The Greenspan Mystique

We may not have a president soon, but we’ll have someone just as powerful: an infallible philosopher-king named Alan Greenspan.

That, at least, is the way much of the world views the seventy-four-year-old economist and clarinetist who has been chairman of the Federal Reserve Board through the longest unbroken period of growth in history: 116 months and counting. It’s safe to say the Fed — which has authority to set interest rates and thus adjust economic growth — is Greenspan, but he has become something more: He helped form the fiscal policy that produced the biggest budget surpluses the world has ever seen.

But how good is Greenspan? And why is he so popular, considering that his job, as old Fed chairman William McChesney Martin put it, is to “act as a chaperone, taking away the punch bowl when the party gets too wild”?

On the second question, Bob Woodward in Maestro: Greenspan’s Fed and the American Boom has a convincing answer. “In this culture,” he writes,

politicians, actors, and nearly all public figures are produced and handled. Greenspan emerges as one of the few who seems to maintain a steady and sober detachment. . . . Although his words are almost unbearably opaque, he appears to be doing something rare — telling the truth. . . . The public has rewarded his caution, reflection and the results with their confidence. That he is the unelected steward of the economy is simply accepted.

Authenticity, honesty, and results: So far, so good. But how good? Would this boom have happened without him? Would it have been even more impressive? And would it now be coming to an end, as more and more analysts believe?

A little over thirteen years ago, Greenspan was sworn in as chairman of America’s central bank — issuer of currency, regulator of financial institutions, and guardian of the dollar. Since he was named by Ronald Reagan to replace Paul Volcker, he has been appointed to three more four-year terms, once by George Bush, who later accused him of causing the recession that led to his defeat (“I reappointed him and he disappointed me”), and twice by a grateful Bill Clinton. “Of all the important people in Clinton’s life, nearly all — including himself — had let him down or not lived up to their full promise,” Woodward writes. “Hillary had failed to deliver health care. . . . Vice President Gore, though loyal, had not yet emerged as a vibrant successor. . . . Greenspan alone had stood and improved his ground.”

Greenspan has three major accomplishments — at least as far as most people see them:

* He helped defuse four financial crises: a stock market crash, the Mexican currency collapse, the “Asian contagion,” the Russian default.

* He convinced Clinton to take the steps that turned a deficit into a surplus.

* Through raising and lowering interest rates at just the right times, he guided the U.S. economy to unprecedented prosperity — with high growth and low inflation.

Greenspan’s most important accomplishment, however, is something entirely different. It is that he has managed — by keeping an astoundingly open mind — to compose a sensible, imaginative model of the New Economy. This model in Greenspan’s head is a work in progress, as it should be. The problem is that Greenspan is not completely convinced of his creation, and he keeps backsliding. Still, the achievement is remarkable when you consider that Greenspan has two strikes against him: He’s an economist and a politician.

Within a week of his swearing-in, Greenspan was faced with the worst one-day debacle in stock-market history. On Monday, October 19, 1987, the Dow Jones Industrial Average fell 508 points, or 23 percent, wiping out $ 1 trillion in wealth. At times that Monday there were no buyers, at any price, for sellers of shares of large companies. “Alan, you’re it,” Gerald Corrigan, president of the New York Fed, said. “This whole thing is on your shoulders.”

Greenspan did all the right things: He resisted a plan, pushed by other regulators, to shut down the New York Stock Exchange (which would only have increased the panic and unfairly allowed institutions, but not individuals, to sell shares); he told Corrigan to encourage large banks not to call their loans to institutions under pressure; and he issued a one-sentence statement before the markets opened Tuesday: “The Federal Reserve, consistent with its responsibilities as the nation’s central bank, affirmed today its readiness to serve as a source of liquidity to support the economic and financial system.” The Fed would lend money at low rates to banks, preventing a credit crunch.

