Rational Unexuberance

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Rational Unexuberance

The Age of Turbulence: Adventures in a New World

By Alan Greenspan

(Penguin Press, 531 pp., $35)

Alan Greenspan's book--part autobiography, part narrative of his eighteen years as chairman of the Federal Reserve, and part oracular survey of various Big Questions--has been on the New York Times best-seller list for many weeks as I write. But it has evoked only minor response, in spite of its author's fame and importance. The substance is complex, Greenspan is not exactly terse, and the prose plods. At least it is not written in Fedspeak, the foggy language behind which the Greenspan Fed used to think it was hiding its tracks, until at the end it opted for more transparency. For those who care seriously about the American economy, about monetary policy and the financial markets, there are nuggets of insight in this book, not all of them intended.

Readers should keep an important fact in mind. Greenspan and his immediate predecessor Paul Volcker were far and away the best chairmen that the Fed has had so far in its history of almost a century. (I leave Ben Bernanke out of this reckoning altogether because it is still so early in his tenure.) Greenspan's finest hour was his and his colleagues' management of the long period of prosperity from 1992 to the recession of 2001, especially the last half of the 1990s. It was an amazing and valuable success. The nature of that success is rather interesting: if I am right, it depended on a side of Greenspan's character that is not often noticed, even by himself.

By 1995, the economy of the United States had reached a degree of prosperity--as measured, for example, by the lowness of the unemployment rate--that most professional economists regarded as dangerously inflationary. This conventional judgment was almost unanimous among conservatives, but it was much more broadly held than that. Those observers naturally thought that it was time, or past time, for the Fed to clamp down and bring the broad economic expansion to a stop. The Greenspan-led Fed did no such thing. Month by month, it let the expansion continue. The United States enjoyed five more years of considerable and unusual prosperity, and produced hundreds of billions of dollars worth of goods and services that would have been dissipated in excess capacity and unemployment if the Fed had done the conventional thing. The price level actually slowed down instead of speeding up.

How did this episode of second sight come about? Greenspan tends to take credit for the intuition that the growth rate of productivity in the American economic machine was in the process of increasing dramatically. In fact, between 1995 and 2000, output per hour worked in the non-farm business sector rose at the rate of 2.5 percent per year, compared with 1.5 percent annually in the preceding five-year period. That may not seem like much of a difference, but in the world of productivity growth it is a big deal. This meant that the national capacity to produce was increasing faster than previously thought, and therefore the economy could safely be allowed to expand further than the conventional rules of thumb would have permitted, without running into an inflation barrier.

But this version of the story--Greenspan's version--is a little too neat. Productivity had indeed accelerated, but other pieces of good luck were also important: the beginnings of managed health care brought cost savings to many businesses; the appreciation of the dollar reduced the dollar prices of imports; and foreign competition tended to stifle both wage increases and the pricing freedom of American firms. Even the productivity spurt was more complicated. Greenspan emphasized the cost savings brought about by the introduction of computers into offices, stores, and factories; but in fact a larger part of the productivity acceleration on a national scale came from spectacular cost reductions in the production of computers, printers, and so on.

I am inclined to give Greenspan greater credit for something deeper and more important than a good guess about the productivity trend. He led his colleagues into an unusual attitude of empirically anchored flexibility. Instead of simply obeying the standard rote instructions--"When the unemployment rate reaches 6.5 percent, raise interest rates!"--Greenspan and the Federal Open Market Committee kept trying to discern which way the wind was actually blowing before leaning against it. Did inflation seem to be picking up? Were there definite signs of overheating? If not, let the economy expand for another month and then check again. It worked, and Greenspan deserves much praise for substituting pragmatism for doctrinal rigidity in the making of monetary policy. Central banks are not often like that. I don't doubt that his thoughts about the productivity trend provided aid and comfort at tense moments, but I think that his real achievement was the willingness to adapt to observation.


It is an interesting sidelight that in his book Greenspan barely mentions any of his colleagues on the Board of Governors. The Fed is notoriously chairman-centered. But among those colleagues at various times were several fine economists, among them Alan Blinder, Ned Gramlich, Alice Rivlin, Janet Yellen, and perhaps others who have slipped my mind. If I had been in Greenspan's shoes, I would have been in and out of their offices all the time, talking about current data and the Fed's options. There is none of that in this book. Maybe everyone was out giving speeches.

