Now What, Alan?

• Author: JONES, DAVID M.
• Position: Alan Greenspan

Greenspan's struggle to rescue the economy and keep the peace with a new president.

Few would disagree with the assertion that Federal Reserve Chairman Alan Greenspan had reached the pinnacle of success as he began a fourth four-year term as head of the U.S. central bank in June of last year. Indeed, until quite recently, most have found it difficult to do anything but heap praise on Greenspan and his fellow Fed policymakers for presiding over a record-long economic expansion, in which real GDP growth was unexpectedly strong, inflation was uncharacteristically subdued, business investment and productivity were surprisingly high, and most impressively, the unemployment rate plunged to a three-decade low.

Suspecting correctly that a permanent surge in productivity growth, arising from a business high-tech investment boom, had lifted the non-inflationary "speed limit" for real GDP growth, Greenspan was more tolerant of rapid growth during the 1996-2000 period than many thought prudent at that time. To be sure, Greenspan tightened the Fed's policy stance in 1999 sufficiently to absorb the extra liquidity provided in 1998 to cope with the global financial contagion. Nevertheless, the Fed Chairman did not begin a series of counter-cyclical rate hikes until early 2000, when he perceived that a wealth-induced surge in aggregate demand growth exceeded growth in potential supply, thereby exerting increased strain on an already fight labor market and threatening an escalation in wages and prices. In all, the Fed hiked rates three times in 1999 and three times in 2000, with the last rate hike in May 2000 amounting to fifty basis points, double the normal size.

In recent months, however, critics have been howling that this earlier Fed tightening was excessive and that Greenspan missed the boat in failing to foresee a particularly sharp plunge in economic growth in the final two months of last year. This rapid loss of momentum reflected the combined effects of declining stock prices, which operated through an attenuated wealth effect to curtail consumer spending, and rising energy prices, which acted like a tax increase on debt-heavy consumers.

Why did the usually prescient Fed fail to foresee that the economy would hit a wall in the final two months of 2000? The simple answer is that Fed officials were too complacent last fall; they were convinced that they could achieve an often-elusive "soft landing" Also, there is every reason to believe that the last thing Greenspan wanted to do, following the bursting of the NASDAQ bubble in early 2000, was to be accused of trying to lend a helping hand to battered stock market participants. In the fall of 1998, stock traders and investors cheered when the Fed eased to fight the global financial crisis; this Fed-induced dose of financial bullishness helped propel the NASDAQ to bubble-like highs. From the Fed Chairman's point of view, a post-bubble rescue mission by the Fed would pose the ultimate...