The Fed had responded to the great crash in 1929 in the opposite way. It raised rates, cutting off credit so banks stopped lending and called in their loans, and failed businesses started to “pile up like so much roadkill,” as Justin Martin writes in Greenspan: The Man Behind the Money (using a typically infelicitous metaphor). “This is the process — not stock market crashes per se — that causes economies to slide into the dumper,” Martin continues, placing the blame on three brief-tenured Fed chairmen in the early 1930s: Roy Young, Eugene Black, and Eugene Meyer. The morning after the 1987 crash, the market seemed not to respond to Greenspan; by noon, the situation appeared almost hopeless. Then, suddenly, at 1 P.M., stocks rallied, and the Dow finished up 102 points. Within a year and a half, it had regained its losses.

Greenspan was never certain of what turned the market around. But whether his statement was the reason, the fact is that the market did rebound — just as it did after the Mexican financial crisis of 1995 (a tidbit revealed in Woodward’s book is that Greenspan telephoned Rush Limbaugh to urge him to back the $ 40 billion Mexican rescue package). So too the market bounced back after the devastation in Asia in the fall of 1997, when the currencies of Korea and Thailand collapsed and the Dow fell 554 points in one day. And then the market did it again after the default of Russia in 1998, which toppled the house of cards built by a hedge fund called Long-Term Capital Management, started by a former Salomon Brothers ace and two Nobel Prize-winning economists.

In this last case, Woodward discloses, “Greenspan wasn’t happy” that William McDonough, president of the New York Fed, had “lent the good name” of the institution to a deal by which sixteen Wall Street firms contributed $ 3.6 billion to prevent Long-Term Capital from reneging on its debts (owed to many of these same firms), which may have triggered a world financial crisis, even a recession. But the chairman stuck by McDonough during congressional hearings questioning the Fed’s role.

Greenspan, who was once prominent in the circle around the “Objectivist” writer Ayn Rand, still describes himself as a libertarian. He is instinctively squeamish about dispatching government money and power to fight battles in the private markets — which may be why he didn’t rate the risk of contagion from Long-Term Capital as high as McDonough did. But on Mexico and Asia, he backed the interventionist plans of Treasury secretary Robert Rubin and the International Monetary Fund. All of these crises dissipated, but the interventions had planted the risk that, when you bail someone out, you encourage him to act recklessly in the future. While the actions were questionable in economic terms, they helped Greenspan enhance his reputation as a magician and build political capital with Clinton.

Greenspan already had impressive political capital by the time he sat down for his first meeting with Bill Clinton in Little Rock on December 3, 1992 — more than a year before Mexico and a month after the election of the first Democratic president in twelve years. The chairman made his pitch in a three-hour session: Interest rates were high because budget deficits were high. Banks and private investors were worried about inflation, so, in lending money (or buying bonds), they insisted on a large interest-rate premium for protection. Nothing could do more to help the economy than a drop in long-term interest rates, Greenspan told Clinton. The Fed didn’t control long rates, only short rates, but — Woodward reports Greenspan told Clinton — “credible action to reduce the federal deficit would force long-term interest rates to drop, as the markets slowly moved away from the expectation of inevitable inflation.” Then the economy, just emerging from a shallow recession, would recover vigorously, thanks to “demand for new mortgages, refinancing at more favorable rates and more consumer loans.”

Greenspan, as Martin puts it, “had been waiting a long time to deliver this spiel.” Bush’s advisers had earlier rebuffed him, but now he was offering a deal. He told Treasury secretary Lloyd Bentsen that if Clinton would propose a budget reducing the deficit by $ 140 billion or more in 1997, he would back the administration publicly; long-term rates would fall, and so would inflation, making Greenspan’s job a lot easier. Clinton agreed, and the chairman dutifully made headlines by telling the Senate Banking Committee the president’s plan was “serious” and “credible.” Within a week, long-term rates began to fall. Woodward writes that Greenspan’s impact on Clinton “was real and positive — a degree of influence he had not begun to approach during the more than five years he had been chairman under Reagan and Bush.”

