Wednesday, March 09, 2005

Think Again: Alan Greenspan

Think Again: Alan Greenspan

By Stephen S. Roach

January/February 2005

U.S. Federal Reserve Board Chairman Alan Greenspan is credited with simultaneously achieving record-low inflation, spawning the largest economic boom in U.S. history, and saving the world from financial collapse. But, when Greenspan steps down next year, he will leave behind a record foreign deficit and a generation of Americans with little savings and mountains of debt. Has the world’s most revered central banker unwittingly set up the global economy for disaster?

“Greenspan Is Responsible for the U.S. Economic Boom of the 1990s”
Only in part. The United States experienced an extraordinary period of prosperity in the 1990s. Between 1993 and 2000, 21 million new jobs were created in the United States, and in 2000 the country’s unemployment rate briefly dipped below 4 percent for the first time in 30 years. During this boom, the U.S. economy grew at nearly 4 percent a year, adding more than $2 trillion to real U.S. gross domestic product (GDP)—more than the annual output of France.

But many stars aligned to produce that outcome, not just good monetary policy on the part of Greenspan’s Fed. For starters, a judicious focus on fiscal discipline by former President Bill Clinton’s administration brought the budget deficit under control. The Clinton administration managed to lower the deficit every year between 1993 and 1997. By 1998, there was a surplus that lasted until 2001. The 1990s also saw a powerful wave of corporate restructuring and technological change. Together, these two forces set the stage for sustained low inflation and a powerful acceleration of productivity and employment growth.

Greenspan’s leadership in monetary policy undoubtedly played an important role in fostering the conditions that allowed the U.S. economy to surge in the 1990s. The chairman helped achieve the economy’s high-performance potential during that time period. But no one should believe that the economic boom of the 1990s was the work of just one man or just one monetary policy.

“Greenspan Defeated Inflation in the United States”
No. Credit for breaking the back of double-digit inflation goes to Paul Volcker, Greenspan’s tough and courageous predecessor. In the summer of 1979, when Volcker assumed the reins at the Federal Reserve, inflation was raging at 12 percent a year. Eight years later, when Alan Greenspan took over, the inflation rate stood at around 4 percent. During Greenspan’s 17-year era, inflation slowed further to 2.5 percent per year. But 80 percent of the drop in inflation occurred under Volcker’s stewardship at the Fed.

True, Volcker put the United States through its worst recession in modern times. It was the only way to unwind the destructive interplay between wages and prices that drove U.S. inflation. Greenspan’s major challenge was to finish the job Volcker started. That was no easy task, and Greenspan’s successes should not be minimized. In only one of Greenspan’s 17 years at the Fed (1990) did inflation move above 5 percent; in 11 of those years, inflation was 3 percent or lower.

But there were serious complications along the way, not least of all a dangerous flirtation with outright deflation, or an overall decline in the price level, in early 2003. This problem resulted from Greenspan’s biggest gamble—a willingness to push U.S. interest rates to extremely low levels during a period of rapid economic growth. The move gave rise to the destabilizing stock market bubble of the late 1990s, a speculative excess unseen in the United States since the roaring 1920s. The bursting of that bubble in early 2000 transformed an orderly disinflation (i.e., when inflation merely decelerates) into a close call with actual deflation.

“Greenspan Rescued the United States from a Stock Market Meltdown”
Maybe, but at what cost? In early 2004, Greenspan gave a speech to the American Economic Association, arguing that the Fed should feel vindicated in its efforts to contain the 2000 stock market shakeout. By slashing the federal funds rate—the interest rate at which the Fed lends money to other banks—by 5.5 percentage points between January 2001 and June 2003, the Fed limited the severity of the recession that followed the burst of the bubble.

