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Master of the Boom

January 12, 2001

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[Review of Bob Woodward, Maestro: Greenspan's Fed and the American Boom. New York: Simon and Schuster, 2000, pp. 270. This review originally appeared January 12, 2001.]

Maestro

Economists who learned their monetary theory by reading Mises, Hayek, and Rothbard will find Woodward's Maestro an exercise in frustration. If it's any consolation, so too will economists who anchor their thinking in the equation of exchange, gauge the influence of the Federal Reserve by tracking the various monetary aggregates, and make distinctions between the short run and the long run with the Phillips curve in mind. All this monetarist stuff had fallen by the wayside even before Alan Greenspan assumed the role of Fed chairman in 1987.

Though not explained by Woodward, the phasing out in the early 1980s of Regulation Q, which forbade the payment of interest on checking-account money, destroyed the critical link between monetary theory and policy prescription. To implement a monetary rule (or even to track the discrepancies from money-growth targets), it was essential to know what counts as money.

During the heyday of monetarism, assets arrayed in order of decreasing liquidity exhibited a sharp break point between those that served as the medium of exchange and those that were more properly classified as savings. The most clear-cut monetary aggregate was based on the black-and-white distinction between highly liquid assets on which no interest is paid and slightly less liquid assets which do command an interest payment. For practical reasons in the case of currency and for legal reasons (Regulation Q) in the case of checking-account money, there was no interest yield on these two components of M1, the most closely watched monetary aggregate.

The strong long-run link between M1 and the overall price level was based on the empirically demonstrated constancy of M1's velocity, or frequency of circulation. The ratio of national income to the money supply that was observed historically could be expected to persist into the future. And happily for the monetarists, M2, M3 and the still-broader reckonings of the money supply moved in proportion to M1.

This pattern of movements suggested that money and savings were pretty strict complements and that the propositions of monetarism were robust with respect to the definition of the money supply. The monetarists' rendition of the equation of exchange features the frequency with which money is paid out as income: MV = Py. With velocity (V) constant or nearly so and real income (y) determined by the underlying economic realities, the price level (P) varies in direct proportion with the money supply (M).

But everything went haywire after monetary deregulation. The definition of money lost its crispness, the different monetary aggregates ceased to move together, and the corresponding velocities became erratic. This is the irony of monetarism: implementing its policy recommendations, which were intended to allow the market economy to perform at its laissez-faire best, depended critically on this one little piece of intervention called Regulation Q.

Woodward, of course, is not an economist but a newspaper reporter, and he is writing for a lay audience. He may be forgiven, then, for not mentioning Regulation Q and the velocity of money. He does mention a certain clash between President Bush's budget director and the Fed chairman that can only be understood in terms of the waning relevance of monetarist policy prescription. Richard Darman, whose appointment in 1989 as budget director Greenspan initially supported, soon turned on Greenspan, arguing that the Fed was mismanaging the money supply and, in particular, that the money-growth rate was too low. Greenspan defended his actions, saying that Darman had some sadly out-of-date notions. As Woodward explained, "The Fed couldn't even measure the money supply accurately, let alone control it" (p. 63).

The Darman-Greenspan clash served as one of many examples of the political perversities in the relationship between the administration and the central bank. Woodward explains why the clash made no sense to Greenspan: "Public bashing by the president's top economic advisers would only encourage the opposite of what they wanted, forcing the Fed to assert its independence and delay lowering interest rates" (p. 62). We can only wonder why Darman didn't claim the Fed was too loose.

The money-growth rule had given way to an interest-rate stance. Though not used by Woodward, "stance" is the strongest word that applies here. The equation of exchange was gone, but there was no alternative equation — or principle or notion — to take its place. There was no interest-rate rule. The attention to interest rates in connection with economic growth and with worries about central-bank intervention, however, catches the attention of Austrian-oriented economists.