But this story is a little pat. “Clinton was an odd hybrid,” Martin writes. He “grew enamored of the idea of deficit reduction wedded to an old-fashioned Keynesian stimulus package to jump-start the economy. But a stimulus package, by necessity, would raise government spending, adding to the deficit.” Woodward makes no mention of this package, pushed by Hillary Clinton and Labor secretary Robert Reich. Ultimately, the president sent it to the Hill, but it was defeated by Republicans and moderate Democrats like John Breaux.

Then, too, history shows little correlation between high deficits and high interest rates. Deficits, for instance, rose during Reagan’s term, but rates fell sharply. Greenspan may have been as disingenuous as Clinton at their meeting, since the Fed chairman must have known that the key in fiscal policy is not how but how much: It is the level of spending that counts — the amount that the public sector is sucking out of the private sector — and where that spending is going. Whether the spending is financed through borrowing (thus creating deficits) or through taxes is not nearly as important. Still, by pushing Clinton to reduce the deficit, Greenspan may have encouraged him to do two good things: put a damper on spending, and watch the long-term bond rate as an indicator of his administration’s success.

The price, however, was high for a libertarian — $ 241 billion in tax increases. Ever since, Clinton has claimed that his tax rate hikes turned the deficit into a surplus — a dangerous legend. The truth is that the deficit disappeared because the economy boomed, not vice versa. What was beneficial about Clinton’s role was not his tax hikes but his overall budget, which indicated that he wasn’t the profligate Democrat that Wall Street had feared. And don’t forget that the stock market and the economy did not really take off until after a Republican Congress — the first in five decades — was elected in 1994.

The Fed’s main job is to calibrate interest rates in a way that keeps inflation in check but does little harm to business activity. The cliche is that the economy is like a huge ocean liner whose captain needs to start rotating the wheel months, or even years, before the ship makes it turn toward port — but the cliche happens to be true. The Fed chairman, the board’s governors, and the twelve regional bank presidents have two resources at hand: They can directly set the discount rate, which the Fed charges banks that borrow its money, and they can indirectly raise or lower the federal funds rate that banks charge each other for overnight loans.

It is this second resource that has received most of the attention in recent years. The Federal Open Market Committee, whose membership includes the governors plus five of the regional presidents, meets eight times a year to decide what to do with the funds rate. If the FOMC wants to raise rates, it sells some of the bonds it holds in inventory; and the buyers take cash out of circulation to purchase them. When cash becomes scarce, then it becomes more expensive and rates rise. If the Fed wants to lower rates, it buys bonds, creating new cash that it pumps into the economy.

Back in 1978 — to replace Arthur Burns, who had been Greenspan’s mentor at Columbia University — President Carter named G. William Miller as Fed chairman. Miller proved a disaster, allowing inflation to get utterly out of hand. Consumer price increases eventually were rising at an annual rate of 14 percent. Miller lost his job after seventeen months, and Greenspan’s predecessor, Paul Volcker, inherited a mess. Volcker had only one choice: He raised the Fed funds rate quickly, all the way to 19 percent by 1981. The prime rate, charged to banks’ best customers, peaked at 21.5 percent, and unemployment rose to 10 percent. But, Volcker, as Martin writes, “succeeded in breaking inflation’s back. The consumer price index’s annual rate of change fell to 3.2 percent and never rose above 5 percent for the duration of his tenure.”

Volcker was a superb Fed chairman, and Reagan reappointed him in 1983. But by 1987, Reagan wanted his own man, and — at the suggestion of James Baker — Greenspan was picked. Greenspan had been the chairman of the Council of Economic Advisors under Gerald Ford — a two-year tumultuous term that included a deadly combination of inflation and recession called “stagflation,” the WIN campaign (“Whip Inflation Now”), a silly attempt to thwart higher prices by getting consumers to bargain harder and resist consuming, and the New York City financial crisis — during which Ford, with Greenspan’s backing, wisely refused to step in with federal aid. In 1981 Reagan asked Greenspan to head a bipartisan commission to find a way to preserve Social Security. Its recommendations — mainly payroll tax increases — were signed into law in 1983.