That cure may cause bigger problems down the road. Bubbles have developed in other asset markets (especially corporate bonds, mortgage-backed securities, and emerging-market debt). And Greenspan’s rock-bottom interest rates have led to the biggest bubble of all: residential property. Annual inflation in U.S. home prices is now running at a 25-year high of 8.8 percent, with 15 states experiencing double-digit increases in residential property values between mid-2003 and mid-2004.

At the same time, the home-buying and consumption binge has put individual Americans deeply in debt. Greenspan takes comfort that rising home values compensate for increased borrowing, but that rationalization assumes a permanence to rising property prices that belies the long history of volatile asset markets. So far, the Fed and debt-addicted U.S. homebuyers have bucked the odds. Over the last four years, debt accumulated by U.S. families was 60 percent larger than overall U.S. economic growth. Many households in the United States now spend near record-high portions of their monthly incomes on interest expenses, leaving consumers in a precarious position should either interest rates increase or the growth in incomes slow.

History shows that central banks aren’t always able to cope when bubbles burst. That was the case with the Bank of Japan in the 1990s, after the Japanese stock and property markets collapsed, and it could still be the case in the United States today. The United States dodged a bullet when the stock market tanked in early 2000. There are no guarantees that highly indebted Americans will be as lucky the second time around.

“Greenspan Saved the World from the 1997–98 Asian Financial Crisis”
False. Time magazine devoted its February 1999 cover to the “Committee to Save the World.” Featured were then U.S. Treasury Secretary Robert Rubin, then Deputy Secretary Lawrence Summers, and Greenspan, all celebrating the end of the worst global financial crisis in more than 60 years. In truth, the world weathered the Asian financial storm only to chart increasingly dangerous waters in the years that followed.

Global economic imbalances have intensified dramatically since 1999. The United States’ gaping current account deficit says it all—$665 billion in mid-2004, equal to a record 5.7 percent of U.S. GDP. Never in history has the world financed such a massive deficit. The United States is sucking up more than 80 percent of the world’s surplus savings, requiring capital inflows that average $2.6 billion per business day. And the U.S. deficit is bound to get worse before it gets better.

This huge balance-of-payments gap reflects major disparities between global savings and consumption. A savings-starved U.S. economy is living beyond its means, while Asia and, to a lesser extent, Europe, are plagued by low consumption and high savings. Consequently, the United States is now the world’s consumer of last resort. Asian economies, by contrast, are more prone to save and rely on export-led growth strategies, and they are unwilling or unable to stimulate domestic private consumption.

The result is an enormous buildup of U.S. dollars held by Asian nations (more than $2.2 trillion in mid-2004, or twice Asia’s holdings in early 2000). These countries then recycle this cash back into the United States by buying U.S. Treasuries. This process effectively subsidizes U.S. interest rates, thus propping up U.S. asset markets and enticing American consumers into even more debt. Awash in newfound purchasing power, Americans then turn around and buy everything from Chinese-made DVD players to Japanese cars.

This is no way to run the global economy. Asia and Europe are increasingly dependent on overly indebted U.S. consumers, while those consumers are increasingly dependent on Asia’s interest-rate subsidy. The longer these imbalances persist, the greater the likelihood of a sharp adjustment. A safer world? Not on your life.

“Greenspan Was Alone in Foreseeing the Productivity Revolution”
Yes. In the early 1990s, when the United States was mired in a productivity slump, Greenspan was largely alone in believing that an important shift was at hand. He was right. Worker productivity in the United States grew 3 percent a year between 1996 and 2003, double the anemic 1.5 percent annual increase of the preceding 20 years.

The productivity breakthrough had a profound impact on the performance of the U.S. economy, as well as on Greenspan’s command of monetary policy. High-productivity economies can withstand rapid growth without an increase in inflation. So, as U.S. productivity climbed in the late 1990s, Greenspan boldly let the economy fly without raising interest rates. Investors, of course, were thrilled with Greenspan for not standing in the way of rapid economic growth. The stock market bubble of the late 1990s (which he initially warned of, but later ignored) reflected this exuberance. As Greenspan said in early 2000, “When we look back at the 1990s.… [w]e may conceivably conclude…[that] the American economy was experiencing a once-in-a-century acceleration of innovation, which propelled forward productivity, output, corporate profits, and stock prices at a pace not seen in generations, if ever.”

