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The case against Alan Greenspan
To the list of those responsible for the economy's pain, some have added the Maestro's name.
August 8, 2002: 11:00 AM EDT
By Mark Gongloff, CNN/Money Staff Writer

NEW YORK (CNN/Money) - There's a growing list of shamed corporate executives, Wall Street analysts and inept government officials being blamed for the current misery in the economy and the stock market, and many of those names are obvious.

But some observers have put one name at the top of the list that probably will surprise most people -- Alan Greenspan.

That's right, the Maestro, the Federal Reserve chairman often credited with the magical ability to control global markets and economies with the mere sound of his voice, the man who allegedly whipped inflation.

These critics blame Greenspan for the outrageously swollen bubble in stock prices in the late 1990s, which led to excesses of investment that overheated the economy and threatened inflation, forcing the central bank to raise interest rates in 1999 and 2000, which led to a recession that began in March 2001.

"He was a very poor central bank chairman," said James Grant, editor of Grant's Interest Rate Observer. "He was passive in the face of what will go down as a very destructive bubble."

If only Greenspan had stepped in earlier -- and one vague warning about "irrational exuberance" doesn't count -- the bubble wouldn't have been so big and the subsequent popping wouldn't have been so painful, Grant and other critics say.

Fed officials were not available for comment.

At the very least, critics say, Greenspan could have made the symbolic gesture of tightening margin requirements, which the Fed controls but hasn't touched since 1974. Margin buying is the process by which investors borrow from brokers to buy stocks. Rampant margin buying encourages speculation, and the Fed could have clamped down on brokers' ability to lend.

"The Fed was given control of margin lending in response to the excess speculation in the 1920s," said Lacy Hunt, chief economist at Hoisington Investment Management. "When that bubble burst, a lot of small individuals were hurt, and the Fed was given that tool to use to prevent those types of situations from happening again.

"It was not used this time, even though it was debated in Fed circles -- Greenspan opposed it," Hunt added.

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Greenspan also could have taken a humbler attitude about his own substantial myth, lowering expectations about his and the Fed's ability to miraculously fix the world's every financial problem.

"People called him clairvoyant, and he never said, 'Shucks, it's not me, it's the cycle -- I am a federal employee. I don't see around corners, and I never have. Don't put too much stock in this bureaucracy called the Fed,'" James Grant said.

While Grant didn't want to second-guess the Fed's failure to raise its target for short-term interest rates during the late 1990s -- which would have lessened the funds available for over-hyped dot.com stocks, fiber-optic cable and similarly foolish investments -- others are certainly willing to do so.

Relatively mild interest-rate hikes -- say, 25 basis points every six months -- in the late 1990s would have been met with groans of agony from Wall Street but would have kept the bubble under control, according to James Padinha, economic strategist at Arnhold & S. Bleichroeder.

"Once the excesses got to the point where the Fed had to do something about them, the kinds of rate hikes we eventually did see had an outsized impact on the economy -- which ended up tanking, and then the Fed had to ease drastically," Padinha said.

In Greenspan's defense

Padinha notes, however, that Greenspan has been an excellent crisis manager. Greenspan's legend was largely built, in fact, on guiding the Fed's quick and reassuring action in the wake of the 1987 stock-market crash, the 1998 crises in Asia and Russia, the Sept. 11, 2001, terrorist attacks and more.

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And other defenders -- of which there are many -- note that it's all too easy to look backward and see the precise inflection points where strong economies become inflationary economies, where sluggish economies become recessions and where strong stock markets become bubbles. Timing policy perfectly to prevent such inflection points is more a matter of luck than anything else.

And the Fed is not charged with manipulating stock markets. It has two roles -- fighting inflation and helping the economy grow.

"Greenspan doesn't need to offer any mea culpa," said Wayne Ayers, chief economist at Fleet Boston Financial and a former Fed economist. "The Fed has no mandate to contain asset market inflation -- using monetary policy to deflate a bubble can have severe consequences."

"No one should take seriously the notion that he could have explicitly aimed at capping the wealth of the public, and there would have been hell to pay had he attempted to do so," Ayers added.

Defenders also note that the Fed has made deep and powerful rate cuts when it saw the economy was in trouble, while unemployment and inflation have been largely in check for years.

"Greenspan's perfectly fulfilled his mandate," said Brown Brothers Harriman economist Lara Rhame, another former Fed economist. "And there are a couple of things he couldn't have manipulated even if he'd wanted to [such as] Enron and WorldCom -- these are things that the Fed can't possibly have been prepared for."

Still, some Wall Street critics counter that the Fed didn't see the trouble soon enough -- a charge similar to the one levied by supporters of the first President Bush, whose presidency was cut short by a sluggish recovery from the 1990-91 recession.

The Japan syndrome

Today, with the Fed's target for a key short-term interest rate at 1.75 percent, a 40-year low, the economy still hasn't caught its breath, and a growing number of economists are fretting that another downturn is on the way, requiring still more rate cuts and raising ever-scarier comparisons with Japan, where interest rates are at zero, but whose economy still can't get moving.

Though most economists think the United States is fundamentally different from Japan, there's at least a risk that the low, low interest rates of the past year have encouraged consumers to take on too much debt and eat up too much home equity already, meaning another downturn -- which could lead to more layoffs and tighter credit requirements -- could catch consumers without the ability or desire to borrow any more money.

"We're in a situation where the economy is the most highly leveraged in the post-War period," said Paul Kasriel, chief economist at Northern Trust Co. in Chicago. "If the Fed had to raise interest rates, that could bring the whole system down. And it's not clear that holding rates where they are or lowering them will save us from another recession."

Kasriel and other critics of the current Fed modus operandi would prefer to see monetary policy put on a sort of automatic pilot, tightening the supply of money when demand for loans is high and loosening it when demand for loans is low.

"The Fed is a price fixer; it fixes the price of short-term credit," Kasriel said. "If there's an increase in demand for credit, interest rates want to rise. But because the Fed is fixing the price of credit to keep rates from rising, it has to create more reserves or allow banks to create more money, and that's what leads to bubbles."

For example, companies borrowed extensively in the late 1990s to buy back stock in order to fight the dilutive effect of issuing reams of stock options. If the Fed had been on auto-pilot, allowing interest rates to rise as companies borrowed, then perhaps companies wouldn't have gotten themselves in so much debt.

Such an approach to monetary policy might also remove the cult of personality that has developed around the Fed chairman. Perhaps fewer people would care to hear his opinion about, for example, tax cuts -- an issue that Greenspan has discussed extensively during his tenure, having great impact on fiscal policy, an area he's supposed to be leaving alone.

"He goes up to Congress, and they ask him questions about everything except monetary policy," Kasriel said. "It's unprecedented that a central banker is sort of viewed as an omniscient economic policy czar. It's not his responsibility."

With such a hands-off philosophy at least partially in mind, James Grant has devised what might be the most radical approach for future central bankers.

"When I'm asked what I would do if I were Fed chairman, my invariable answer is, 'Resign,'" he said.  Top of page




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Market indexes are shown in real time, except for the DJIA, which is delayed by two minutes. All times are ET. Disclaimer Morningstar: © 2014 Morningstar, Inc. All Rights Reserved. Disclaimer The Dow Jones IndexesSM are proprietary to and distributed by Dow Jones & Company, Inc. and have been licensed for use. All content of the Dow Jones IndexesSM © 2014 is proprietary to Dow Jones & Company, Inc. Chicago Mercantile Association. The market data is the property of Chicago Mercantile Exchange Inc. and its licensors. All rights reserved. FactSet Research Systems Inc. 2014. All rights reserved. Most stock quote data provided by BATS.