Greenspan and Volcker

When President Bill Clinton was asked by a journalist what it was like to be the most powerful man in the world, he famously pointed to Andrea Mitchell, NBC’s White House correspondent, and said, “Ask her. She’s married to him.” The husband in question was Alan Greenspan, then chairman of the US Federal Reserve. Towards the end of his 18-year reign at the Fed, this nerdy student of economic statistics had acquired a reputation for being all-powerful and all-knowing, a rock star among central bankers. In the event, Greenspan’s hallowed status was an invitation to nemesis in a period when the economy, and more especially the financial system, were shifting from the heavily regulated postwar model to the more freewheeling, turbocharged global capitalism of recent years. Sure enough, after a long tenure in which growth was relatively robust and inflation remained low, the great financial crisis of 2007-08 intervened. Greenspan’s reputation was irrevocably blighted. One of the many paradoxes of the man, as Sebastian Mallaby rightly highlights in his exceptional new biography, is that Greenspan was better qualified than any other central banker of his generation to steer a course through these turbulent economic times. Yet he was an implausible future leader of the Fed at the start of his career. Raised by a Jewish single mother in New York, he had no wish to go to college when he left high school and secured a place at the elite Juilliard music conservatory, where he played the tenor saxophone and clarinet. He soon dropped out and became a sideman in a second-tier jazz band. But Mallaby, a senior fellow at the Council on Foreign Relations and a columnist for the Washington Post, points out in The Man Who Knew that Greenspan was a musician with a difference. During the breaks, he studied books about economic history and finance while his peers smoked dope. He was fascinated, too, by the American business pioneers of the late 19th and early 20th century. In the summer of 1945, he enrolled at New York University to read economics. In his subsequent career as an economic consultant, he developed what Mallaby calls a matchless “feel for the kinks in the data” and a sense of when an economic model’s “competent extrapolation was worth less than human judgment”. While he had respect for the verdict of markets, he was no believer in the efficient market theory, whose proponents deny the existence of market bubbles. In a paper in 1959, he explored the connections between the financial sector and the real economy, demonstrating how stock prices drove corporate investments in fixed assets, which in turn drove booms and busts in the capitalist economy. The Nobel laureate James Tobin was later to capture the credit for Greenspan’s insights. In Mallaby’s account, the shy and introverted young economist craved control over a confined domain. He wanted to be right, and to know that he was right; and he thrived on problems that he could solve alone, without seeking others’ opinions. His unyielding individualism made for an uncomfortable first marriage that lasted less than a year, after which he became for decades an eligible bachelor who dated news anchors, senators and beauty queens. Only when he was 70, after his mother died, did Greenspan marry Andrea Mitchell. That same individualism and his reluctance to go with the crowd made him a natural acolyte of Ayn Rand, the Russian émigré and novelist known for her fierce libertarianism. Rand, who for many years was Greenspan’s mentor, championed free markets and argued the merits of selfishness in all things, including sexual relations, and called for radical shrinkage in the role of the state. During this period, in which he became the de facto chief economist of Ayn Rand’s coterie, Greenspan delivered a lecture in which — irony of ironies — he described the creation of the Fed that he was later to lead as “one of the historic disasters in American history”. He was a firm believer in the gold standard, a fierce opponent of bank bailouts and a fervent critic of US antitrust laws. He preached what Mallaby terms a kind of libertarian Leninism and declared in the same lecture series that a laissez-faire economy was “the only moral and practical form of economic organisation”. And he warned that the US was surrendering itself to “the primordial morality of altruism, with its consequences of slavery, brute force, stagnant terror, and sacrificial furnaces”. He wanted to be right, and to know that he was right; and he thrived on problems that he could solve alone How can these hot-gospelling libertarian beliefs be reconciled with the actions of the partisan Republican insider who steered President Ronald Reagan away from his instinctive urge to return to the gold standard, who was a dedicated exponent of discretionary monetary policy at the Fed and a consummate bailout practitioner, and whose support for the markets came to be known as the “Greenspan put”? In the end it was his urgent desire to be at the centre, at the heart of policymaking, that overcame Greenspan’s libertarian instincts. He was an instinctive politician with a genius for compromise and manipulation. The manipulation was at its most honourable