Within two months of that statement, the stock market collapsed, but the productivity miracle did not. Whether it will endure, though, remains an open question. Most U.S. businesses have an advanced it infrastructure. The lack of new corporate hiring and the sharp falloff in business expansion point to ever more hollow American corporations. Moreover, the pendulum is now swinging back toward greater government regulation, further constraining corporate risk-taking. The drivers of the productivity miracle of the past eight years may not be sustainable, after all.

“Greenspan Spells a Strong Dollar”
Not necessarily. Until recently, the dollar has generally been stable during Greenspan’s 17-year tenure, a noteworthy accomplishment for any central banker. An exception came in 1994 and early 1995, when the dollar weakened sharply, only to regain its strength in the latter half of the 1990s.

But the dollar’s past may not be prologue. Global imbalances—underscored by America’s record balance-of-payments gap—are best corrected through a cheaper dollar. A cheaper dollar means higher U.S. interest rates, which in turn will suppress U.S. spending and enable a long overdue rebuilding of national savings. Conversely, other currencies will strengthen, forcing the export-led economies of Asia and Europe to embrace long-overdue reforms, including lowering tariffs and making labor markets more flexible.

Today, even Greenspan acknowledges that the world needs a weaker dollar. That’s the verdict from America’s record (and rising) current account deficit and from Asia and Europe’s excess dependence on exports. The hope, of course, is that the dollar experiences a “soft landing,” a gentle descent over several years. But in light of the massive U.S. current account deficit, the risk of a hard landing is all too real. The more the current account deficit grows, the greater the odds of an abrupt adjustment. The dollar may be an accident waiting to happen, with a sharp decline in the greenback raising the possibility of collateral damage to stocks, bonds, and price stability. Given the central role the United States plays in driving the world economy, any shock “made in the U.S.A.” could reverberate around the world.

“Greenspan Leaves the U.S. Economy in Good Shape for the Future”
The jury is still out. By congressional mandate, the Fed’s goals include price stability, full employment, and economic growth. Greenspan’s Fed has made progress on all three.

However, some unintended consequences of Greenspan’s efforts may jeopardize the United States’ long-term economic future. Consider the profound shortfall in U.S. savings. The United States’ net national saving rate—the combined saving of households, businesses, and government—fell to 0.4 percent of national income in early 2003, and it has since risen to just 2 percent. Lacking in domestic savings, the United States must import savings from abroad and run massive current account deficits to attract that capital.

Greenspan shares some blame for this problem. It all goes back to the asset economy, his often-expressed belief that financial assets can play an important role in sustaining the U.S. economy. He made that argument in the late 1990s when stock prices went to new highs, and he reiterated it recently with regard to surging home prices.

The catch is, people interpret Greenspan’s analysis as advice. So individuals view the appreciation of their home as a proxy for long-term saving and are therefore less inclined to save the old-fashioned way—by putting away cash from their paychecks. This scenario sets U.S. citizens apart from those in most other Western economies. Only in the United States are people aggressively tapping the savings in their homes (through mortgage refinancing) to finance current consumption.

Moreover, the rapid buildup of debt, both domestic and foreign, leaves a savings-short U.S. economy in precarious shape. The problem is compounded by the 77 million aging baby boomers, now approaching their retirement years, when they need savings more than ever. To the extent that Greenspan has condoned asset-based savings (homes) in lieu of income-based savings (cash in the bank), he has unwittingly compounded the United States’ most serious long-term problem.

