One for the Money

In December 2015, America’s central bank, the Federal Reserve, raised its target interest rate by one-quarter of 1 percent. This was the first such action in exactly seven years, when the Fed cut rates all the way to zero in the depths of the Great Recession. It was a move that came despite the fact that the Fed’s preferred measure of inflation was six-tenths of a point below its 2 percent target, which it had not met since the spring of 2012 and was trending down, suggesting that there was room for employment to grow before inflation threatened.

The Fed committee looked past all that, projecting that there would be four similar rate increases during 2016, as the economy gained more strength. That projection turned out to be highly premature. Employment and inflation surveys repeatedly came in weak enough that the Fed was forced to delay rate hikes. At the time of writing, there has not been one yet in 2016.

For Fed watchers, this is an entirely unsurprising state of affairs. For every one of those seven years, as America suffered its worst bout of mass unemployment since the 1930s, the Fed has been consumed with worry over future inflation, and very obviously itching for some excuse to halt unconventional stimulus and raise interest rates above zero. Replacing Republican Ben Bernanke as Fed chair with Democrat Janet Yellen did precisely nothing to address this tendency.

Why? One place to look is The Man Who Knew: The Life and Times of Alan Greenspan, a new biography by the former Economist reporter and author Sebastian Mallaby. Greenspan, who was Fed chair from 1987 to 2006, was more responsible than any other single person for transforming that institution and its broader political culture into the form we know today: one obsessed with inflation, unconcerned with economic inequality, ranking price stability far above full employment, and always ready to backstop a bloated and disaster-prone financial sector.

Mallaby’s book is compelling reading. Against my better judgment, I found myself rather sympathizing with Greenspan, while still noting his immensely negative influence—but not for the reasons Mallaby gives. When it comes to assessing Greenspan’s legacy, Mallaby gets both his worst flaws and his best qualities wrong.

But first, the good stuff. Mallaby deftly leads the reader through Greenspan’s life, from Ayn Rand cultist to consultant to D.C. power player to world’s greatest economic policymaker. The skill with which the portrait is painted, and the tremendous amount of research that clearly went into the work, are the best parts of the book.

Greenspan was an ambitious but shy data-obsessed nerd who stumbled into extreme political skill. For a relative newcomer to the Greenspan legendarium, this was the most surprising and interesting part of the book. It turns out that a deep facility with statistics, a reticent demeanor, and a nose for power relationships can be parlayed into a serious political career. Whether it was helping Richard Nixon intimidate Fed chair Arthur Burns into keeping rates low before the 1972 election, besting Henry Kissinger in a straight bureaucratic knife fight while appearing not to do so, or stacking the Federal Reserve Board of Governors with his favored cronies, Greenspan was one of the most fearsome political operatives in Washington in his day.

Also surprising were Greenspan’s economic beliefs. He never bought any of the neoclassical theories coming out of the University of Chicago, dismissing “rational choice theory” and other such ideas that cast government regulation as always prone to backfiring. While he was in general agreement with those notions, his own economic perspective was much more ad hoc—fundamentally premised on the idea that relationships between economic variables were constantly changing and therefore not very amenable to modeling.

Instead of constructing complex models, he loved to dig into any sort of obscure data set he could find, to see what relationships might pop up. As a result, he was among the first to spot the increasing rate of personal indebtedness that began in the 1970s, particularly for home loans, understanding early on that recovery from recessions would be harder, as people struggled to spend while under a load of debt.

That data-focused, theory-skeptical approach was partially vindicated by the financial crisis, as many heavy-duty theoreticians failed to see it coming—or, indeed, loudly predicted that it could never happen. However, it also illustrates a blind spot of both Greenspan and Mallaby. Throughout the book, to his credit, Mallaby is concerned with detailed descriptions of how monetary policy works. But, like Greenspan, he does not investigate one major reason why personal indebtedness began to grow in the mid-1970s: inequality. That is the point at which productivity increases were infamously decoupled from wages, and inequality began to grow in earnest. But because, as Franklin D. Roosevelt’s Fed chair Marriner Eccles once wrote, “mass production has to be accompanied by mass consumption,” the middle class needed a new source of purchasing power to be able to partake in new production. They did that by borrowing more and more, until the 2008 crisis.

This is not a minor point. Inequality was central to Fed policy during the so-called “Great Moderation,” over most of which Greenspan presided as chair. With the marginal purchase made with borrowed money, the Fed’s interest rate tool was much more immediately effective; there was no more need to induce recessions to stop inflation. Yet this came at the expense of a massive debt buildup that eventually led to disaster.

Instead, Mallaby’s major criticism of Greenspan is that he was too hesitant to use interest rates to prevent bubbles from forming. In the late 1990s, and again in the mid-2000s, Greenspan kept rates low because inflation was low and stable and employment was trucking along.

The argument here is that because financial crises can cause such lasting damage, the Fed should use its monetary policy to maintain a stable financial sector, at the cost of reduced employment and output—taking a mild hit now to avoid a bigger one later. The wisdom of this argument is core to any assessment of Greenspan’s legacy, so it deserves close consideration.

As an initial matter, it is far from clear that higher interest rates would actually reduce financial instability at all. A paper from the International Monetary Fund from a couple of years ago examined the probable effects of raising interest rates on financial stability, and outlined two possible positive effects and three negative ones. The net effect would depend on the relative size of each option, and it’s not obvious what the result would be.

Indeed, during an expanding financial bubble, higher interest rates might even harm the economy as a whole while failing to prick the bubble. As John Kenneth Galbraith wrote about the pre–Great Depression bubble, “higher interest rates would have been distressing to everyone but the speculator,” because returns on the stock market were so spectacular that a somewhat higher cost of funds would barely even have been noticed. The several rate raises in 1999–2000 had little if any effect on the stock bubble at the time.

