The Hindu Business Line : End of an era at the US Fed

MR Alan Greenspan held his last Open Markets Committee meeting on Tuesday, January 31 2006, before he laid down office as Chairman of the US Federal Reserve Bank. It was the end of a glorious 18-year tenure that began with his appointment to the post by President Reagan. He was reappointed by President George W.Bush Senior, President Bill Clinton and President George W. Bush (Junior). Mr Ben Bernanke, a professor well-renowned in monetary circles and a former Chairman of President Bush's Council of Economic Advisers, takes his place.

When Mr Greenspan was named as Chairman to succeed the legendary Paul Volcker (the same gentleman who recently created a stir in Indian politics with his report on oil for food scams), Mr Volcker had demonstrated his anti-inflation credentials by raising interest rates — perhaps a bit too sharply.

The recession his interest rate rise is said to have brought about was perhaps a necessary cure for inflation. The human cost of the cure was high, in terms of jobs lost and economic growth denied. But Mr Volcker has his place in the history of the Federal Reserve as the person who took the unpopular but necessary decision to raise interest rates to snuff out inflation.

On taking over as Fed Chairman, Mr Greenspan faced a daunting challenge. The dollar was falling. And Mr Greenspan had to show he had the competence to handle a serious crisis of confidence with a sudden slump in the American stock market. Black Monday, as it was called, signalled the fall of stock prices to historic lows in US history.

In 1987, Chairman Greenspan came to the rescue of the markets with a bold initiative, pumping adequate liquidity to bail them out and help all investors. It was a brave gesture — a blend of boldness and calculated risk-taking. The markets revived and the threat of a stock market collapse was averted.

Other central bankers would surely have shied away from such bold actions on account of sheer fear that allegations would be made regarding their being in cahoots with speculators. But Mr Greenspan, reinforced by his faith in the American economic fundamentals, dared to play the positive card and thereby helped the US economy and with it the global economy. An equally impressive replay of Black Monday was the manner in which Mr Greenspan handled both the aftermath of the Asian crisis and the Russian meltdown. That was also a classic illustration of his aplomb and finesse. He was also able to restore faith in the system when the hedge fund Long-Term Capital Markets failed, threatening to place at risk billions of dollars belonging to banks and institutional investors.

Mr Greenspan's remedy was the same as the one he had applied on Black Monday. He remained confident and adequately funded the markets, to enable a return of confidence, instead of condemning the markets as speculators. He knew better than to quarrel with the fundamental structure of the American capitalist society, which worked on the basis of a successful stock market.

There are, of course, some who find fault with Mr Greenspan. One such criticism relates to his stance on the IT boom of the 1990s. Many fortunes were undoubtedly made, and many more lost, because of the Internet boom. But this was a necessary part of the evolution of capitalism, especially in a period of technological innovation and creative destruction.

Undoubtedly, the IT boom helped reward many bright technological entrepreneurs and recreated the Silicon Valley, as we know it today. The venture capitalists of Silicon Valley, who flourished in the dotcom boom, nurtured the IT revolution and thus created a new wave of increased productivity in the US, through IT innovation.

The early 1990s saw the inflation hawks crying out loud for sharp increases in interest rates. Mr Greenspan held to his belief that an IT-led productivity surge was already taking place in the US economy and would help manage inflation. He felt it should not be crushed by sharply raising interest rates.

He held his hand and brought about a benign interest regime, helping to reduce the Fed funds rate — the rate at which the banks borrow from each other and the Fund — to a historic low.

Thus, Chairman Greenspan enabled the US, and thereby the global economy, to grow under such a favourable combination of interest rates and accommodative monetary policy. The global economy as a whole benefited from the resultant growth of the US, which emerged as the world's main engine of growth.

Of course, Mr Greenspan has had his detractors. He is blamed by some for tolerating, or rather helping to manage, Bush's extravaganza on the fiscal front. He is reported to have come out publicly in favour of Bush's tax giveaways. It is, however, not clear to what extent a central banker can be held responsible for a Government's flawed fiscal management.

True, Mr Greenspan encouraged the growth of the US economy, fed by the asset boom, including housing price increases, which incidentally resulted in house-owners financing consumption by sales of their appreciating assets. But, in 1996, he himself cautioned the markets against the burst of irrational exuberance. He was clearly worried about the asset price hassles, but that is an inevitable concomitant of a low interest rate regime and a growing economy.

Mr Greenspan seems to have rightly argued that attempting to prick an asset bubble may result in a worse slowdown in the economy than letting market forces play out and dealing with the consequences. That view is shared by most experts, including Mr Bernanke.

Although Alan Greenspan has latterly tried to restore the balance by a series of increases in the Fed funds rate (the fourteenth such increase was last Tuesday), he leaves a difficult legacy for his successor, who will find it hard to replicate his generally low interest rate regime. He has declared himself in favour of inflation targeting. His stance will be sorely tested in the coming weeks and months, since the politicians will watch his moves carefully. An interest rate rise is always unpopular, particularly as the elections approach. Mr Bernanke will have to watch his step carefully.

A more critical challenge, which is part of the Greenspan legacy, is the rising current account deficit of the US coming on top of its fiscal imbalance. There are well-known economists already predicting a collapse of the dollar, in the event that the Asian economies and the mid-eastern oil giants shift their reserves out of the greenback. Mr Greenspan managed to be a central banker not only for the US but for the world as a whole, inspiring trust in his ability to manage the economy. Although his low interest regime left the investors in US gilts with low returns, his management of the stock market was creditable. Corporates boomed and the market rose with them.

The investors of the world flocked to the US, notwithstanding all signs of obvious vulnerability. Mr Greenspan had a great deal to do with this phenomenon, in which the US drew investors of the world in spite of its high fiscal and current account deficits. He was literally a financial wizard for the whole world.

As many observers have pointed out, Mr Greenspan's historic legacy owes as much to his own contributions as to the phenomenon of increasing globalisation. With increasing integration of financial markets, the US' central banker became the world's central banker, and the world often awaited his decisions with bated breath.

But it is difficult for Mr Bernanke to repeat the achievements of his legendary predecessor. For one thing, the world would be less forgiving of mistakes. For another, there is a more troublesome environment with rising crude prices and a threat by the Asian powers to pry loose from the greenback.

One observer has said that Greenspan owed his success to his ability to read a variety of statements giving data about the American economy and draw relevant conclusions from them. He did not treat corporate entities as adversaries. He was more business-oriented than his predecessor, Mr Paul Volcker. Nor was he dogmatically inclined to follow monetarist orthodoxies.

It is, however, appropriate to refer to a recent review of Alan Greenspan's years at the Federal Reserve, held at a special meeting of American Enterprises Institute, entitled "Life after Greenspan". A former Fed Chairman and a top Economic Adviser to President Bush in his first term, Mr Larry Lindsay predicted a difficult first few months for Mr Bernanke as the Fed debates the appropriate point to end the tightening cycle.

It would be cataclysmic, pointed out Mr Lindsay, if the Fed was divided and did not act as a unified institution. May Mr Bernanke have Greenspan's good luck even if he does not share his touch. The US economy, as well as the world economy, rides on his success.

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