At least as far as FOMC activities were concerned, Greenspan started off as a kind of Volcker Junior. Inflation had begun rising from below 4 percent in late 1988, and the Fed’s governors — who had given its chairman unprecedented power (gained, as Woodward demonstrates, through Greenspan’s exceptional political skills) — moved quickly to cut it off.

The Fed funds rate rose from 6.5 percent to 9.75 percent by 1989, despite kicking and screaming from the Bush administration, which had just taken office. Then Greenspan began cutting rates, but, coming on top of an oil price shock precipitated by the Gulf War, the action was too little, too late, and the country went into a brief and shallow recession (or, in the jargon of economists, negative growth) from mid-1990 to early 1991.

Greenspan’s manipulations of interest rates were not better than average, or perhaps even below average, but that would change.

Rates had continued to fall through 1993; the economy revived, but there was no inflation in sight. In fact, the Consumer Price Index had dipped close to 2 percent. But Greenspan, in poring over the economic data, was convinced that inflation was coming back, and he began in February 1994 a regime of aggressively raising short-term rates, boosting them from 3 percent to 6 percent. Martin writes: “There’s an impression — widely held and mistaken — that Clinton simply stood by and accepted this change in direction by Greenspan and the Fed. Hardly. The president was livid.” But the chairman was right. As a result of the rate hikes, the economy slowed in early 1995, but there was no recession — instead, a classic soft landing. Then, the Fed cut funds rates mildly from 6 percent to 5.25 percent, and growth accelerated again.

But the consensus of expert opinion held that this new prosperity could not possibly last. In the New York Times in February 1996, economist Paul Krugman ridiculed high-growth proponents like financier Felix Rohatyn (and me, for that matter). Such folks were living with a “delightful fairy tale,” he wrote. “In fact, the so-called revolutions in management, information technology and globalization are vastly overrated by their acolytes.”

Krugman was dead wrong. In fact, the next four years would see the most powerful economy in history, with gross domestic product rising an average of more than 4 percent, unemployment falling below 4 percent, the Dow doubling, inflation tame at about 2 percent — and all in the very late stages of a recovery that began in 1991.

It was just this powerful economy that presented Greenspan with his next challenge. According to prevailing theory, he should have slammed on the brakes again, raising interest rates to choke off inflation before it got started, but he held off. His suspicion was that technology was increasing the output of workers. If that was true, then inflation would not have to be the inevitable byproduct of low unemployment and high growth — the relation enshrined in the Phillips Curve, which dominates macroeconomic thinking.

“Greenspan,” Woodward writes, “had been questioning the official productivity numbers for almost three years.” These figures showed that productivity — that is, the economy’s output for a given input — was still stagnant. He asked Larry Slifman, a top Fed economist, to run the numbers a different way. When he did, he found that, indeed, the traditional figures were flawed. “There was a real world out there,” Woodward paraphrases Greenspan, “and they were not measuring it properly.” The chairman’s conclusion was that “the dominant feature of the outlook was uncertainty. Since higher inflation was not a foregone conclusion, it would be best to do nothing.”

So, for three years (with the exception of a quarter-point hike in 1997), the Fed held rates steady. It proved the right choice: Inflation did not increase; in fact, growth of the consumer price index dropped to 1.5 percent by early 1998. Still, Greenspan was not sure if this productivity growth, which had begun to show up dramatically in the statistics, was real. On December 5, 1996, at the annual dinner of the American Enterprise Institute, he warned of “irrational exuberance” in the stock market, implying that shares might be in a bubble, puffed up by enthusiastic investors who had lost sight of the fundamental value of the businesses they were buying. At the time, the Dow was at 6,437, and investors who sold out at the chairman’s warning missed gains of 70 percent or more. Greenspan issued similar warnings later but then, suddenly last year, changed his tune. In a series of speeches, he made it clear that something really was happening in the economy that was different, and that the rise in stock prices — not to mention the condition of high growth and low inflation in the economy — wasn’t so irrational after all.

