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| Commentary |
The World After Greenspan
December 7, 2005
By Axel Leijonhufvud
Professor of Economics, Emeritus, UCLA
(Commentary from December 2005 Forecast Conference)
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Greenspan's Legacy
Unquestionably, a very successful tenure as Fed Chairman. But the media hype about
him has gone too far. Greenspan has been referred to as Athe most powerful man in
the world today.
But consider: The Fed has raised the discount rate 12 or 13 times (I have not kept
count) without significant effect on the markets. This is commonly thought to be the
virtue of Greenspan's gradual approach. But another way to look at it is that
monetary policy had been so loose that the Fed had lost contact with the market. The
levers of monetary policy provide little leverage. How powerful is the Fed today?
Last 5 Years of Greenspan's 17-year Tenure
The world is awash in dollar denominated liquidity B but until recently with no
noticeable inflationary pressure. Monetary stimulus of this magnitude without
inflation is unprecedented, particularly since real interest rates have been below
the economy's rate of growth.
What makes this even more remarkable is the reckless fiscal policy that has ruled at
the same time.
How do we understand it? To what extent has it been of Greenspan's making? Has he
simply been lucky, benefitting from a unique historical conjuncture?
An answer comes in two parts
(1) With the end of the (first?) "Irrational exuberance" five years ago, the problem
was impending domestic deflation. It was to be expected that businesses would to
move to clean up balance sheets and households to increase their savings. With a
passive monetary policy, this increase in liquidity preference would have threatened
a very sizeable recession.
Greenspan's Fed responded with an extreme anti-monetarist policy, essentially letting
the demand for money at extremely low interest rates determine the supply. This was
the right recipe for making the recession mild and short. But the policy was too extreme
B it went too far.
(2) If monetary policy has been overly expansive, why have inflationary pressures taken
so very long to make themselves felt?
The popular answer runs in terms of globalization and competition especially from low
wage countries.
Obviously, this is part of the answer. But inflation is a monetary phenomenon. One has
to look behind this story of foreign competition in manufacturing for the monetary factors.
The main explanation lies in the willingness of Japan, China, South Korea, Taiwan and now
Russia to absorb tremendous, ever increasing amounts of dollar reserves in order to prevent
B or rather postpone B the appreciation of their currencies.
This is not Greenspan's monetary policy but the monetary/exchange rate policies of these
surplus countries that have produced this seemingly favorable conjuncture. In this respect,
President Bush and Chairman Greenspan have been fortunate: Their lax fiscal and monetary
policies have not produced inflation in large part because of the policies of foreign
central banks.
So: Some questions:
Being able to run a highly expansionary monetary policy without causing general inflation
is an quite unusual situation. If you grasp the opportunity, what are the likely consequences?
Answers in brief:
(A) asset price inflation
(B) all-around deterioration of credit standards, and
(C) in the US case, a further decline in personal saving
(D) An aggravation of the US trade balance and an indefinite postponement of the eventual
adjustment. The combination of US and foreign monetary policies have prevented both elasticity
and absorption mechanisms from operating.
Terms of trade need to turn against the US. Can happen either through a decline in the exchange
rate, or foreign inflation or US deflation. All three are stuck.
Rising consumption in China, Japan, etc or falling consumption in the US could do it. But the
relevant foreign countries are not stimulating domestic consumption and we are consuming in
excess of our incomes.
The obvious question: How long can this go on?
The obvious answer: Nobody knows.
But the foreign central banks amassing these dollar holdings are investing in a depreciating
asset. Their prospective capital losses (in terms of their own currencies) are huge.
Presumably, their governments are willing to take these losses to keep their export industries
growing. But these exchange rate policies direct investment into industries that may face very
hard times once the necessary adjustment in the US terms of trade comes about. As one day it must.
Bernanke
Will inflation targeting be an adequate strategy for dealing with the problems that sooner or
later must come home to roost??
One historical example will suggest the limitations of inflation targeting to you. Through the
1980's Japan had virtually no CPI inflation. But it did, of course, have tremendous asset price
inflation. When the stock market and real estate bubbles burst, the Japanese might have wanted
to inflate, but all that monetary policy was able to accomplis for 15 years was to stave off a
serious deflation. The point, of course, is this: The Japanese Central Bank did not have a stated
inflation target in the 1980's. But if it had had one, it would have done nothing different...
Greenspan avoided a deeper recession but at the price of making the fundamental imbalances affecting
the US economy considerably worse (trade balance, undersaving/overconsumption, real estate bubble).
For the disastrous long-term fiscal deficit, the Fed has no responsibility. But on the day when
foreign central banks decide not to increase their dollar positions further, it will drop a very
big problem into the lap of the Fed.
When the Bernanke Fed comes to face a crisis, it will not have available to it Greenspan=s remedy
B of making the US consumer just spend more and save less.
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