No Controlling Authority - role of Federal Reserve System chairman Alan Greenspan in manipulation of economic cycles

Reason, Oct, 2001 by Michael W. Lynch

The economy is too complex for even Alan Greenspan to handle.

Throughout the 1990s, Federal Reserve Chairman Alan Greenspan basked in the glory of a strong economy--and a strong stock market. Greenspan-worship perhaps never reached the ridiculous heights chronicled by disgraced journalist Stephen Glass, who in 1998 penned a fictitious article for The New Republic about an investment bank that actually created a shrine to Greenspan. But Glass' fabrication, which included tales of traders celebrating Greenspan's birthday with cake and song, wasn't so ridiculous that people didn't believe it at first. "As far as the financial markets go, [Greenspan's] more powerful than God," the honest-to-god, real-life chief market strategist for the investment banking firm Ferris, Baker Watts effused to the Baltimore Sun in 1998.

Today, with the economy slowing, the NASDAQ tanking, and the Dow Jones Industrial Average sliding sideways, Greenspan is coming in for criticism. "Alan Greenspan is out of control," wrote Fox News Channel's Bill O'Reilly earlier this year. "Take that to the bank. The guy messed up big time and now will not explain himself." More recently, the famously irritable talk-show host has been lambasting Greenspan on the air, decrying the Fed head's general unwillingness to talk in anything other than the most inscrutable terms.

Yet if Greenspan were ever to explain himself clearly, O'Reilly wouldn't like what he'd hear. Neither would all those people who desperately want a single person to be in "charge" of the economy, making sure that stock portfolios remain flush and jobs secure. Hard-truth time: As skillful as he may be, Greenspan has never managed the U.S. economy. "The Fed didn't cause the boom," says Lee Hoskins, who served as president of the Cleveland Federal Reserve Bank from 1987 to 1991. "The slowdown in economic activity wasn't caused by monetary policy."

"If the Fed is trying to steer the macro economy, it has an impossible task," adds Lawrence H. White, the F.A. Hayek Professor of Economic History at the University of Missouri's St. Louis campus. All the Fed controls, after all, is the money supply. To be sure, that's no small matter. "If it gets things wrong," cautions White, "it can drive the economy through business cycles, and through its history the Fed has done that many times. If they get things right, they avoid being a source of disturbance, but they don't affect the real growth of the economy. The best the Fed can do is avoid being a source of disturbance."

Yet even among those who know better, it is widely assumed that the Fed sets interest rates. As the Ferris, Baker Watts market strategist told the Baltimore Sun back in the late '90s glory days: "Greenspan controls interest rates....Interest rates control the money flow. And money makes the market go." Actually, the Fed sets only the discount rate, the interest rate at which it lends to other banks. As for other interest rates, it attempts to affect them by either buying or selling bonds, which either sucks money out of the economy or puts money into the banking system.

But the Fed can't force banks to lend. And it can't force companies and individuals to borrow. Sometimes it can't even affect, let alone determine, other rates for money borrowed over longer periods of time. Although the Fed started cutting its discount rate last December, the yield on the 10-year government bond actually increased from 4.75 percent to 5.09 percent since March. "Real interest rates, adjusted for inflation, have natural values that are independent of monetary policy," says University of Georgia economist George Selgin. "The Fed has no ability to set real interest rates. None."

Is Selgin overstating his case? Consider that Greenspan was unable to gradually moderate the stock market's tech bubble, which he first addressed back in late 1996 with his famous comments on how escalating security prices may be the result of "irrational exuberance" among investors. At the time, the Dow was at 6,300 and the NASDAQ stood at 1,600. As long as the market was going up, no one much cared that Greenspan was powerless to pull the indexes down to earth. In fact, as late as September 2000, a source as sophisticated as The Financial Times of London declared that Greenspan had achieved the much-coveted "soft-landing," as if he were in fact piloting the economy. Now that the NASDAQ has dropped more than 60 percent from its peak, people may care more than ever about what Greenspan has to say. But that doesn't mean he's any more able to pull us out of the current doldrums than he was to ease us out of our mind-blowing bubble.

Ascribing dictatorial powers to the Fed chairman is nothing new. Indeed, there was a time when virtually all sophisticates believed the government could control and effectively manage the economy. "In the mid-1960s, a report from the Council of Economic Advisers stated that we had sufficient knowledge to manage the economy and it was incumbent on us to do so," says Hoskins, the former chief at the Cleveland Fed. "That proved to be the big mistake. We started with low inflation and unemployment and sent them both into double digits." This outcome was supposedly impossible according to standard economics of the era.