Exit The Maestro: The Economy Owes Much To His Deft Handling Of Inflation
Gradualist. Greenspan's start at the Fed was rough. Two months after taking office, he faced Black Monday, when the Dow Jones industrial average dropped 23 percent in a single session. Some investors and economists blame Greenspan for the crash, as he began his Fed term with an abrupt series of interest rate hikes. Regardless of who caused the crash, the Fed's reaction was right. It quickly provided liquidity and persuaded banks to make loans. All in all, the experience turned Greenspan into a gradualist, says Stack: "He learned quickly not to try to drive the economy like a sports car." Greenspan has remained so ever since, as evidenced by the series of 11 consecutive quarter-point interest rate hikes (with one more likely this week) that the Fed has undertaken over the past 16 months to raise the benchmark federal funds rate from 1 percent to 3.75 percent.
The 1987 crash most likely reinforced Greenspan's willingness to learn on the job. The chairman himself summed it up recently at Jackson Hole in his famously circumlocutory manner: "Despite extensive efforts to capture and quantify what we perceive as the key macroeconomic relationships, our knowledge about many critical linkages is far from complete and, in all likelihood, will remain so."
The 1987 episode laid the groundwork for what many Fed watchers consider Greenspan's greatest triumph. During the mid-1990s, the U.S. economy was sailing, with inflation contained and unemployment creeping ever lower toward 5 percent. Yet those conditions troubled economists, many believing that unemployment could not remain below 6 percent for long without stoking inflation. By 1997, that conviction was putting enormous pressure on the Fed to raise rates.
Greenspan, however, sensed something was different. Although it wasn't yet showing up in the economic data, he speculated that the widespread adoption of information technology, among other factors, was leading to an increase in productivity among American workers. If so, the relative scarcity of available labor would not necessarily push prices higher.
"The staff didn't believe it. I didn't believe it," says Laurence Meyer, a Fed governor at the time. "The chairman was the only one who believed there was a productivity acceleration. It was a brilliant call."
As a result of Greenspan's insight, the Fed did not raise rates, allowing the unemployment rate to safely fall below 4 percent. "Greenspan has a medley of greatest hits, but to me, this was his greatest," says Alan Blinder.
The downside, though, was that already enthusiastic investors became positively euphoric. Even though Greenspan's Fed took no direct action to curb the late-1990s market hysteria, the chairman did speak out. As early as December 1996, he asked, "But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions . . . ?" The line, part of an otherwise unremarkable awards dinner speech, sent the Dow down 145 points soon after the next day's opening bell.
Laissez faire. The markets rebounded that day and proceeded to scale new peaks until the 2000 crash. Other than a bit of additional jawboning, the Fed made little effort to bring the stock market back from the brink. It would seem that although the Fed chairman's economic philosophy had branched out considerably since his days as a dogmatic libertarian, at root he has remained a disciple of the late philosopher Rand.
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