The picture that emerges from Greenspan's narrative is that monetary policy is all reading reports and making decisions, decisions, decisions. This is probably inevitable: the active participant is unlikely to see the patterns in his own behavior. But there is a lot that is predictable, and properly predictable, about monetary policy. John Taylor, a highly respected Stanford economist, proposed a formula that is known around the world as the Taylor Rule. It is a reasonable approximation that any central bank has two goals: the first is to keep the rate of inflation near some low target level; the second is to keep the level of aggregate output (as measured by inflation-corrected gross domestic product) near the economy's normal capacity to produce. That is what the central bank would like to do. But all that the central bank actually controls is a short-term interest rate. The Taylor Rule dictates that if the inflation rate is too high, the Fed should aim for a higher interest rate (and vice versa); and if aggregate output is too low, the Fed should aim for a lower interest rate (and vice versa).

Taylor constructed a simple algebraic formula that combines the inflation gap and the output gap, and tells the central bank what interest rate to aim for. His original construction looked at the inflation gap and the output gap in the recent past, and proposed or predicted a target interest rate. The modern fashion looks instead at some measures of the "expected" inflation gap and output gap in the near future. The modern fashion also gives the central bank a third goal: to avoid sudden drastic changes in interest rates that might upset financial markets. In this form, or even in its original simpler form, the Taylor Rule has been found to approximate pretty well how central banks actually behave. Some of what central banks do could be done by a robot that was fed the appropriate information. The creative part of what central banks do is written in their deviations from the Taylor Rule.

Two economists at the Federal Reserve Bank of Richmond, Yash Mehra and Brian Minton, have recently formulated a Taylor Rule modern-style for the Greenspan years at the Fed. It "predicts" the Fed's actions fairly accurately, which is no surprise: after all, the rule tells the robot to do sensible things. But there are some noticeable deviations, and that is where one should look for the real non-routine imprint. After the stock market crash of 1987, for example, the Fed quite rightly created a lot of liquidity, so that disrupted financial markets would not force fundamentally sound firms into default and bankruptcy. In doing so, it pushed its target interest rate below its Taylor Rule value; the rule does not take this classical central-bank duty into account. Then in 1988, when order had been restored, the Fed withdrew that now-excessive liquidity, and the relevant interest rate was temporarily high. This deviation marks a job well done, and Greenspan generously shares credit with Gerald Corrigan, then the president of the New York Federal Reserve Bank, and the man in the trenches.

In 1994-1995, the Fed tightened sharply, and the relevant interest rate rose well above its "predicted" value. The occasion this time was a more innovative piece of monetary policy: a "pre-emptive strike" against an inflation that was not yet visible, and possibly not widely expected. No such inflation materialized, but of course that leaves open the possibility that it would have done so if the Fed had not acted. We know that the real economy faltered slightly in 1995 but then resumed strong growth; and the rate of inflation kept on falling.

In 1997-1999 came Greenspan's finest moment, and it shows in the Mehra- Minton calculations. The output gap was not merely small; on most readings it was negative. Even with an acceptable rate of inflation, the Taylor Rule and conventional best practice would have called for tightened monetary policy and higher short-term interest rates. Instead, as already described, the Fed deviated from routine and picked its way carefully, and the whole country benefited from good years that might have been blah or worse.

The good years ended with the bursting of the dot-com bubble in 2001, and that raises another question. It is often argued that the Federal Reserve ought to include among its goals the stabilization of asset prices, especially the price of equities. (And houses?) On this reading, Greenspan should have tightened earlier, and deflated the bubble whose collapse probably precipitated the recession of 2001. That would have been another deviation from the Taylor Rule, which ignores asset prices. The coiner of the phrase "irrational exuberance" knew that the stock market boom was an accident waiting to happen. He argues briefly but cogently against extending the central bank's turf to asset prices. That would ask the Fed to do something that it cannot possibly do well, and would often conflict with its capacity to pursue the goals already on its agenda.


All this involves a more basic question. There is a general tendency to turn the Fed into an all-purpose economic policy agency, if only because it is competent and reasonably non-political. But remember that monetary policy is supposed to work by maneuvering a short-term interest rate. That single instrument cannot simultaneously perform as a regulator of goods-and-services inflation, the real output gap, and asset inflation. In principle, a single instrument can pursue a single objective. (On the very day that I was writing this, it was announced that the third-quarter real GDP rose by a strong 3.9 percent and the Open Market Committee decided to lower the federal funds rate by a quarter of a percentage point as prophylaxis against the damage that might be done by the continuing slump in housing. God knows what the Taylor Rule is saying. The Fed will be criticized for this decision, and it would have been criticized for the opposite reasons if it had left the funds rate unchanged. Mothers, don't raise your child to be Fed chairman!)

