“The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed, the world is ruled by little else.” — John Maynard Keynes.

Bob Woodward set for himself a rather difficult task. In his book, Maestro, he attempts to paint a heroic portrait of a purposefully ambiguous Federal Reserve Board Chairman Alan Greenspan. Although Woodward does a competent job of explaining some of the more Byzantine aspects of the operations of the Federal Reserve, his effort falls too often into hagiography. Even if one accepts the portrayal of Greenspan as a maestro beautifully and skillfully conducting the orchestra of the economy, one has to be concerned about any system so critically dependent upon having a rare expert.

The primary obligation of the Federal Reserve Board seems straight forward enough: Increase the money supply at the same rate that wealth is created in the economy. Create too much money and too many dollars will chase too few goods and inflation results. Inflation adds noise to economic transactions and calculations making the economy less efficient. In the long run, inflation suppresses real economic growth. Miscalculate on the other side and the country experiences deflation and possible recession.

Unfortunately, measuring the money supply is problematic. With various monetary instruments from currency, to bank deposits, to deposits in mutual funds, defining and quantifying the monetary supply has become more and more difficult.

The Federal Reserve Board also relies on indirect measures to divine the present and future states of the economy. If prices start to increase, or growth appears to be unsustainably fast, or unemployment becomes low enough to increase rapidly wage rates, then the Board may indirectly infer that the money supply has grown too large and raise interest rates. The entire effort is complicated by the fact that the actions to increase or decrease the money supply can take months to affect the economy. Therefore, the Federal Reserve Board must attempt to anticipate the future and act proactively.

Greenspan has been the Federal Reserve Chairman since 1987. He was appointed by President Ronald Reagan to replace Paul Volcker. Volcker was not a very popular character. He had the unenviable task of driving interest rates to 19% in a painful but successful effort to wring double-digit inflation and inflationary expectations from the economy.

Perhaps Greenspan’s initial luck was not that much better than Volcker’s. His tenure began just before the stock market experienced a precipitous 20% drop in 1987. Greenspan wanted to comfort the markets without loosing monetary discipline. Greenspan responded with the vague but reassuring statement, that the Federal Reserve was prepared to insure that there was no liquidity shortage in the economy. The country survived this 1987 stock market drop and in a few short years, the market exploded upward much further than in it had been in October 1987.

The only recession during Greenspan’s tenure, thus far, occurred after the energy price increases during the Gulf War. The Bush Administration, pled, begged, and even tried to berate the Federal Reserve into loosening the money supply. To this day, George Bush (41) believes that Greenspan cost him the 1992 election.

As Woodward points out, the first Bush Administration made two important strategic errors. The first was to publicly pressure the Federal Reserve to ease interest rates. Always sensitive to maintaining not only the independence but also the appearance of independence of the Board, Greenspan was less inclined to reduce rates when he might appear to be doing so in response to political pressure.

Bush’s second mistake was to not take the political initiative in explaining the economic recovery. The economy had been actually recovering from 1991 on. The unemployment rate was still high, but unemployment is a lagging indicator of the economy. Bush appeared detached and was not successful in conveying his concern for those the economy had not yet helped. It was Bush’s political failings more than Greenspan’s monetary policy that caused his defeat to Clinton in 1992.

According to Woodward, Bill Clinton avoided both mistakes. Clinton’s most important political asset was his ability, sincere or not, to invoke the sense that he empathized with those who were suffering. He “felt their pain.” Perhaps most importantly Treasury Secretary Robert Rubin knew Greenspan well and was savvy enough not to lobby publicly Greenspan for specific actions. Greenspan’s policies managed to insure robust economic growth in 1996, the presidential election year, and helped ease Bill Clinton into a second term.

Nonetheless, in the mid-1990s, budget projections clearly showed Federal budget deficits of $200 billion indefinitely in the future. The unemployment rate was a little under 6%, about as far down as it could go, so the conventional wisdom had it, without triggering inflation. The Federal Reserve was prepared to keep the economy from overheating. Such actions would have likely killed the growth of the late 1990s that obliterated the budget deficit and plunged unemployment rates to 4%.

Woodward explains that Greenspan was intrigued with apparent contradictions in the economic numbers. On the one hand, conventional measurements suggested that productivity, output per worker, was growing only slowly. On the other hand, profits were going up, wages were not increasing rapidly and there were no signs of inflation. Greenspan’s conclusion was that computers and communications advances were increasing worker productivity in ways that were not being measured.

Others favored this same hypothesis. It was not novel, but it was controversial. Important economists did not subscribe to the argument that productivity was really increasing. The prominent Liberal economist Paul Krugman of Stanford University ridiculed other economists who suggested that higher growth rates could be sustained by increases in productivity. Krugman believed that, “…the so-called revolutions in management, information technology and globalization are vastly overrated by their acolytes.”

It is an interesting irony that Greenspan, former member of Ayn Rand’s inner circle, was leaning toward looser monetary policy, while Liberal economists were not so sanguine about the rapid growth in the economy.

In any case, Greenspan’s skill and fortune may be running up against an inevitable recession. At present, the economy is struggling at near zero growth rates. This last week, the Federal Reserve decreased interest rates by 0.5%. If the reaction of the stock market is a measure, the reduction is too small and too late to avoid a recession. We shall see in the next year, whether the Maestro will be able to cajole one more virtuoso performance from the economy.

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