A Candid Conversation with Greenspan

Having retired, former Federal Reserve chairman Alan Greenspan is no longer required to testify at length before Congress about the state of the global economy, the future direction of interest rates and the health of the stock market. But he was willing to sit down in his low-key Washington office for a two-hour tutorial with NEWSWEEK's Jon Meacham and Daniel Gross. Some highlights:

NEWSWEEK: How should Americans judge your legacy as Fed chairman?
I was very fortunate. I emerged on the scene at the beginning of this extraordinary half-generation. And my tenure ended as events began to change. At the Federal Reserve, we created policies that took full advantage of the way the global economy was working, which enabled us to gain what has really been a remarkable rise in American standards of living. I'd like very much for people to say, "Well, he caused all of that." But I don't think the evidence holds up very well for that hypothesis. What I did was create essentially a risk-management-based procedure to implement monetary policy.

When you became Fed chairman in 1987, if someone had said that in the next 20 years we're going to have virtually uninterrupted economic growth, would you have said, "That is a banker's fantasy"?
I would have said it was psychiatric inadequacy. I do realize how extraordinary, how unusual, this period has been. The very nature of its discontinuity from history is what forced me to reach beyond the usual economic variables to seek an explanation of what it's all about. And as you know, I concluded that it was the result of a seminal geopolitical event, the end of the cold war.

That was clearly an important political event, by why was it the most important economic event of our lifetimes?
On one side of the Iron Curtain were essentially centrally planned collectivist societies based on the principle that collective activity is what produces wealth and therefore there are no individual rights to property. On the other side were capitalist societies built around the market system, with free trade and individual-property rights. The classic case was East Germany versus West Germany, which were two economies coming from the same history, culture and language ... The conventional wisdom was that East Germany's economy was three fourths the size of West Germany's, and that the Soviet Union, while having major shortfalls, was a formidable economic power. Then the Berlin wall came down, and the economic ruin behind the Iron Curtain was utterly unexpected and unimaginable. Central planning did not work in the Soviet Union. And the standard of living in East Germany was not 75 percent of West Germany, but somewhere between a third and 40 percent. The impact of that on the rest of the world was dramatic.

How, specifically?
The evidence of the power of the marketplace versus central planning, as exposed so demonstrably in Europe, led to an extraordinary rise in foreign direct investment in these countries. In China, for instance, foreign direct investment, which had been $4 billion in 1991, by 2006 was over $70 billion a year. Deng Xiaoping called the transformation "socialism with Chinese characteristics." What it was was creeping capitalism.

It's common to hear complaints from many quarters about China's rapid rise. Does it worry you?
I am not, as many people are, concerned about China becoming a threat militarily. In my book, I'm essentially forecasting that what happened to the communist parties of Europe is likely what will happen to the Chinese Communist Party ... They are going to be a formidable economic power, which I think is all to the good.

Looking back, was there anything you could have done to stop the technology bubble of the 1990s?
I concluded that we could not prevent the bubbles that emerged while I was at the Fed ... What we had happen to us in the 1990s in the stock market wasn't on purpose. We did tighten the economy quite significantly at various times during the 1990s. And what we found was that instead of defusing or incrementally declining the bubble, we enhanced it ... You can only break a bubble if you break the underlying basis of the economy. Basically, it's not possible to defuse a bubble before its time has come.

Which gets us to where we are today: the housing bubble has burst, the subprime-mortgage market has melted down and we're in a credit crunch. Critics have charged that the Fed contributed to the trouble by keeping interest rates low for so long.
This particular problem was an accident waiting to happen. The euphoria that existed in the expansion of the housing-market bubble induced investors around the world who'd had a huge buildup in liquidity—largely because of the lower real long-term interest rates that occurred as a consequence of the end of the cold war—to invest in something with a higher rate of return. And, lo and behold, the subprime-mortgage market provided it.

The mortgage brokers were just meeting demand from investors?
Precisely. And so you had Wall Street's securitizers basically then talking to the mortgage brokers saying, "We'll buy what you've got." ... The big demand was not so much on the part of the borrowers as it was on the part of the suppliers who were giving loans which really most people couldn't afford. We created something which was unsustainable. And it eventually broke. If it weren't for securitization, the subprime-loan market would have been very significantly less than it is in size.

People want the Fed to cut interest rates to alleviate tight credit conditions. Do you think the financial marketplace has come to view interest-rate cuts as a crutch? And is that an appropriate role for the central bank?
To the extent that [the Fed] interferes with the economy, we do help some of the people who are involved in rather questionable financial activities. The problem basically is that if you do effective monetary policy and stabilize the economy, you will raise all asset prices—those that are assets owned by prudent investors, but also the prices of assets of those who have taken very silly risks and should be punished as a consequence. There is no simple solution. If we do something which works for the society as a whole, we will inadvertently and undesirably bail out, if you want to put it in those terms, the people who have taken silly risks.

And how does the housing market look now?
On top of all this, we've got a housing outlook which is very unfavorable. There are estimates of about 200,000 new mainly completed units that are atrophying and have to be sold quickly. But the sales of homes are falling even though housing starts are falling sharply ... That's putting downward pressure on prices. There's an Act II to this: as prices go down, the net worth of individuals goes down. And their propensity to spend goes down.

The question everyone wants to know is, are we in a recession or headed for one by the end of the year?
Well, we're not in one now. That we're not headed for one is a forecast which has yet to unfold one way or another.

You were for years a figure of reassurance, whether during the stock-market crash of 1987 or September 11. People are going to look at the title of your book, "The Age of Turbulence," and say, "My God, if Greenspan thinks this is turbulent, what are we going to do?"
Well, the way I put it in economic terms, provided we can create a sufficiently flexible financial economic system, we can essentially absorb the turbulence and its extremes without significant job loss or economic disruption. Turbulence is, as we get into the 21st century, probably a necessary condition to maintain an economy worldwide as high-powered as the one that now exists.

So we need a certain degree of instability in order to grow?
It appears as though we need a certain degree of turbulence in the financial system to create the stability in the private system. A B-2 bomber is run almost wholly on computerized adjustments. Hundreds of thousands, maybe millions of adjustments that are going on all the time keep the plane stable. That's not actually a bad analogy to the turbulence in the economy. In one sense it's benevolent turbulence.

Reading your opinions of the various presidents you've worked with, it was surprising that you ranked Clinton near the top, given your personal political views, as well as Nixon, given his reputation.
Both were tops in IQ, not in character. Nixon, as I point out, I really misjudged. He was a Jekyll and Hyde. With Clinton, there's a moral looseness about him. When I heard the rumors about Monica Lewinsky I thought, it's not possible. I don't care how corrupt the president of the United States is, they just don't do that to themselves. The person who had true character was Gerald R. Ford. I felt more comfortable with him, and I trusted him more than anybody.

How about the next president? Hillary Clinton seems to be the front runner on the Democratic side. What's your view on the junior senator from New York?
Very smart. She is probably everything that everybody says about her. She wouldn't be a bad president, but she won't attack the issues which really require coming to grips withduring the campaign. The absolute blindness of candidates to the obvious issue of Medicare's problems is just truly discouraging to me.

Who would you like to win next year?
Is one of the choices leaving the office open?