But governments have more than a single objective, even just in the macroeconomic field, and so they need more than a single macroeconomic policy instrument. There is, in principle, another and more versatile instrument, namely fiscal policy--the management of the spending and revenue sides of the large federal budget. The trouble with the agencies that operate fiscal policy is that they are neither competent nor reasonably non-political. This fact creates problems. In a less non-ideal world, monetary and fiscal policy would need to be coordinated; if they are jointly seeking two or three objectives, the division of labor has to be worked out with care and skill. In our system, however, this happens poorly and fitfully if it happens at all, and then it is more personal than institutional. Greenspan was apparently able to work well with Robert Rubin and Lawrence Summers on the Mexican and Russian financial crises during the Clinton years. But his role in the administration of George W. Bush was far from admirable.

To put it briefly, Bush, Cheney, and (after the dissenting Paul O'Neill was forced out) their secretaries of the Treasury were irresponsible about fiscal policy. They pursued an agenda of favor-the-rich tax reduction in season and out. What happened on the spending side of the budget is more complicated, but the result was chronic budget deficits (the adjective is important) and a growing public debt. Cheney famously asserted that deficits do not matter. Greenspan thinks that they do matter, and quite a lot, and also that they create problems for the conduct of monetary policy. He should have been up front in opposing what he now says he thought to be dangerous policy. If the public and Congress heard anything, they heard that he was going along, and certainly not sounding the alarm that he now says he felt. In fact, he was more conspicuous on the administration's side than was seemly in a Fed chairman.

His excuse, as he now tells the story, is that he kept saying in congressional testimony, and in speeches here and there, that the tax reductions should be offset by reductions in federal spending. That was ideological advice at best. More to the point, it was lame advice. It was not going to be heeded, and Greenspan must have known this. He was already a sort of oracle: if he had wanted to take a stand, he could have done so. There is no point in telling us of his misgivings now.

At one point Greenspan comments that he cannot tailor his remarks to the interpretations that others will place on them. This does not ring true. As Fed chairman, he was used to having the press hunt for coded meanings in every nuance of every word he uttered, including "and" and "the." He tiptoed through his words with precisely this sensitivity in mind. It is not credible that he was shocked, shocked that he was broadly understood as endorsing the Bush-Cheney fiscal policy. If he had wanted to be counted in opposition to this fiscal irresponsibility, he could easily have arranged it. He could even have said, with much truth, that fiscal policy was none of his business, just as monetary policy was none of Bush's or Cheney's.

So why did Greenspan do it? I think it was mostly ideological conformism. He defines himself more than once as a libertarian Republican, rather like Milton Friedman, whom he describes as never having been on the wrong track. This is surprising, and not merely because a wise person would know that nobody has never been on the wrong track. More specifically, one of Friedman's pet tracks was the belief that monetary policy should obey a simple, totally automatic rule: make the money supply grow at a steady rate of 1/2 of x percent per month every month, and x percent per year every year. (The fixed rate x is to be determined by the long-run growth rate of the economy and the tolerable rate of inflation, but the details are irrelevant.) But Greenspan's talk and practice have been dedicated to just the opposite.

We have known for a long time that as a young adult, Greenspan was a member of Ayn Rand's circle. When he was sworn in as the chairman of President Ford's Council of Economic Advisers, he invited Rand and his mother to the ceremony. I have more than once had to reassure alarmed friends that there were no Randian traces in Greenspan's monetary policy actions. I would stand by that judgment now. Unlike Greenspan, though, I have never been able to take Rand seriously, as a thinker or as a novelist.


In the second half of Greenspan's memoir, having completed his Washington narrative, he turns to his reflections on broad economic and social issues: economic growth, the capitalist system, China, Russia, globalization, corporate governance, energy, and still more. Then, in the last chapter, he talks about The Future. These pages tell us more about the chairman's ideology.

