on track.

It should be additionally noted that Stanford University professor John Taylor, a likely candidate to succeed Greenspan as Fed Chairman, has taken a senior Treasury Department position in the new Bush administration, thereby opening a new channel of potential criticism of Fed actions. Another point of possible conflict surfaced in February, when Treasury Secretary O'Neill, in a Bloomberg Television interview, praised the Government Sponsored Enterprises (GSEs) Fannie Mae and Freddie Mac, and said the two companies "don't receive a subsidy" as critics often argue. That position puts him at odds with Greenspan, who has been critical of the GSEs for taking on a massive amount of debt, under the banner of an implicit government guarantee, to facilitate housing finance.

Moreover, the possibility of growing friction between Greenspan and the new administration is increased by the already evident tendency of Bush to publicly comment on Fed policies, something Rubin forbade anyone in the Clinton administration to do to preserve Fed credibility.

All of this raises the question of whether Greenspan will prove as helpful to Bush--and adept at managing the economy--as he was during the previous eight years.

David Jones is President & CEO of DMJ Advisors, LLC and Chairman of the Board of Aubrey G. Lanston & Co., Inc.