The irrational exuberance about Mr Fed

When his term as a board member runs out on 31 January 2006, Alan Greenspan, the 79-year-old chairman of the Federal Reserve, America’s central bank, must retire.

His successor, who should be named within weeks, will have to clean up the mess he is leaving behind.

This is not the conventional view of the 18-year-long Greenspan era at the Fed. In the last few months paeans of praise have been sung for the world's first celebrity central banker.

"What were the secrets of his extraordinary success and can he pass them on to his successor?" Harvard professor Ken Rogoff wrote, on bended knee, in August. "Alan Greenspan is the Michael Jordan/Lance Armstrong/Garry Kasparov of modern day central bankers," he added.

But hang on a minute. What was the legacy Greenspan inherited from his giant predecessor Paul Volcker and what is he leaving behind?

Volcker was hauled into the top Fed job in August 1979 in the middle of an inflationary dollar crisis. President Lyndon Johnson had set the fuse for the inflationary blow-out fully 15 years earlier by trying to fight an expensive war in a far-away country and at the same time, with his "Great Society" programmes, running up multi-billion dollar budget deficits at home.

Does this sound familiar? It should. Economic text books call it a "guns and butter" policy and it is precisely what President George W. Bush, with Greenspan's connivance, has been doing.

In the 1970s, two oil shocks were also tossed into the inflationary stew - odd how history repeats itself. So in 1980 Volcker had to propel US prime bank lending rates to a peak of 21% to rescue the American economy.

In 1987 the then US treasury secretary James Baker pressured Volcker to make way for Greenspan, a conservative Republican successor. By then Volcker's tight monetary policy had hauled inflation down from 13.5% in 1980 to 1.9% in 1986 and growth was barrelling along. It was not, then, a bad choice.

Greenspan's first decade in office was punctuated by a succession of developing country debt crises, first Mexico in 1994-2005 and then in Asia and Russia in 1997-2008. His hands-on, risk- management approach to monetary policy worked well. Shrewdly he saw, which many did not, that global inflation was in retreat and that he could let the US economy off its leash.

All went fine until 1996 when he began to smell a rat and famously announced, on 5 December 1996, that "irrational exuberance" had gripped New York's stock market. Trouble was, he did nothing about it. He kept interest rates too low, allowed the great bubble to inflate, before it imploded in 2000.

At this point Greenspan turned into the mad axe-man of central bank governors, chopping interest rates eleven times from 6.50% to 1.75% in 2001 alone. As it moved to even lower rates the Fed released a piece of economic research, of a quality which a decent economic undergraduate could have produced, arguing that such activism was needed to head off the sort of deflationary spiral which had engulfed Japan in the early 1990s.

The panicky rate cuts, coupled with the equally ill-judged decision by the new President Bush to slash taxes and plunge the Federal budget into deficit, revived the US economy. But it created a pernicious new bubble, this time in the housing market.

In what some professional economists are interpreting as an astonishing, and little noted, volte-face, Greenspan, has, in speeches and publications since August, begun publicly to express increased concern about asset price inflation. He seems to agree that American consumers' decisions to take advantage of super-low interest rates and borrow heavily against the soaring value of their homes to buy consumer goods, may have had something to do with the worrying build up of the forecast $800 billion (2005) American current account deficit.

Is this a tacit admission that he has erred? Rate cuts were needed in 2001. But a more measured pace would arguably have resulted in a healthier and longer lasting recovery. So Greenspan's legacy is more mixed than some would like to admit.

Intellectually he has tied himself in knots to justify his policies. On the one hand, although uncertainty surrounds all economic policymaking, he has argued that central bankers should not try to prevent asset price bubbles because they cannot be sure when a bubble is a bubble.

Having it both ways, he has also insisted that central banks should indeed move very aggressively to head off the economic damage a bursting bubble can create.

The success of the Bank of England in covertly pricking the UK housing bubble in the past two years and the potential instability in the global (as well as the US) economy, which Greenspan's policies have contributed to, suggest that he has been wrong on both counts.

Central bankers are paid to lean against the wind, especially when dealing with profligate governments. Until this year, when he has finally begun to push up US rates (even in the aftermath of Hurricane Katrina), Greenspan has failed on this score too.

Central banking is not proving as easy in a low inflation era as some believed. Asset market bubbles threaten on one side and on the other deflation-induced impotence beckons as rates fall towards zero.

The European Central Bank has been attacked for being too cautious. Under Greenspan's too personalised rule, the Fed has been both too activist and not activist enough. But the biggest worry now is what comes next. So far, George W. Bush's record on the appointment of top economic policymakers has been appalling.

  • Stewart Fleming is a freelance journalist based in Brussels