He is much taken with Joseph Schumpeter's notion of "creative destruction"; it is almost Greenspan's leitmotif. Schumpeter's idea was that the mainspring of economic growth is innovation, the risky introduction into economic life of new goods and services, new methods of production, new organizational principles, new ideas generally. Innovation brings about economic advance, but it also diminishes or destroys the value of assets associated with earlier innovations. Among these doomed assets are factories and equipment, skills, jobs, knowledge, even reputations. Creative destruction is a price we pay for progress. Greenspan embraces this concept with enthusiasm.

The process described by Schumpeter and endorsed by Greenspan pretty clearly benefits "society as a whole" in a meaningful sense. But there are always losers as well as winners. And innocent losers at that: innocent in the sense that they could not possibly have evaluated the odds and adapted to them in advance. (Classic example: the town long supported by a factory that has now become irrecoverably obsolete.) Creative destruction causes what we have learned to call collateral damage. Greenspan exhibits no sympathy at all for losers. This absence of fellow feeling for innocent losers is common among libertarian Republicans; and it strikes me as characteristically Randian.

Does it matter? It would certainly matter less if it were just an attitude. But it is an ideological axiom that affects policy decisions. The practical policy question is whether anything ought to be done by the government to cushion the costs of progress to the losers, at least to the innocent losers. George W. Bush campaigned as a "compassionate conservative." He lied. The argument against doing anything for losers is that the policies actually proposed would often throttle the golden goose by getting in the way of the processes of innovation and creative destruction themselves, thus losing the economic growth from which they are inseparable. Attempts to preserve obsolete jobs are a standard example: if they succeed, they discourage the new thing. This argument is valid as far as it goes, but it does not go very far. Not all social policy has to follow that pattern. There are ways to protect the worker, if not the job. Finding and elaborating such efficient policies would be a worthwhile agenda for economic engineering. One would like to have seen more of that in Greenspan's reflections. I betray my age by remembering Tom Lehrer's words: "Once the rockets are up, who cares where they come down? That's not my department, says Wernher von Braun."

There are traces of this failure of imagination--of moral imagination--in several of the topical chapters that make up the second half of the book. On Latin America, for instance, Greenspan is preoccupied with the dangers of "populism." He appears to give no clear definition of populism; it seems to be, by default, the antonym of capitalism, involving abrogation of the rule of law and individual rights. It is hard not to be against that. But there is no serious analysis of the economic and social conditions that foster populism. How should a capitalist democracy deal with a corrupt elite and a grossly unequal sharing of the benefits of economic growth? Surely that is a real and urgent question.

Presumably Greenspan would say that more, and more open, competition is the ultimate answer, and this is a reasonable thing to say. But the economically entrenched and politically dominant elite will resist. And asking the truly disadvantaged to take the long view is both unrealistic and unjust. The notion that putting any limits at all on inequality and exploitation is destructive of democratic capitalism is simply false. It is contradicted by the history of all successful capitalist countries, including the United States. So there must be better and worse ways for Latin America to evolve. If you would like a picture of how a more populist-inclined capitalism might function, Greenspan is not your man. The question does not seem to interest him.

To take a very different example, Greenspan's discussion of the chronic current-account deficit of the United States is far more subtle than the others. Greenspan argues that the underlying source of imbalance is the gradual attenuation of "home bias" around the world. It has long been observed that countries had a strong tendency to buy domestically produced goods and to invest in domestic industries even when it was economically disadvantageous to do so, even apart from protectionist obstacles to trade and investment. This home bias has been diminishing, partly because trade barriers have been reduced, partly because transportation costs have become less burdensome, partly because information flows more freely, and partly autonomously. This is an important aspect of globalization.

Greenspan makes an interesting case that this development, combined with the sustained profitability of real investment in the United States, is the main story behind the current account deficit. He thinks it will probably unwind itself harmlessly. This is a rather benign view. It may underestimate the risk of a disorderly, self-exacerbating run on the dollar if foreign holders should be spooked by fears of a sharp depreciation, for any of several reasons. He would admit this adverse possibility, but he downplays its likelihood. He may be right. He has read the literature, used the work of the Fed's excellent research staff, and weighed the evidence. This issue is part of his regular turf, and it shows. There are other good chapters in this book--on corporate governance, for example--and other perfunctory ones; but the moral to be drawn is finally that you can be a superb chairman of the Federal Reserve without being a significant or universal social thinker.

Robert M. Solow is Institute Professor of Economics emeritus at MIT. He won the Nobel Prize in Economics in 1987.

By Robert M. Solow

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