Greenspan faces his toughest test as boom gathers pace

This article also appeared in The Sunday Times(London) on February 14, 1999.

PEACE has broken out in Washington - well, if not peace, at least quiet. Congress has adjourned and its members have left town for a brief holiday and to learn from constituents just where they stand now that Bill Clinton has been acquitted of crimes he obviously committed. The occasion of their leaving is a long, holiday weekend: tomorrow we celebrate the birthday of George Washington, famous for being unable to tell a lie.

Congressmen return to voters prosperous beyond the wildest dreams of all save the most avaricious. Despite recent jiggles, share prices remain at levels that have swollen the value of pension funds and family savings. The unemployment rate remains at a near 30-year low, after employers took on an additional 245,000 workers in January, more than half of them professional and managerial.

Even the chronically high unemployment rates among blacks and Hispanics have fallen to the lowest levels since the government began keeping records in the 1970s.

Not only are jobs plentiful, pay is also rising. Average hourly earnings are 4% up on a year ago. And because productivity last year rose at twice the average rate achieved since 1973, prices are stable. Better still, even in the face of stable prices, the outlook for corporate profits is growing rosier.

Only two months ago Merrill Lynch said the profits of the companies in the S&P500 index would drop 5% this year. Now it predicts a 3.5% rise - and Merrill is one of the gloomier houses: Byron Wien of Morgan Stanley pronounces himself "optimistic [that] earnings are going to exceed expectations".

So what can voters possibly have to say to their representatives, other than "Good to see you"? The answer seems to be "Save social security". Clinton has convinced Americans their beloved retirement scheme faces insolvency as fewer and fewer workers put in the money that is to be drawn out by more and more pensioners.

Just how the social-security system is to be saved is not yet known. Clinton wants to draw on funds from taxes and increase the return earned on those funds by investing a small portion in shares. The Republicans agree it would be wise to put some pension money in shares but want to let people decide for themselves how to invest, rather than have government bureaucrats do it for them.

However that battle is resolved, one thing is certain: there will soon be an increase in the amount of money chasing shares.

Wall Street brokers could not be happier - well, yes they could.

The Republicans want an across-the-board 10% tax cut and since high earners pay most of the taxes, they would benefit most from such a cut. But they are not counting on such a bonanza just yet. As usual, the Democrats would prefer to have government spend money rather than return it to those who earned it.

So Clinton has put forward new programmes and is proposing some modest, targeted tax cuts for people such as stay-at-home "carers". The betting is Clinton will win, not because his proposals are better, but because the opposition seems to have taken lessons in ineffectiveness from the Tories.

Whether Clinton spends more or the Republicans tax less, America is entering a period of looser fiscal policy and this puts the policy ball squarely in Alan Greenspan's court.

The Federal Reserve chairman is now faced with an economy growing more rapidly than anyone guessed it would, with a labour market so tight almost every available man, woman and child is at work, with a government about to ease fiscal policy, and with asset prices that must seem to him of "bubble" proportions.

Under ordinary circumstances, his response would be clear: raise interest rates. But these are not ordinary circumstances.

For one thing, the world economy, although no longer thought to be on the brink of doom, is still fragile.

Ignoring the critics who say he should concentrate solely on the needs of the American economy, Greenspan feels he must worry about Asia, Latin America and perhaps even Russia. Such are the delusions of grandeur to which a central banker, especially one as successful and adored as Greenspan, is prone to succumb. So he hesitates to raise rates lest such a move adversely affect economies struggling with the consequences of their own financial mismanagement.

Then, too, Greenspan has to consider the possibility that all he has to do is nothing, and the American economy will remain in the Goldilocks period in which it has found itself for the past eight years. It is growing at a rate of close to 4%, which at one time seemed unsustainable but has proved to be possible without igniting inflation. If productivity continues to rise, and if cheap imports remain a barrier to domestic price increases, a fully employed American economy may continue to grow without overheating.

Both those "ifs" have a good chance of being realised.

The huge investment of the past decade in computers and other efficiency-enhancing capital equipment seems finally to be paying off in lower costs. And there is no sign that the world's excess capacity, the source of America's cheap imports, is about to dry up. Indeed, there is every prospect that hard-pressed Asian factories will continue to provide American consumers with goods at bargain-basement prices for years to come.

So Greenspan's decision next month will not be an easy one.

Of course, a 20% drop in share prices might take the edge off of his worries about an asset bubble and persuade him to leave interest rates unchanged. As you Brits say, "We'll know on the day". Until then, any guess is as good as any other.