“Greenspan Is Politically Independent”
Yes, but… Unfortunately, the Federal Reserve is located in Washington, D.C. That thrusts its chairman into the political arena and has led to some indelicate episodes for Greenspan over the years, including his endorsement of the Bush administration’s 2001 tax cuts as the wisest way to spend the government’s budget surplus—a surplus that has now disappeared into thin air.

Despite such momentary lapses, there is no evidence that Greenspan has politicized U.S. monetary policy. Although Greenspan is a Republican (he first entered public service as an advisor to President Gerald Ford in 1974), he had no compunction in raising interest rates on GOP administrations, including the current one, at inopportune times. Over the years, Greenspan has been critical of fiscal policies pursued by Democrats and Republicans alike.

But with Greenspan, the line between politicization and policy activism is blurred. There is no mistaking Greenspan’s aggressive stance on several key issues driving financial debates and policy. In early 2000, Greenspan made a strong (and ultimately wrong) case for why there wasn’t a stock market bubble. More recently, he minimized the immediacy of the United States’ current account deficit problems and played down the risks of an oil shock. And, in October 2004, he dismissed concerns over the United States’ excess household debt.

The sheer weight of Greenspan’s point of view can bear critically on financial markets and the real economy. To the extent that his intellectual activism aligns with Fed policies, investors tend to take Greenspan’s messages too far. This tendency compromises his position as an independent central banker. Moreover, his recent role as a cheerleader for policies such as tax cuts compounds already serious imbalances and imparts a pro-growth bias to his central banking philosophy that could make the endgame all the more treacherous. That was the case with stock buying in the late 1990s and could well be the case today in condoning the household debt binge, overvalued property markets, and Asian demand for U.S. Treasuries. Greenspan’s stances may not be political—nor may they be prudent.

“It Will Be Difficult to Replace Greenspan”
Hardly. Alan Greenspan’s term as a member of the Federal Reserve Board of Governors expires on the last day of January in 2006, at which time he is required to step down. When he does, Greenspan will have served as chairman for more than 18 years under four different presidents, making him the second longest-serving chairman since the founding of the Fed in 1914.

There is understandable apprehension over the transition to new leadership at the Federal Reserve. Business leaders, politicians, and investors expressed similar concerns when the Volcker era came to an end in the summer of 1987. “There is concern in Washington,” Paul Glastris reported in the Washington Monthly in 1988, “that Alan Greenspan sees himself as the new Paul Volcker and that he may seriously damage the economy.” Yet, aside from a small flutter in the financial markets, the U.S. economy barely skipped a beat when Greenspan replaced Volcker. Shepherding the world’s most dynamic economy is not a personal accomplishment. It has more to do with the interplay between markets, consumers, businesses, politicians, and policymakers than any cult of personality a Fed chairman may or may not have.

A key challenge for Greenspan’s successor will be rebuilding private-sector savings. It’s a critical step if the United States is to close its balance-of-payments deficit and an essential insurance policy for an aging population of baby boomers nearing retirement. Although prudent fiscal policy and budget deficit reduction by the U.S. Congress will be part of any fix, the Fed’s monetary policy can also play an important role in fostering a long overdue improvement in national savings.

At the same time, the next Fed chair must be a true internationalist—facing the increasingly daunting challenges of globalization. The United States has enjoyed an unprecedented dominance of the global economy since the mid-1990s. But, like U.S. geopolitical hegemony, its economic dominance is unlikely to last. The next Fed chairman will have to walk a delicate line between domestic imperatives and the challenges posed by other players in the global economy.

History cautions against rendering a premature verdict on the accomplishments of any one economy, or any one central banker. When Alan Greenspan arrived at the Fed in the late 1980s, Japan and Germany dominated the world economy, and the United States was down and out. Over the last 20 years, the fickle pendulum of economic prosperity swung the other way, as the United States redefined the very concept of global economic leadership. Greenspan will be a tough act to follow. But his success was as much an outgrowth of history as it was a reflection of any one person.

Stephen S. Roach is chief economist at Morgan Stanley.