And Greenspan's defense of his particular interest-rate stance has a certain appeal. "A particular fed funds rate [the one criticized by Darman] had to be seen by markets as the best rate for the economy, not as an artificially low rate influenced by political pressure" (p. 62). Teasingly, terms such as "artificially low interest rate" and "unsustainable growth" are encountered in different contexts and variations throughout the book. The reader could easily wonder, Is Greenspan thinking like an Austrian economist, after all?

It is known, though not reported by Woodward, that Greenspan gave lectures on the time-preference theory of interest and the Austrian theory of the business cycle 30-odd years ago under the auspices of the Nathaniel Branden Institute. Yet the reader looks in vain for any evidence in this book that the Maestro is concerned with the function of the interest rate as an allocator of resources within an intertemporal structure of capital or that the Federal Reserve, by distorting the interest rate, can induce serious economywide misallocations.

Quite to the contrary, there is abundant evidence that he was inclined to assume away all complications concerning capital in order to draw conclusions about the productivity of labor. If he could claim that productivity had increased, he could engineer a lower interest rate, a.k.a. a higher money-growth rate, without worrying about inflation.

Repeatedly, Greenspan indicated that he "believes but cannot prove" that productivity has increased on an economywide basis. His thinking was organized around an accounting identity as it applies on a disaggregated basis to particular industries. Looking for confirmation and support, Greenspan summons Larry Slifman and other Federal Reserve researchers into his office and wrote out the equation: Price = labor costs + nonlabor costs + profits. Woodward reproduces the equation and punctuates it with the response of the researchers: "They agreed" (p. 173).

Well, yes, we can see how they would agree. What the equation says is that per-unit accounting profits are equal to the price minus the per-unit costs and that these costs can be divided into the mutually exclusive and jointly exhaustive categories of labor costs and nonlabor costs. But Greenspan made something of it by assuming that nonlabor costs — which, we should note, include the cost of borrowing — are constant.

This assumption is a particularly un-Austrian or even anti-Austrian one and is an especially peculiar one to be made by a Fed chairman, whose very actions change the cost of borrowing. Granting him his assumption, though, we can easily follow his argument that if profits are rising, which they seemed to be in the industries examined, while neither prices nor wages were rising, which also seemed to be the case, then labor productivity must be rising. It's a mathematical necessity. Woodward produces some numerical calculations to illustrate the point.

Embracing this belief that productivity has increased gets transformed into a declaration that we have now entered a new economy and that the old Phillips curve, which suggests that monetary stimulation will result in short-run growth but long-run inflation, is no longer relevant. Having orchestrated the longest boom in Federal Reserve history, Greenspan seemed convinced — except when self doubt occasionally crept in — that such booms do not necessarily lead to busts. Increasing productivity allows for the simultaneous achievement of low interest rates, low inflation, low unemployment, and sustainable economic growth. This view, it turned out, was very compatible with the view held by Bill Clinton, who was always quick to ridicule the idea that our problems are too much economic growth and too many people working (p. 123).

Economists sometimes lapse into the misunderstanding that increased labor productivity means that workers have somehow become superworkers. But it means no such thing. Rather, workers become more productive when they work with more and better capital. And for some industries, they will get more and better capital if the Fed reduces borrowing costs. We see, then, that the Fed's own cheap-credit policies can give rise to a measurable increase in labor productivity in some industries and to the impression that productivity in general has dramatically risen. Undeniably, there were some productivity gains in the 1990s — just as there were in the 1920s — but the simultaneous productivity gains in several industries is more likely to be indicative of an unsustainable boom than of an end to the era of boom and bust.