when Greenspan used data to swing opinion among members of the Fed’s interest rate-setting body, the Federal Open Market Committee. The supreme example was in 1996, when growth was strong and the stock market excitable. Nobody could explain the combination of rising profits and an apparently flat rate of productivity growth. This mattered because if productivity growth was truly flat, inflation was looming and interest rates needed to rise. But if productivity was accelerating, there was no need to head off inflation. Greenspan had a hunch that productivity was rising faster than the aggregate numbers suggested and instructed his researchers to break it down by business sector. They duly assembled statistics for productivity across 155 categories of business, going back to 1960. In this “trove of data” Greenspan found that weak productivity in the service sector was depressing economy-wide numbers and had even fallen, which seemed nonsensical given the enormous investments made by law firms, business consultancies and other services companies in information technology. The data were clearly flawed because these companies could not be getting less out of their workers in such circumstances. By showing that productivity was growing faster than the official data allowed, Greenspan was able to rout the monetary hawks on the FOMC and save the economy from a premature interest rate hike. Less admirable, though entirely understandable, was Greenspan’s way with difficult Fed governors. He put them in charge of committees that tied them down on secondary issues and carefully choreographed FOMC meetings to undermine their influence. He picked his fights with care and avoided confrontation by calling on others whom he could rely on to deploy aggressive argument on his behalf. His cultivation of the media resulted in a reverential press. And he conveyed an image of the accomplished technocrat, riding above mere politics. Mallaby quotes the Nobel laureate Robert Solow as comparing this master of evasion at Congressional hearings to “a bespectacled sea squid”: sensing danger, he would “flood his surroundings with black ink and then move away, silently”. Much of this guile was learnt when Greenspan was advising the Nixon administration in various capacities. And he was party to a notably disreputable ploy to curb the authority of the then Fed chairman, Arthur Burns. At the suggestion of Treasury secretary John Connally, Nixon and his henchmen decided to bring Burns into line. Burns had been urging the president to take a stand against inflationary wage increases. So the Nixon team planted a mendacious story with United Press International that Burns had simultaneously been lobbying behind the scenes for a personal pay rise. Charles Colson, who later served time in jail for organising Nixon’s dirty tricks, called Greenspan to ask him to persuade Burns to change his tune on the economy. Greenspan denies involvement but Mallaby produces convincing evidence to the contrary from Colson’s notes and the White House tapes. What is certainly true is that Burns, Greenspan’s friend and one-time mentor, lost his inflation-fighting zeal thereafter. The greatest paradox of Greenspan’s reign at the Fed was that he grasped the fragility of the financial system and was able to identify market bubbles, yet was reluctant to prick either the dotcom bubble or the property bubble that preceded the financial crisis. As Mallaby remarks, “he decided that targeting inflation was seductively easy, whereas targeting asset prices was hard; he did not like to confront the climate of opinion, which was willing to grant that central banks had a duty to fight inflation, but not that they should vaporise citizens’ savings by forcing down asset prices”. That is surely right. The politics of central banking are brutal. It is impossible for central bankers to inflict a mild recession in the interests of avoiding a much bigger recession later without incurring the wrath of politicians and threatening their own careers. Hence late-period Greenspan’s self-serving mantra that bubbles could not be identified in advance; that, as Mallaby puts it, “the debris from bust bubbles can be cleaned up after the fact”; and that they should not be pricked because the requisite interest rate hike would puncture the economy. Mallaby’s verdict on Greenspan is not ungenerous. He credits him with prescience on a range of matters that now tend to be forgotten in the shadow of the financial crisis and points to the value of his empiricist approach to economics, one that “avoided the mathematical hubris” of the professional econometricians who excluded the financial sector from their calculations. He was, says Mallaby, ultimately guilty of one serious analytical error, which was to underestimate the costs of financial fragility. I would put a little more emphasis than Mallaby does on Greenspan’s adherence to asymmetric monetary policy, whereby he put safety nets under collapsing markets but chose not to curb bubbles — despite having shown great skill throughout his career in identifying irrational exuberance. But that quibble does nothing to undermine the achievement that this deeply researched and elegantly written biography represents. While Greenspan offered considerable assistance to Mallaby and his team of researchers, I detect no sense of capture in the balanced and well-judged conclusions. As a description of the politics and pressures under which modern independent central banking has to operate, the book is incomparable. The Man Who Knew: The Life and Times of Alan Greenspan, by Sebastian Mallaby, Bloomsbury, RRP£25/Penguin Press, RRP$40, 800 pages

