Fast and loose

Over at Felix Salmon's place, guest-blogger Yves Smith chastises Alan Greenspan:

Remember, a central banker actually has very few policy tools, and monetary policy is a blunt instrument. Moral suasion is one of their powerful but often not effectively used instruments. Greenspan, unfortunately, was an enabler, fond of impenetrable statements that left everyone perplexed but not worried since in the end he'd open the money tap in times of trouble. It was a hollowing out of the role of the central banker who, as William McChesney Martin famously remarked, was supposed to take the punch bowl away just when the party was getting good. Greenspan didn't merely help create widespread asset inflation via overly aggressive rate cuts in 1998 and 2002, but also set a tone that makes it hard for his successor Bernanke to deliver tough messages.

If there were ever any doubts about Greenspan's willingness to rock the boat, they were dispelled, irrevocably, on December 6, 1996. Greenspan, the evening before, had used the now famous phrase, "irrational exuberance," as a question rather than a statement about a recent runup in the equity markets. The Nikkei fell 3% overnight. European markets traded down 2-3%. The Dow dropped 145 points before rallying late in the day.

And Greenspan took the trouble to clarify his remarks and retreat from any implication that stocks were too high.

Now readers might think this confirms Greenspan's power, but actually it shows the reverse. The stock markets are not the Fed's job. And worse, a Fed chairman should not try to talk the markets up. This revealed how Greenspan was hostage to the markets, and that attitude may have taken root at the Fed.

I'm not sure I'd cite William McChesney Martin as an example of a fellow who took the punchbowl away when the party got going; during the last five years of his twenty-year fed term, he allowed inflation to spike from 1.6% in 1965 to 5.7% in 1970, rather higher than is thought fitting by today's central bankers.

I think it's justified to fault Mr Greenspan for concern with the stock market . . . only most of the people mad that he worried about falling prices were also mad that he didn't pop the stock bubble by raising rates. As a friend reports, he once saw Greenspan heckled by one Punchbowl Paul, who demanded to know why he hadn't done something about the speculative bubble.

Greenspan blinked, then said "If you're asking whether we know how to use the tools of the central bank to deflate a stock market bubble, the answer is yes." He then stood silently while the various financial types in the room pondered just how high he would have had to raise rates, and margin requirements, in order to pop that particular bubble, and the fairly hideous economic effects that would have resulted from such an action.

But I don't think that the world would have been a happier place if Greenspan had kept the lid on the punchbowl in 1998 and 2002. We haven't had a really bad, deep recession in 26 years, and it seems reasonable to think that the Fed's willingness to control inflation, while releasing liquidity as necessary, are very much responsible for that change. Had Greenspan not opened the taps when times got tough and markets were unhappy, we might well have had some really nasty fallout.

The problem really is that central bankers, like most government institutions, are equipped to fight the last war. Alan Greenspan (and now Ben Bernanke) had excellent tools to deal with price inflation and liquidity problems. But our central bankers don't have much on tap to deal with asset price inflation, i.e. speculative bubbles. Nor do they have any way to keep a flood of capital from flowing into our markets and lifting all boats, so to speak . . . nor from flowing back out and leaving us to deal with the mess. In the latter case, I don't think that they should have those tools. But that means they can't protect us from all bad financial events.