Once lauded in congressional love-fests and accorded rock-star-like status by legions of stock market investors, Federal Reserve Chief Alan Greenspan is increasingly being attacked by critics.1 A previous generation of promoters blamed Greenspan for raising interest rates in 2000 and causing the bear market.2
A new set of critics now claims that Greenspan failed to take sufficient action to pop the emerging stock market bubble before it got out of hand. His famous “irrational exuberance” speech in 1996, and recently released FOMC minutes from the same year, indicate that Greenspan, in spite of his public agnosticism about asset valuations,3 was aware of a bubble several years before it peaked.4
Greenspan himself recently weighed in on the matter, claiming that there was no way for the Fed to have deflated the stock market bubble without risking an unnecessary recession, and, moreover, that they weren’t even really sure that there was a bubble until after it burst.5
The current debate over Greenspan’s alleged policy failures misses the crucial question: Could anyone, no matter how capable and well-informed, successfully perform the job that he is supposed to do? Were his alleged errors sins of incompetence? Could a better man than Greenspan have done a better job?
The issue is whether there is any economic rationality in the way that a central banker sets interest rates at a particular level. Mainstream economic doctrine holds that central bankers are necessary in order to prevent the economy from lapsing into recession or overheating into inflation. Can a central banker also save the economy from a stock market bubble? Greenspan is certainly right to ask how he should identify when a bubble is present.
Greenspan is a central banker. The term “central banker” was adopted to deliberately obfuscate the nature of the job, because it sounds better than “price controller.” A central bank can select from an array of economic interventions collectively known as monetary policy. The Fed can raise or lower key interest rates for interbank borrowing and for commercial bank borrowing from the Fed. The Fed can also engage in “open market operations”--the purchase and sale of debt securities from the U.S. Treasury, or in securities markets (and maybe other securities in other markets, as well as some ominous news leaks portend).6 The Fed can also raise or lower margin requirements for the purchase of stocks, thereby controlling the amount of leverage that equity investors can use.
These interventions are aimed at setting (generally increasing) the quantity of money and the terms of credit transactions in the economy. Contrary to mainstream economic doctrine, the Austrian School maintains that the process of central banking is what produced the stock market bubble.7
During the euphoric peak of the bubble, Greenspan’s supporters attributed a god-like omniscience to the Messiah of Monetary Policy. But surprisingly, his detractors don’t question the need for a central banker to possess the mind of God, as some of the imagery used in the debate will show.
A laudatory book acclaimed him as Maestro,8 an honorific term for the conductor of an orchestra. A conductor’s job is to envision in detail the performance of a work of music, then to coach and train the orchestra to bring this realization about. The conductor uses his powers of insight, analysis, persuasion, communication, and baton technique to communicate his views about the work and coordinate the actions of the players. When the performance takes place, the maestro coordinates the actions of dozens of players via hand motions and his baton to produce a technically correct and artistically satisfying performance.
Maestro Greenspan is depicted as a talented central economic planner, one who can conceptualize the output of the economy, then coordinate the activities of millions of economic actors to keep the economy functioning at peak levels. In his role as a coach, he can “talk the economy up” and “talk the economy down” as needed. The Maestro must determine the correct rates of interest, the optimal quantity of money. He must fight inflation and keep the economy out of a recession, and be on guard for asset price bubbles.
Another metaphor is provided by Morgan Stanley’s bearish strategist Stephen Roach, who has been nearly alone among Wall Street analysts in calling attention to the negative consequences of the bubble. Roach argues that the Fed could have “surgically” popped the bubble by raising margin requirements on stock brokerage accounts.9
A surgeon is a highly skilled medical doctor who performs complex operations on live patients to remove or repair damaged or infected body tissue without permanent injury to the patient. Surgery requires an incredible degree of manual skill as well as a detailed knowledge of anatomy, physiology, and pathology. Surgeons must make a diagnosis of the problem, and then take into account the balance between the risk of the operation itself and the risk of allowing their medical problem to deteriorate.10 They operate on the patient, maintaining a life-support system while cutting into body tissue.
Greenspan, as the Master Surgeon of the Economy, must use his diagnostic skills to identify inflation, deflation, or asset price bubbles before the economy suffers a terminal illness. He must then burst them with such skill that they pop harmlessly before they damage the economy. In the same manner that a surgeon must balance the risk of the further spread of disease should he not operate, Greenspan must delicately balance the social costs of an unskillfully burst bubble against those of an increased risk of an unnecessary recession should he raise interest rates too quickly.
The problem with the metaphors discussed above is that they wrongly conceptualize the problem Greenspan faces. The job description that Greenspan's critics have blasted him for failing to perform is impossible.
In a market economy, there will be exchanges between those who wish to consume in the present and those who are willing to forego present consumption for future consumption. When exchanges of present for future occur in a money economy, the ratio between present and future quantities is called the rate of interest. The interest rate is a price that balances the supply and demand for the exchange of future goods for present goods.
One of the most important reasons for borrowing in an economy with division of labor and a supply of accumulated capital is to fund the creation of capital goods. The rate of interest is very important in this process because it organizes the entire capital structure of the economy.
