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Don't write Greenspan off

Marie-Josée Kravis

Alan Greenspan celebrated his seventy-fifth birthday this past weekend, and as his wife Andrea Mitchell assembled a group of admiring friends to mark the occasion, many observers were quite openly beginning to question the Fed chairman’s acuity in dealing with current economic issues. To be sure, Mr. Greenspan continues to enjoy the confidence of financial markets, but more and more commentators are now willing to challenge his views of monetary policy. This is not an unusual occurrence. In fact, the tradition in the United

States has been to have a shadow committee critique and review monetary policy. Mr. Greenspan had escaped such debates, deified as he was for supposedly presiding over a period of unparalleled growth with no inflation.

The economy has slowed, and focus has therefore shifted to policy considerations. Last week, congressmen pressed Mr. Greenspan to comment on the Fed’s response to the slowing economy, suggesting that the central bank had waited too long to ease monetary policy. More and more commentators are arguing that the Fed was too lax in 1999 in anticipation of Y2K problems, and subsequently too stringent in its efforts to correct its apparent mistake.Why the Fed did not lower interest rates on Dec. 19 rather than early January continues to perplex many Fed watchers. Could it be that the maestro is out of tune with the times?

Could it also be that investors and consumers are suffering, not from ‘irrational exuberance,’ but from irrational expectations about the role the Fed can play in moving the economy along? So many young investors and analysts have never experienced a recession and fail to understand that economic slowdowns

perform an important function in correcting excesses and restoring balance to economic conditions. For example, we are witnessing an inventory correction that reflects overinvestment and recent misreading of supply and demand conditions based on rates of growth that were unsustainable. As Alan Greenspan pointed out in his Feb. 28 congressional testimony, ‘even though demand for a number of high tech products was doubling or tripling annually, in many cases, new supply was coming on even faster.’ The Fed would not want to impede adjustments to the imbalances that ensued.

Nonetheless, inventory rebalancing occurred much faster than anticipated —undoubtedly intensified by the tightening of financial conditions and the increase in energy prices, which in turn reduced business and consumer purchasing power. Moreover, better information and the foreshortening of lead times in the delivery of capital equipment have caused business decisions to be more synchronized and compressed into a much shorter time frame. This inevitably complicates the role of the Fed because, in the words of its chairman, ‘we respond to a heightened pace of change and its associated uncertainty in the same way we always have. We withdraw from action, postpone decisions, and generally hunker down until a renewed, more comprehensible, basis for acting emerges.’ How policy can restore confidence remains a daunting challenge for the Fed chairman, causing his critics to wonder whether or not he has been sufficiently sensitive to the credit crunch that so worries investors and consumers.

The chairman has admitted his conundrum. He himself has said that ‘this unpredictable rending of confidence is one reason that recessions are so difficult to forecast. They may not just be changes in degree from a period of economic expansion, but a different process engendered by fear. Our economic models have never been particularly successful in capturing a process driven by nonrational behavior.’ This is quite an admission by the man who was supposed to hold so many of the levers of economic life. He does not wield a magic wand after all, and healthy debates about monetary policy are warranted.

Nevertheless this is not the time to lose confidence in the chairman of the Federal Reserve. He may be 75, but just last year, at 74, he was believed to walk on water. We certainly overestimated his powers, and he probably erred in many decisions, but questioning his basic effectiveness now would simply erode confidence further to no one’s benefit.

He must contend with many fundamental changes in the economic landscape. The onslaught of technology has transformed economic decision-making, production, and delivery of goods and services. It remains unclear whether recent improvements in productivity were structural or temporary. The change in the country’s fiscal position from deficits to surpluses raises questions about the Fed’s management of its own portfolio, which until now has been focussed on Treasury securities. Just as business in general has had to contend with new challenges, all is not business as usual at the Fed.

This calls for a revival of the debates of the seventies, when the shadow committee nourished a real debate on monetary policy and Fed actions. It does not justify gratuitous Greenspan-bashing.

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