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S. Balakrishnan

Mr Alan Greenspan's policies have received the stamp of approval from the acolyte of monetarists. Writing in the Wall Street Journal, Mr Milton Friedman, who was awarded the Nobel Prize for his work in monetary economics, commends the US Fed chief for his aggressive rate-cutting and liquidity-easing in the past year.

Mr Friedman draws parallels between 1929 and 1999. Both years were preceded by stock market boom. But the 1929 market crash was not countered by monetary policy, which on the contrary, exacerbated the situation with excessively high interest rates and tight liquidity.

Soon the fallout was felt in the real economy stretching America's depression well into the thirties. In his writings, Mr Friedman concludes that the depression need never have happened if the Fed had loosened money supply in time. Mr Greenspan has never hesitated to inject liquidity into financial markets in times of crisis, of which in his eventful tenure of a decade and a half, he has faced three - the 1987 market crash, the 1998 Asian, Russian and LTCM (Long-Term Capital Management) collapse and the September 2001 terrorist attacks. On all three occasions, his response was immediate - rate cuts without the formality of the FOMC meeting and the assurance of liquidity support from the Fed as needed to market players to meet their obligations. His tactics worked. The markets quickly recovered from all these cataclysmic events.

All this is a far cry from Mr Friedman's original golden rule: increase the money supply by four per cent every year and leave the market to do the rest. Instead of putting monetary policy on autopilot, the Fed looks at a wide range of statistics and indicators to decide its monetary stance. This proactive approach has enabled the US central bank to push the limits of monetary expansion and maximize growth consistent with low inflation.

Unfortunately for Mr Greenspan and his fellow central bankers the world over, a new enemy has appeared on the horizon - deflation.

Japan is the first country to experience the chill winds of a sustained period of falling prices. Even zero interest rates have failed to lift its economy from the slump.

Mr Keynes foresaw this and even gave it a name - the liquidity trap.

He refers to a situation when only pessimism abounds and people do not spend and businesses do not invest even at extremely low interest rates.

This may be Mr Greenspan's biggest challenge yet: to stop America from descending into a spiral of falling prices, spending and investment.

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