THE FED'S GLORY DAYS ARE OVER
By Justin Fox

(FORTUNE Magazine) – FOR ALMOST A QUARTER CENTURY, Federal Reserve chairman Alan Greenspan and his predecessor Paul Volcker have enjoyed a free pass from the nation's politicians. When Senate Minority Leader Harry Reid declared in March that Greenspan was "one of the biggest political hacks we have in Washington," he effectively announced its expiration. The Nevada Senator's words (echoed by other Democratic critics) were more than just partisan sniping over the issues of the day. They may well signal the end of the era of Fed dominance of U.S. economic policymaking.

It's important to recognize just how unique this era has been. Federal Reserve chairmen haven't always been seen as nonpartisan oracles of economic wisdom. For much of the Fed's 91-year history, they haven't even been free to conduct monetary policy without political interference. From 1942 to 1951 the Treasury Secretary dictated the Fed's interest rate decisions. In 1972, President Nixon browbeat Fed chairman Arthur Burns into keeping rates low in an election year.

What elevated the Fed in recent decades was fear of inflation and divided government in Washington. (Between 1981 and 2001 there were only two years during which one party controlled both houses of Congress and the presidency at the same time.) Volcker became chairman in 1979, when inflation was stuck in double digits. He then proceeded to bludgeon the wage-price spiral into submission, in the process causing the worst economic downturn since the Great Depression. Volcker caught flak from Congress for that, but the success of his anti-inflation crusade eventually earned the Fed new clout. The Reagan administration appointed Greenspan in 1987 with the idea that the veteran Republican policy wonk would be more malleable. Instead, he built on Volcker's legacy, the gridlocked nature of Washington politics, and his own economic and diplomatic skills to become a national institution.

Neither of the conditions that enabled this rise of the Fed still holds. Inflation is far from the top of the list of Americans' economic worries, and Washington's political gridlock has broken up. President Bush doesn't need the imprimatur of the Fed chairman to get things done. He surely has been pleased to get Greenspan's endorsement or at least tacit approval of his tax cuts, Social Security changes, and plans for a consumption tax. But he just as surely would have proceeded without it.

A Fed chairman's power rests on his ability to persuade. Even on the Federal Open Market Committee, which determines monetary policy, the chairman is just one of 12 votes. Outside the Fed, Greenspan's clout has owed much to a political balancing act. Now that virtually all power is on one side of the political aisle, balancing can be hard.

As a result, some of Greenspan's recent utterings have sounded to his former Democratic fans like the fawnings of a partisan suck-up. In the case of his backing for Social Security reform and consumption taxes, the criticism is unfair: As an economist of libertarian leanings, he would have said the same things a decade ago. The charge that Greenspan has gone soft on the budget deficit since the early 1990s, when he persuaded Bill Clinton to accept austerity now in exchange for surpluses and lower interest rates later, holds more water. Contrary to Democratic rhetoric, the current budget situation isn't as bad as that of the early 1990s, but Greenspan certainly isn't holding President Bush to the standard of fiscal responsibility set in the Clinton years. If he tried to, he would probably be shown the White House door.

Whoever replaces Greenspan when the 79-year-old chairman retires, as he is expected to do in January, will, as a newcomer, find the room to maneuver even more restricted. This isn't necessarily bad: The nation's biggest economic policy choices should be made by Congress, and it might be healthy if our elected leaders learned to stop waiting--and leaning--on the words of the man at the Fed.

As for the Fed's core responsibility of setting monetary policy, the institution's diminished status could play out two ways. One would be a return to the bad old days when it answered to the whims of politicians--an ominous prospect if budget problems worsen and politicians start looking to inflation as a way out from under them. A more salutary form of political control would result if congressional Republicans--who have talked about the idea for years but never pushed it, because Greenspan disapproved--gave the Fed an inflation target, between zero and 2%, say, and held the chairman to it. This would rob the Fed of some of its glamour. But do we really need mystique in our central bankers? -- Justin Fox