The question is why, and the answer is productivity growth. Since 1995, output per hour has been rising at 3.5 percent annually — twice the rate of the preceding quarter-century. The reason is technology, but not just any technology:

The development of the transistor after World War II appears to have initiated a special wave of innovative synergies. It brought us the microprocessor, the computer, satellites, and the joining of laser and fiber-optic technologies. By the 1990s, these and a number of lesser but critical innovations had, in turn, fostered an enormous new capacity to capture, analyze, and disseminate information. It is the growing use of information technology throughout the economy that makes the current period unique.

Still, it was only in the mid-1990s that the full value of computer power was realized “after ways had been devised to link computers into largescale networks.” Then, Greenspan gets to his revolutionary idea:

At a fundamental level, the essential contribution of information technology is the expansion of knowledge and its obverse, the reduction in uncertainty. Before this quantum jump in information availability, most business decisions were hampered by a fog of uncertainty. . . . In that environment, doubling up on materials and people was essential as a backup to the inevitable misjudgments of the real-time state of play in a company. Decisions were made from information that was hours, days, or even weeks old.

But no more. Computers networked by the Internet reduce risk and raise productivity. Businesses get more output from the same inputs because they know more about what’s happening within their own factories and stores and within their markets. The traditional business cycle works this way: Prosperity reduces unemployment and increases the demand of consumers for more goods. That demand bumps up against supply, which can’t catch up. So prices rise. The Fed comes in with interest-rate increases to stop inflation, and the economy slows down, usually into a recession. Then the process begins again. But under Greenspan’s model, supply does keep up with demand because productivity increases output. So inflation remains tame. At the same time, the reduced risk raises the value of the underlying assets of a corporation, so its stock-market value rises.

Greenspan’s model makes sense of the late 1990s. The problem is that he himself seems unconvinced.

The two new books that treat the life and times of Alan Greenspan are remarkably complementary. Maestro: Greenspan’s Fed and the American Boom, the eighth book about government by Bob Woodward, begins in 1987 with Volcker’s decision to retire. There are only brief flashbacks to Greenspan’s childhood, his years as a musician and a Randian Objectivist, his career as an economic consultant, and his years on Ford’s Council of Economic Advisors. Maestro is typical Woodward, for good and bad. The good is that he shows, in wonderful detail, how Greenspan made decisions — and you feel you’re right there.

Woodward is evenhanded, intelligent, and clear, and even though it’s obvious that finance isn’t his favorite subject, he makes no mistakes and describes arcane procedures well. The bad is that Woodward is often an awkward writer (“Greenspan and he would be number one and two at one of the most important arms of the most important government in the world”) and, as usual, provides infuriatingly limited notes. “The core of this book,” he writes in the acknowledgments, “comes from more than one hundred sources who agreed not to be revealed.” One, evidently, is Greenspan. Woodward asks the reader to trust him — and while in general I do, I want to know who told him what so I can apply my own judgment. I suspect Woodward, like any journalist, goes easy on his best sources — maybe even Greenspan and Clinton.

Since Justin Martin, a former staff writer for Fortune magazine, lacks Woodward’s reputation, he has to make up for it with more candor and hard work. He has talked to everyone — except, it appears, Alan Greenspan, Bill Clinton, and George Bush — and he’s talked to them on the record: Gerald Ford, James Baker, Milton Friedman, Henry Kissinger, Greenspan’s ex-wife Joan Mitchell Blumenthal, his current wife Andrea Mitchell, his high school girl-friends, nearly every important Fed governor who is still alive, and on and on. But, curiously, Martin seems to have made no use of the treasure trove of verbatim transcripts that the Fed began releasing recently (with a five-year lag) of its Federal Open Market Committee meetings. Those transcripts (more than the highly touted off-the-record interviews) form the core of Woodward’s book. They reveal Greenspan as a tough, smart politician and an intellectual with an open mind. When the FOMC gathers, the chairman, as Woodward points out, traditionally gets his way, but there is always the chance that he won’t, and, if he doesn’t, he’s through. Greenspan — who seems to have known every important person of the second half of the twentieth century, from Stan Getz to John F. Kennedy — makes abundant friendships and seems genuinely interested in other people’s lives. He is far more the son of his gregarious mother Rose than of his distant father Herbert, a stockbroker and economic consultant.