Still, during the housing bubble, mortgage rates were generally pegged to the Fed’s interest rate, so it’s at least possible that raising rates might have choked off the boom before it got too big. Let’s grant that for the sake of argument.

We must be very clear about what this means: deliberately creating a mini recession because Wall Street is doing its supposed job (allocating capital to its most productive use), like a cracked-out baboon. It may mean permanently lowering growth and eschewing full employment if bubbles are a frequent occurrence, as they have been in the last few decades. The housing bubble, for example, began to inflate only a couple of years after the dot-com collapse.

This is a crappy way to run a country. A capitalist system is prone to serious crisis, as we learned in 1929 and again in 2008. Hence, the number one task of economic policy is to prevent depressions and mass unemployment. Without that, there could be enormous upheaval. But the New Deal, World War II, and, to a lesser extent, the Obama presidency proved that the upheaval can be minimized. Government spending can restore full employment, thus undoing the damage of a recession, and stringent regulation can restrain the size and riskiness of the financial sector, thus keeping it from blowing up the economy. High taxation, full employment, and redistributive policy can reduce inequality, which keeps income circulating widely and thus preserves the strength of monetary policy tools.

To abandon all that in favor of using the central bank to deflate bubbles is to submit to atrocious economic performance for the foreseeable future. As John Maynard Keynes wrote in 1936,

The right remedy for the trade cycle is not to be found in abolishing booms and thus keeping us permanently in a semi-slump; but in abolishing slumps and thus keeping us permanently in a quasi-boom. . . . [A]n increase in the rate of interest, as a remedy for the state of affairs arising out of a prolonged period of abnormally heavy new investment, belongs to the species of remedy which cures the disease by killing the patient.

Mallaby, by contrast, casually dismisses the possibility of restraining Wall Street with regulation. Regulators failed before the 2008 crisis “and will likely fail in future,” he writes. What about the thirty-year period following World War II, when there were no financial crises? That is not discussed, and neither is the Dodd-Frank financial reform legislation. Mallaby also implicitly dismisses the value of government spending as economic stimulus, writing that “no amount of cleanup work could prevent a prolonged downturn” after the 2008 crisis. This is at odds with the opinion of most economists, who believe that a much bigger stimulus would have quickly restored full employment. But Mallaby doesn’t discuss Obama’s Recovery Act at all.

The basic reason the United States economy is sick is that it has slowly abandoned all the hard-won lessons from the New Deal era. Alan Greenspan is more responsible than anyone else for this act of forgetting. For his entire massively influential career, he helped to secure lower taxes on the rich, to cut social programs, and, especially, to deregulate finance. He ran the Fed with little concern for issues of distribution, effectively enabling the growth of inequality by viewing any wage increases as a harbinger of inflation. For a child of the Great Depression, this was a fantastic effort of willful ignorance.

In the beginning his ideology had the brittle idiot mania of the Ayn Rand fan he was in his younger life (and Mallaby’s portrayal of these days is quite good). As he got older, it evolved into the weird inverted communism of the later George W. Bush years, where government handouts were generally frowned upon except when Wall Street firms landed themselves into trouble, in which case they got huge government cash infusions and nearly endless cheap loans.

Mallaby cites the fact that this became the hegemonic view in both parties as evidence that Greenspan was “scarcely ideological” in his later years. On the contrary, it shows that his very strong ideology gained widespread acceptance—so much so that even long after he is gone, it is still a major obstacle preventing sensible monetary policy.

All this inverts Mallaby’s portrayal of Greenspan’s decision in the late 1990s and the 2000s to let economic growth ride instead of attacking stock bubbles with interest rates. The former choice, in particular, was remarkable. He made the decision after a prolonged investigation into data minutiae, developing a hunch that productivity growth wasn’t showing up properly in the traditional statistics—a view not shared by most of the rest of the economics profession, including current Fed Chair Janet Yellen, who was on the Fed board at the time.

Given that attacking the stock bubble with higher interest rates might not have slowed the bubble in the slightest, and that the late 1990s were the one period when the relentless march of inequality temporarily reversed itself, that decision was in reality Greenspan’s finest hour. It could not have happened without his unusual intellectual skills and independent mind, and the result was the only period of sustained full employment from 1980 through the present day.

A final point: Mallaby does not address  potential defects in the Fed, Greenspan’s signature institution. At this point, most Fed watchers have lost hope that the institution will be able to cast off the Greenspan legacy and begin to take full employment as seriously as it takes inflation and the stability of Wall Street. Yet there may be hope in changes to the Fed structure. Many writers, including myself (see “Free Money for Everyone,” Washington Monthly, March/April 2014), have advocated that it be granted the ability to deposit newly created money directly into the bank accounts of citizens, on a per capita basis.

Since the 2008 crisis, during its several halfhearted efforts at unconventional stimulus, the Fed nearly quintupled the American monetary base (from $860 billion to $4.1 trillion) in an attempt to get spending and employment up and moving again. If even a small fraction of that money had been placed directly in American pockets (sometimes called “helicopter drops”), the damage of the Great Recession would have been healed years ago. More importantly, the danger of the zero lower bound would be permanently abolished.

Despite the recent good economic news, there is little chance in the near future of reversing the huge increase in inequality or seriously shrinking the bloated financial sector ushered in by Greenspan and his political allies. But a helicoptering Fed could at least keep the economy pressurized and growing. For future economic policymakers, it’s an idea worth considering.