Alan Greenspan will retire as Chairman of the Federal Reserve in January 2006,
and his retirement promises a flood of swooning retrospectives. Writing anything
else at this moment risks the charge of churlishly raining on the parade. However,
there are good grounds for a more critical reading of Greenspan's eighteen-year
tenure at the Fed.
As Fed Chairman, Greenspan has been one of the world's most powerful policymakers
for almost two decades. During that time he has been a leading booster of globalization
and financial deregulation, developments that have contributed to a new U.S.boom-bust
cycle founded on financial exuberance and cheap imports. Financial exuberance
has driven up asset prices and supported consumer borrowing and spending. Cheap
imports have contained inflation and partially compensated households for wage
stagnation and heightened economic insecurity. The new cycle is a Faustian bargain,
the price of which will be paid when the bust phase begins.
The Greenspan Fed's support for this new boom-bust cycle is evident in its
disregard of the over-valued dollar and persistent growing trade deficits, which
have damaged U.S. manufacturing. To Greenspan, the over-valued dollar has been
a boon that has helped contain inflation by cheapening imports. Side-by-side,
the trade deficit has been viewed as the product of "consenting adults"
taking advantage of beneficial trading opportunities afforded by globalization.
Meanwhile, manufacturing has been tacitly analogized to agriculture, and its
decline rationalized as part of an inevitable transformation into a post-industrial
Lastly, the Greenspan Fed has shown a deep aversion to financial market regulation.
Thus, it refused to use existing regulatory instruments (margin requirements)
to curb the stock market bubble of the 1990s. And more importantly, it has refused
to contemplate new regulations that could have helped curb the subsequent housing
The chickens are now coming home to roost. Though the housing price bubble
helped escape the recession of 2001, it has left households saddled with debt.
However, the economic expansion has still proven fragile owing to the massive
leakage of spending out of the economy via the trade deficit. This leakage is
a problem, but it is difficult to address owing to de-industrialization and
the new economic environment associated with globalization and financial deregulation.
In the pre-globalization era large trade deficits could be corrected by dollar
depreciation (as happened in 1985). To prevent inflation from increased domestic
consumption and reduced imports, interest rates could be increased. Taxes could
also be raised and government spending cut.
However, such corrections are now far more difficult. First, globalization
has allowed the trade deficit to reach record levels, making the scale of adjustment
unprecedented and the inflation danger greater. Second, de-industrialization
means that America may lack the manufacturing capacity to replace imports, which
means the only way to close the trade deficit may be through recession and unemployment
that lowers incomes and import purchases. Third, higher interest rates could
burst the housing bubble, triggering recession.
Unwinding structural imbalances is always difficult, but the current difficulty
is compounded by scale and circumstance. Debt-financed consumption has borrowed
demand from the future. That means even without economic shocks, the economy
is already headed for a period of weaker demand. If house prices fall, wiping
out consumer wealth, that weakness could be severe and the Fed may have difficulty
containing it. Lowering interest rates, to stimulate the economy, may be little
more than "pushing on a string." With expectations of falling house
prices, buyers are likely defer purchases no matter what the interest rate,
as happened in Japan after its property bubble burst in 1990.
The Greenspan Fed has cavalierly allowed imbalances to develop, brushing aside
dangers with blithe references to the flexibility of the U.S. economy. The next
Fed Chairman must take exchange rates and trade deficits seriously. Globalization
means that exchange rates matter more, not less. The system of financial regulation
must also be rebuilt. Financial innovation makes asset price bubbles more powerful,
and the Fed must be able to contain them without recourse to the blunderbuss
of interest rates that wreaks havoc on innocent sectors.