Volcker: The Triumph of Persistence, by William Silber, Bloomsbury RRP£25/RRP$30, 448 pages The economy suffers a malaise. A fiscal deficit yawns but government is paralysed. The only agency that can act is the US Federal Reserve. It all sounds very familiar. Paul Volcker was chairman of the Fed from 1979 to 1987. His foe was inflation – the opposite of the high unemployment fought by Ben Bernanke today. But the pressures on the two men from purist academics and interfering politicians are eerily similar. That makes this fine new biography especially timely. William Silber’s theme is the tension between monetary and fiscal policy, between the ascetic central bankers and the wilful politicians, and how one must check the other. Silber, a professor of finance and economics at New York University’s Stern School of Business, argues that Volcker’s achievements went beyond taming inflation; by keeping interest rates high, he also forced Ronald Reagan to rein in the budget deficit. That is relevant to today’s debate, which pits supporters of the Fed against Republican critics who say that by striving to push down long-term interest rates, the central bank is relieving market pressure on politicians to tackle the public finances. Most of Silber’s account is devoted to the three main policy episodes of Volcker’s career: his role in ending the link between the dollar and gold at the US Treasury in 1971; in fighting inflation at the Fed a decade later; and in proposing the “Volcker rule”, which restricts commercial banks from speculating, in 2010. Volcker, still influential at 85, comes across in this book as determined and principled but also pragmatic. He misses out on early chances to become Fed chairman or Treasury secretary because presidents Lyndon Johnson and Richard Nixon do not trust him to do what he is told. When a crisis unfolds, however, he does what is needed – even when that means bailing out the creditors of Continental Illinois in 1984, and thus establishing the idea that some banks are too big to fail. It is for his fight against inflation at the Fed that Volcker is best known. Throughout the 1970s, under the chairmanship of Arthur Burns, the central bank was quick to cut interest rates whenever unemployment seemed likely to increase. By the end of the decade prices were rising by close to 15 per cent a year. Volcker changed the regime at the Fed and targeted the money supply (although never to the satisfaction of monetarist economists). Short-term interest rates rose as high as 19 per cent, the economy fell into recession, but inflation was crushed. As Silber notes, the price of gold fell and the dollar rose once Volcker was in charge, suggesting markets believed he would avoid inflation. But interest rates on treasuries stayed high as Reagan’s tax cuts led the government to borrow more and more. In early 1982, the Fed raised interest rates again by 2 percentage points in the teeth of recession. Silber argues that it was the knowledge that the private sector would get no relief on interest rates unless the government reined back that pushed the Reagan administration to raise taxes later that year, and led to further deficit reduction in 1985. It is interesting to compare that situation with the present day. Now, short-term interest rates are close to zero, inflation is low and inflation-protected bonds do not imply an investor fear of runaway price rises. But with 10-year Treasury bonds yielding just 1.62 per cent at the time of writing, investors seem happy to lend to the government, despite high deficits. Instead, all the facts indicate that there is little private demand to borrow, in which case the Fed could raise interest rates and still put little pressure on Congress to tackle the deficit. Indeed, it might well have the opposite effect. Silber recognises that, but in a final chapter titled “Trust” he argues that the Fed may at some point have to raise interest rates pre-emptively, and in an economy weakened by recession and unemployment it “may not have the public support that it needs”. What Volcker’s experience shows is that when a central bank is forced to keep rates high by a profligate government, then politicians will threaten its independence. Jimmy Carter appointed Volcker in 1979 and the resulting high interest rates may have cost him re-election in 1980. Volcker’s reappointment by Reagan in 1983 was touch-and-go. In 1986, Volcker was outvoted 4-3 on the Fed board by four Reagan appointees, who wanted to lower rates. He almost resigned but the matter was smoothed over. In January 2014, Bernanke’s term at the Fed will end, and whoever is president will have to appoint a replacement. This book suggests that the most important thing is to choose somebody wise, stubborn and, above all, independent.