Martin’s book, in contrast to Woodward’s, has the form of a conventional biography. (And, by the way, the pictures Martin includes are terrific, especially one with Ayn Rand and one of his bubbly mom when Ford was swearing Greenspan in as CEA chairman). We don’t get around to Greenspan’s appointment as Fed chairman until we’re two-thirds through. We learn, however, that, “by the age of five, he was able to add up three-digit numbers in his head” and his “mother often trotted him out to do this trick to impress guests and neighbors.”

Unfortunately, Martin’s prose is often excruciating, full of cliches and mixed metaphors. I nearly put the book down on the very first page when I read in the acknowledgments: “My research assistant for this project was Stephen Norton. . . . As Frank Lloyd Wright famously said, ‘God is in the details.’ Stephen helped dig them up in spades.” But I preserved — and Norton and Martin prove to have done a lot of digging. They provide fascinating details on the Rand circle (Greenspan’s first wife, Joan Mitchell, was a Randian who later married another Randian, Allan Blumenthal, who was the cousin of Nathaniel Branden, Rand’s most devoted follower). Martin spends a whole chapter on Greenspan’s career as a musician, attending Juilliard and playing saxophone and clarinet with Harry Jerome’s touring band (along with Leonard Garment, another saxophonist who later became counsel to President Nixon). Greenspan was quoted in Stephen Beckner’s 1996 book, Back from the Brink, as saying, “I was a pretty good amateur musician, but I was average as a professional, and I was aware of that, because you learn pretty quickly how good some professional musicians are. I realized it’s innate. You either have it or you don’t.”

That insight turns out to be important. Greenspan’s own innate gift was for numbers — specifically, for assimilating complex economic data, and then making intuitive decisions, as he did both in raising rates in 1994 and in holding them steady during the boom after 1996. When the president named Greenspan to a fourth term in January, Clinton told him, “You know, I have to congratulate you. You’ve done a great job in a period when there was no rulebook to look to.”

Greenspan has been writing his own rulebook, but, as a great assimilator, he can’t be sure how many of his New Economy ideas to include. Greenspan’s great talent is eclecticism — strange as that may seem for someone who sat at the feet of a dogmatist like Ayn Rand — and, in recent years, I wish he had had more faith in his own new ideas and less in the macroeconomics of the past.

In June 1999, with inflation at a modest 2 percent, Greenspan began raising the Fed funds rate again. The FOMC hiked it six times, ultimately to 6.5 percent: the highest rate since 1991, when inflation, by contrast, was over 5 percent. If Greenspan believed his own model — a New Economy, with technology-driven productivity holding down inflation — why was he pushing up rates so aggressively? Neither Woodward nor Martin (who abruptly ends his book in 1998) has an explanation.

The recent rate hikes ended last summer, and the total increase — 1.75 percentage points — was only a little more than half the tightenings of the late 1980s and mid-1990s. Still, Greenspan seems to have gone too far — especially with the double whammy of a spike in oil prices, which always slows growth. My guess is that the chairman has engineered another soft landing — though why a landing at all? This economy can grow at 4 percent without significant inflation, and the Fed should let it.

Meanwhile, of all the alternatives out there, Greenspan is far ahead of whoever is in second place — a fact that George W. Bush or Al Gore should keep in mind when the chairman’s fourth term ends. How good is Alan Greenspan? Oh, he’s very good.

James K. Glassman, a resident fellow at the American Enterprise Institute, is host of the website TechCentralStation.com and co-author of Dow 36,000.