At times, however, Greenspan's worries about the sustainability of the boom seem to have a distinct Austrian flavor. Using "bubble" to mean an unsustainable boom, Woodward summarizes Greenspan's thinking:

There is no rational way to determine that you were in a bubble when you were in it. The bubble was perceived only after it burst. (p. 217)

Could he mean by this that, in an environment of central-bank activism, there is no way of knowing what the natural rate of interest is? What would the market-clearing interest rate be if the Fed weren't intervening? And how could we know, except by watching the economy experience boom and then bust, that the Fed's current interest-rate stance is too tight, too loose, or just right? The Austrians can see why Milton Friedman's quip is about right: The Fed's policy lag is about half a business cycle (p. 115).

In 1996 Greenspan had described asset prices as being based on "irrational exuberance," a term that suggests that the stock market was experiencing a bubble. On reflection, he indicated that it took a "certain hubris" for anyone — including the Fed Chairman — to second-guess the broad wisdom of those who had bought the stocks. Here we get some efficient-market theory is his thinking. But, of course, every time the Fed raises or lowers interest rates, it's because Greenspan has mustered that certain hubris to issue the advice that investors should back off or plunge forward.

Greenspan is admired by Woodward and many others for his guiding wisdom — presumably a wisdom in excess of conventional market wisdom. To make the economy perform better than it would on its own, he needs, of course, both economic wisdom and political judgment. After Greenspan exchanged ideas with President-Elect Clinton in Little Rock in what turned out to be a two-and-a-half-hour meeting, he had to decide whether Clinton was a clever chameleon, putting on a show or, rather, a fellow intellectual, being straight and sincere.

In the Maestro's judgment, he was being straight and sincere. This judgment, which Greenspan makes repeatedly throughout the Clinton presidency, cannot help but affect our confidence that he will make the right judgments about whether or not the economy is experiencing a bubble and whether interest rates should be raised or lowered. Woodward reports that Greenspan himself was willing, on occasion, to do things that weren't strictly legal. But he likened them to "a fire truck driving the wrong way down a one-way street to put out a raging fire (p. 204).

The fifteen chapters in Woodward's book are numbered but not named. The reader's best guide to the book's chronology is the sequence of changes in the federal-funds rate. This key interest rate is tracked in a graph that is included among the book's glossy photos. Though Woodward deals with such episodes as the Mexican debt crisis, the near collapse of the Korean economy, and the LTCM (Long Term Capital Management) debacle, the narrative is organized largely around the FOMC meetings during which the federal-funds rate is raised or lowered.

Debate sometimes centers on whether to raise the rate by only a quarter, letting the market know that the Fed hasn't panicked, or to raise it three-quarters, really getting the market's attention. Two months before the 1992 presidential election, the Fed lowered the federal-funds rate to 3 percent, which in light of the ongoing 3 percent inflation, amounted to a zero-percent real rate. Woodward remarks, "In some respects, it was a bold decision to overstimulate the economy" (p. 42). Well, it's certainly a decision that cuts against George Bush's claim that Greenspan didn't do enough for him.

In many cases, as when inflation seemed to threaten, the meetings would end not with a definite decision to raise the rate but instead with an "asymmetric directive with a tilt toward tightening" issued by the committee to the chairman. Undoubtedly, when Greenspan lowered the federal-funds rate by half of a percent on January 3 of this year, he had in his hip pocket "an asymmetric directive with a tilt toward easing."

Despite the exercise in frustration that coping with all these issues entails, Maestro is a fun read, macroeconomically speaking. We learn, for instance, that, on Newt Gingrich's urging, Greenspan called Rush Limbaugh to explain the seriousness of Mexico's debt problems and that Greenspan toured South Central Los Angeles with Maxine Waters to better understand the issues of income distribution.

We learn that Greenspan studied the theory of relativity and regarded his hypothesis that productivity had increased as analogous to Einstein's hypothesis that light would bend (p. 151), that his research staff considered their assignment to measure the change in productivity as "the economist's equivalent of the Manhattan Project" (p. 173), and that if Greenspan had not been reappointed as Fed chairman in 1996, he would have broken precedent and remained on the Board of Governors until his term expired in 2006. The intellectual atmosphere was more important than the particular pecking order.


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