In searching for profit opportunities, investors must perform economic calculation. This is a prospective estimation of profit and loss based on anticipated prices that will be paid and received by a business venture. At any given time in a complex economy, many production possibilities are technologically feasible. Entrepreneurs allocating capital are essentially looking for the most profitable opportunities, a task that requires economically meaningful prices.
The interest rate is a very important price in economic calculation because it is a means by which present and future uses of resources can be balanced against each other. In addition to anticipated prices of inputs and outputs, the investor must balance present and future uses of investment funds against one another. This calculation requires an estimation of the price of borrowing, or cost of funds, over the life of an investment project.
One of Mises's many important contributions to economic thought was to show that production decisions must be made by private property owners putting their own savings at risk, using market prices if there is to be any economic rationality to the way that prices are formed and production is organized.11 If not, production will result in losses that consume the accumulated store of capital rather than profits, which add to it.
This is true because in the market economy, prices are formed by the judgment of many entrepreneurs risking their own wealth. These many decision makers cannot be replaced by a single central planner. Market prices are determined by the buyer who anticipates the greatest economic value for a given resource and the seller who has the least use for it. Decentralized decision making by multiple owners of assets is necessary to discover profit opportunities within the economy.12
A central planner would have control over the production plan of the economy but not ownership. Without putting their own funds at risk of loss, there is no incentive for the central planner to seek out profit opportunities, so the resulting prices (if there are any) will not reflect the best known use of each form of capital. There is no economically rational way for a central planner to set the correct price of anything.
For a central planner to arrive at the correct price would require him to have the ability to foresee the outcome of a market process involving millions of individual actors. Without the ability to see into the future, there is no way for the central planner to substitute his own judgment for the results produced by the market. The recent demise of the Soviet planned economy has since converted many skeptics to the truth of Mises's argument.13
We can apply Mises's critique of central planning to the credit markets. Mises would argue that the rate of interest in credit markets should be determined by savers who supply funds and borrowers who demand them.
The metaphors used to describe Greenspan--even by his critics--embody the assumption of omniscience. There is no basis to believe that Alan Greenspan or anyone else knows what the right rate of interest is at any time, or has any means at his disposal to figure it out, any more than a price controller could set the right price for shoes, cars, or trombones.
By setting interest rates at a fixed level between FOMC meetings (surprise inter-meeting rate cuts aside), the Fed must be willing to supply any amount of fiat money that borrowers want to borrow at its fixed rate. The interest rate is not allowed to rise to reflect the increase in borrowing.
Ultimately, consumption is limited by production, and economic growth is limited by available savings. If entrepreneurs borrow more to invest in production processes without increasing savings, interest rates will naturally rise until it is no longer profitable for business investors to increase their borrowing. There is no need for a controlled price, nor is there any way for the price controller to arrive at the natural balance between loaning and borrowing that would occur by activity of savers and borrowers in credit markets.14
"Monetary policy" must be seen for what it is: a destructive form of central planning that distorts resource allocation and makes it more difficult for individuals to plan. The demise of Al.com is entirely just.
- 1See for example "Fed Chief Now Blamed for Inflating Stock Bubble," Los Angeles Times, Peter Gosselin, July 21 2002, p A.1.; "Give Greenspan’s Fed Its Share of the Blame," William Greider, The Washington Post, August 13, 2002; "The Case Against Alan Greenspan," Mark Gongloff, CNN/Money.
- 2See for example: Paul Sperry, Greenspan derailed the New Economy: Fed chief makes up for missteps costing high-tech jobs, trillions, who states, “But data show that he is merely trying to return the punch bowl to a party he ended--for no good reason,” and goes on to blame Greenspan for killing the economic expansion.
- 3Exemplified by his statement "To anticipate a bubble about to burst requires the forecast of a plunge in the prices of assets previously set by the judgments of millions of investors, many of whom are highly knowledgeable about the prospects for the specific investments that make up our broad price indexes of stocks and other assets."
- 4FOMC Transcript.
- 5"Greenspan Says Fed Could Not Prevent Market Bubble"
- 6"Fed Considered Emergency Measures to Save Economy," The Financial Times, March 24, 2002. This article states, “The official, who asked not to be named, would not elaborate but mentioned ‘buying US equities’ as an example of such possible measures, and later said the Fed ‘could theoretically buy anything to pump money into the system’, including ‘state and local debt, real estate and gold mines - any asset’.”
- 7The Stock Market, Profits, and Credit Expansion, George Reisman.
- 8Maestro: Greenspan’s Fed and the American Boom, Bob Woodward, Simon and Schuster, 2000.
- 9"Global: Smoking Gun," Stephen Roach.
- 10Roach’s suggestion to “surgically” pop the bubble in the stock market suggests that stock prices can be separated from the rest of the economy. But this is not so. Stocks are a proxy for the price of capital goods. As the price of stocks rise, more investment is drawn into sectors experiencing the greatest growth. The physical capital structure and business organization of the economy is changed. This is why bubbles do so much damage, and why their unwinding is so painful.
- 11"Economic Calculation in the Socialist Commonwealth," Ludwig von Mises.
- 12Man, Economy, and State, Murray N. Rothbard, Ludwig von Mises Institute, 1993. pp. 333-356 and 360-364.
- 13Heilbroner, for example.
- 14Assuming a sound monetary system without fractional reserve banking.
