Greenspan's Global Problem

Alan Greenspan is surely the least criticized American public official since George Washington. In recent weeks the few commentators who have dared to disagree with him have narrowly confined themselves to his testimony on taxes. The implication, of course, is that, in the papal tradition, Greenspan is infallible when he deals with interest rates. At his job Greenspan is, in an economist's words, "God on a good day."

But is he? Looking at the economy today, one has to wonder if the Federal Reserve's handling of it over the last three years has been as wise or as consistent as the myth of Alan makes out. Rather than keeping a steely gaze of the core rate of inflation--the Federal Reserve's historical role--Greenspan has massaged interest rates in response to the crisis of the moment, whether it's Russia's default, hedge-fund failures or bubbling technology stocks.

These are all serious concerns. But should the Federal Reserve Board be using its nuclear weapon--short-term interest rates--to coax and cajole global bankers and American investors to behave well?

Consider what was supposed to have been his finest hour. In the late fall of 1998--in the wake of Russia's default, the panic in global markets and the monster hedge fund Long Term Capital's imminent collapse--Alan Greenspan suddenly and dramatically cut interest rates. The markets rallied and--the mythology goes--the global economy was saved.

But it was exactly the wrong time to cut rates in America. The American economy was roaring--growing at close to 6 percent in the last quarter of 1998. The Fed goosed the economy when it was already on steroids.

Greenspan's dilemma in 1998 was that the Federal Reserve Board has become the banker of last resort of the global economy. This is in contradiction to its role as watchman of American inflation and growth. (The Fed tried hard to disguise this reality in its statements in late 1998.) In solving a global problem, Greenspan may have caused a local one.

The rate cuts weren't all. Greenspan had bought into the overhyped fears about Y2K, and in late 1999 the Federal Reserve swamped the markets with as much liquidity as the private sector wanted. The result of low rates and easy money at a time of galloping growth produced Greenspan's nightmare--an out-of-control stock market. Between November '98 (the first rate cut from 5.5 percent) and February 2000 (when rates finally rose to 5.75), the Nasdaq jumped almost 250 percent, increasing in value by more than $3 trillion. It was irrational exuberance on crack.

Spooked by the spiraling stock market, Greenspan started raising rates in June 1999--only six months after he had cut them--and hiked them six times to 6.75 in an economy in which inflation was virtually nonexistent. (Except for energy costs, which Greenspan had long maintained should not be crucial to the Federal Reserve's considerations.)

The high interest rates proved to be an overdose. In his testimony on Jan. 25, Greenspan announced that growth had slowed to close to zero. Since the Federal Reserve could not have wanted zero growth, by Greenspan's own admission, he went too far. Now he has begun slashing rates in the hope that the stock market will rally and business and consumer confidence will rise.

Looking back over these three years of seesawing rates, the image that emerges of Alan Greenspan is quite different from the popular perception. Far from a supernaturally calm driver running a steady course, Greenspan has veered from guardrail to guardrail, reacting to one crisis only to produce another.

Would Long Term Capital's failure in 1998 have caused a global depression? Who knows? The hedge fund's total bets were more than $1 trillion. (And it continued to lose money after the Federal Reserve's actions.) But the Nasdaq lost $1.6 trillion in two weeks in April 2000, with little spillover. In the last year it has wiped out more than $2.8 trillion in wealth with few cascading dominoes. American markets (though not foreign ones) are large and can absorb big losses. And perhaps wild swings are part of the new age of unfettered global capitalism.

The greater problem is, of course, that this critique makes sense only in retrospect. It is impossible to fault Greenspan for his choices at the time--he made brave and intelligent decisions in a brutal environment. The atmosphere in 1998 was spooky; the stock market was frothing in 1999. Hindsight is 20-20. But that is why we can learn something from it.

Market volatility is here to stay. And the tension between the Fed's international role and its domestic one will only increase over time as countries around the world--particularly in Latin America--link their currencies to the U.S. dollar. Ask an official in almost any country what action would bolster the global economy today and he will reply, "Swift action by the Fed."

Perhaps that will prove enough. But what we will rediscover in the next few months is that economics is a very human science; full of uncertainty, intuition and psychology. From the purchasing manager of a factory--who must now decide whether we are in a soft slump or a hard landing--to the Federal Reserve chairman, people act on the basis of imperfect information. And they are all subject to human error. Even Alan Greenspan.