From the October 2008 issue of Research Magazine • Subscribe!

Greenspan's Legacy

A newspaper story once alleged that some traders at a Wall Street brokerage house had a shrine dedicated to Federal Reserve chairman Alan Greenspan, in which they made offerings in order to propitiate him, as if to some pagan deity.

It was a canard, of course, but it nearly sounded plausible. The lives -- or at least the incomes -- of market professionals depended on Greenspan's actions, almost like the lives of ordinary mortals in Greek mythology were affected by goings-on on Mount Olympus. Moreover, Greenspan's public pronouncements, when he cared to utter them, were almost as profound and inscrutable as prophecies emerging from the famous oracle at Delphi.

Greenspan was a dominant presence not only in the U.S. economy, global financial markets and corporate suites, but in the psyche of ordinary Americans. When the question of Greenspan's reappointment came up during the 2000 Republican primaries, John McCain declared that if the elderly chairman passed away, he would still dress him up in a suit and put him in a chair. The American public, even those who had no understanding of economics, seemed to be more comfortable with Greenspan at the helm. During his tenure going back to 1987, Greenspan successfully managed a number of crises and avoided or reversed several market meltdowns.

Greenspan retired in 2006 -- just in time, as it turned out. A year later the U.S. financial system entered a major credit crisis which has since spread abroad, to foreign markets and financial institutions, and which now threatens to impact the real economy around the world.

Now, in the uncertain economic environment, the role of the 82-year-old ex-chairman is being increasingly questioned. Critics claim that monetary policy under Greenspan was far too lax and that he had been excessively concerned with safeguarding the rally on Wall Street on the one hand and avoiding a recession on the other. What we are now experiencing, the reasoning goes, is the deflation of the various bubbles -- in housing, stocks, consumption, emerging markets and commodities -- that were created by Greenspan's easy credit.

Pumping in Easy Money Until 2000, the reasoning goes, Greenspan ignored the bubble in high-tech stocks. Even though he did warn in late 1996 about "irrational exuberance" on Wall Street, by the end of the decade, when exuberance clearly overflowed its banks, the Fed did nothing to take the market off the boil, raising its rates only in 2000, when it was too little too late.

Once the Internet bubble burst, Greenspan responded to September 11, 2001 by pressing on the monetary gas pedal full throttle, cutting the Fed funds rate to just 1 percent and keeping it there until mid-2004, well after the U.S. and global economic recovery became firmly established.

During Greenspan's tenure, the U.S. economy had not had a serious recession since 1980-1982. This could be seen as a measure of his success in managing the U.S. economy, but critics rightly point out that the market economy is cyclical. It needs periodic recessions to clear up imbalances, eliminate fat and dead wood and start anew with a clean slate. Politicians, of course, hate recessions, but this is one reason why central banks have to be independent of politics.

Without the cleansing effect of a recession, huge economic balances emerged, such as the enormous structural current account deficit in the U.S., which resulted in a massive outflow of dollars into the global financial system and the cheapening of the reserve currency. Easy credit created the subprime mortgage sector which became the starting point of the current crisis, but problems extended throughout the economy. For example, consumer debt in the United States has doubled since 2001, to $14 trillion.

The measure of how deeply entrenched these imbalances have become is the fact that the United States is experiencing a sustained nationwide decline in house prices for the first time in its economic history. Even more unusual, it occurs at a time when inflation, at least as measured by producer prices, is at a 27-year high and approaches double-digits -- i.e., when paper money is losing its value and real estate should be at a premium.

Ben Bernanke, Greenspan's successor as Fed chairman, is in a quandary. He finds himself slashing interest rates in the face of rising inflation. This creates another paradox. The banking system is still distressed, and most bankers describe the lending environment as extremely tight. Yet, there is still a sea of dollar liquidity sloshing around the global financial system. One consequence has been a bubble in commodity markets, which emerged over the past year when investors were looking for assets to buy. This bubble is also deflating now, with oil prices falling more than 20 percent in a month to mid-August.

The result could be a nasty pop for financial bubbles or a dramatic acceleration of inflation -- or both. Since Bernanke will almost certainly become a scapegoat, it is probably useful to remember that it was his predecessor who bequeathed to him this environment.

Too Quick to CriticizeNevertheless, sharp criticism of Greenspan's legacy may have been premature. True, because of his policies, the United States keeps consuming more than it produces, going deeper into hock to fund its spending habits and effectively pawning its productive assets to foreigners.

However, those dollars have been the driving force of real economic progress around the world. China, India, Mexico, Brazil and other countries have been investing their surplus dollars into productive capacities, infrastructure and education. Even if the current U.S. economic downturn is likely to hit emerging economies hard, the changes that have occurred over the past decade are irreversible. Most emerging countries have become more business friendly, their financial and economic systems have been deregulated and liberalized and new classes of educated, skilled entrepreneurs have emerged.

Meanwhile, U.S. dollars accumulated by global central banks have made the world economic system more stable. In 1997, Thailand, South Korea, Indonesia and Malaysia suffered a speculative run on their currencies. The financial meltdown caused a regional economic crisis, and then trouble spread from Asia into Russia in 1998 and Latin America in 2001. Now, however, no speculator would dare attack their currencies in the face of their enormous reserves. Russia, for example, holds around $500 billion at its central bank and stabilization fund. The ruble is now convertible, but not even during the recent dip in its value during the invasion of Georgia did it come under speculative pressure.

Greater Social StabilityIn the U.S., easy money has been an engine of important social, economic and technological change. For example, for all the excesses of the late 1990s stock market bubble, it drove the development and spread of many technologies, including mobile telephony and the Internet. Spearheaded by intense competition and spurred by the lure of enormous profits, a myriad of new ideas and technologies were promptly brought to market.

And although hundreds of Internet operations perished once the bubble burst, taking billions of investors' dollars with them, the positive legacy of the era has endured through a revitalized and expanded entrepreneurial culture.

Similarly in the housing market, subprime mortgages have caused havoc for financial institutions but they also have allowed many people who previously had been excluded from owning their homes to become homeowners. Homeownership has always been considered an important way to revitalize depressed neighborhoods, bolster social stability and improve economic mobility. While there have been defaults on subprime mortgages, they involve only a small fraction of borrowers.

It is very likely that the financial and economic crisis caused by Greenspan's easy money will worsen at home and abroad, eventually impacting emerging economies severely. However, once the crisis passes and the imbalances are corrected, the deeper economic and social changes wrought during these two very creative decades, and oiled by easy money supplied by the Fed, are likely to prove lasting.

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Alexei Bayer runs KAFAN FX Information Services, an economic consulting firm in New York; reach him at abayer@kafanfx.com. His monthly "Global Economy" column in Research has received an excellence award from the New York State Society of Certified Public Accountants for the past five years, 2004-2008.

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