If it’s not broken, don’t fix it. Unless, perhaps, you are Federal Reserve Chairman Alan Greenspan.
After a half-dozen years of record growth, the U.S. economy is slowing to a halt, with revised numbers for gross domestic product growth as low as 1 percent for the fourth quarter of 2000. With the economy as healthy as it was, many are left to wonder exactly what the Fed was trying to do in adopting such a tightening bias two years ago, raising interests rates on six successive occasions. Greenspan may have acted too rashly and precipitated, or at least contributed to, a downturn.
Few people, aside from the Fed’s Board of Governors, can fully describe every factor that contributes to the decision on changes to the federal funds rate, the overnight rate that banks charge on loans of their excess reserves. Yet it is clear from historical and empirical evidence that the Fed guards closely against inflation — seemingly above all else — with the unemployment rate and GDP growth also entering strongly into its deliberations.
Indeed, inflation is a very costly phenomenon, and so it is fitting that Greenspan remains ready to prevent excessive price increases.
The only problem is that there has not been substantial evidence of upward pressure on prices. Even with unemployment at a record low and consumer spending at historical highs, the major indices of price levels, the consumer price index and producer price index, have, for the most part, exhibited fairly normal levels of growth. Why, then, Greenspan’s crusade to raise rates?
One explanation, well-known to economists, is that the Fed is “leaning against the wind.” In this case, Greenspan may have been acting preemptively to stave off inflation. Yet was it entirely necessary to raise rates six times consecutively in order to prevent inflation that had not materialized?
Greenspan’s behavior might exemplify Milton Friedman’s analogy of the “fool in the shower” who, trying to reach the desired water temperature, impatiently alternates between a shower that is too hot and one that is too cold. If, in fact, Greenspan was a “fool in the shower,” then his rate hikes were too extreme but continued along because he did not see his desired results. Under this scenario, he probably waited too long to slow the growth, and thus reacted too strongly as an afterthought.
Now, once the increases have run their course, the economy has reacted more negatively than Greenspan may have intended. Hence we see the recent federal funds rate reductions.
In spite of the “fool in the shower” possibility, it seems likely that Greenspan fully knew what he was doing — launching an attack against the soaring stock market and discouraging investments which he believed displayed an “irrational exuberance” that was not warranted by firms’ earnings levels at the time. And if Greenspan was trying to derail the stock market, he seems to have been somewhat successful. Ostensibly, he was concerned the market could crash and send shock waves throughout the economy.
But the recent slowdown raises serious questions as to whether this strategy was wise. It has caused, by many measures, a tremendous slowing of the economy that was by no means inevitable. In particular, the attack on the stock market has caused a large, negative “wealth effect” by which consumers, seeing their net wealth decrease with the stock market, reduce their spending and investments, which hurts GDP growth. Indeed, these are not trends that engender great enthusiasm among investors and business managers when Greenspan’s name is uttered.
Even still, professional economists, who by nature believed the stock market was artificially and dangerously inflated, are still ardent Greenspan supporters. Yet despite the academic affinity for a more reasonably priced stock market, the recent decline has put a stain on his otherwise successful record, seriously hurting a number of Americans who have seen their portfolios dwindle under Greenspan’s barrage of rate increases.
Greenspan will have to forgive them, then, if he is not quite so popular as he once was — before he started trying to fix things.
William Edwards is a junior in Pierson College. His columns appear on alternate Mondays.