You do not have to be a Nobel laureate to be an outstanding chairman of the Federal Reserve. The essential qualifications for the job—in ascending order of importance—are a grounding in monetary economics, an understanding of the limits of the Fed's power over the economy, steady nerves in a crisis, and the guts to do the right thing when the situation demands it.
The last chairman to score four out of four was Paul Volcker, who ran the Fed from 1979 until Alan Greenspan took over in 1987. Volcker was a competent economist but no great scholar. He understood that control of monetary policy gave the Fed sway over demand and hence inflation, but (except in the short term) over not much else. Whenever the Fed has believed that monetary policy cannot support demand—cannot do even that—the result has been bad. The Great Depression is a case in point. When the Fed has believed that monetary policy can not only support demand but also insulate the economy from lasting supply disturbances, the result has also been bad—as in the surging inflation of the 1970s, following the oil price shocks of that decade. Monetary policy can do one big thing, but not everything. And Volcker understood that.
He was cool under fire as well. He needed to be. In 1980, with inflation at well over 10 percent, he pushed interest rates way up (the Fed's funds rate touched 20 percent in 1981). It was enough to cause a bad recession, but it brought prices back under control. The significance of that bold stroke would be difficult to exaggerate. Bitterly criticized at the time, it established the Fed's inflation-fighting credibility in the modern era. Running the Fed became much easier for Greenspan as a result. Volcker's immediate successor was careful not to squander that hard-earned reputation. But it was a much, much harder thing to build it in the first place.
Greenspan, although not an academic, was a well-regarded applied economist —more so than Volcker. Fortunately for the economy, that did not delude him into thinking that the Fed was more powerful than it is. Its role, in his view, was to provide a stable background of low inflation against which the economy could grow—that, and no more. Except in the short term, monetary policy could not determine how quickly output would grow.
Again like Volcker, Greenspan was steady in a crisis. After the Wall Street crash of 1987, after the Asian debt crisis of 1997-98, and after the collapse of Long-Term Capital Management in 1998, he radiated calm and soothed the markets.
But Greenspan never had to do what Volcker did—namely, put the economy in recession to squeeze out inflation. You could say that was to his credit, because he never let inflation get out of hand in the first place. (Neither did Volcker: He inherited his inflation problem.) The fact remains, Greenspan's resolve to do what Volcker had to was never tested.
How is Ben Bernanke, nominated by President Bush to replace the retiring Greenspan, likely to measure up? Bernanke's academic credentials are far better than those of either of his predecessors: He's a former head of the Princeton economics department and a widely cited authority on monetary economics. In practice, if Volcker and Greenspan are any guide, that background may be not especially valuable. But it need not be much of a drawback, either. Bernanke's expertise does not seem to incline him to hubris, so far as the Fed's powers are concerned—just the opposite. Whether he will stay cool in a crisis, and whether he would be willing to become deeply unpopular if circumstances demanded it, we may be unfortunate enough to find out.
One difference between Bernanke and Greenspan that many on Wall Street are emphasizing, perhaps for lack of anything else to say, is that the nominee favors an approach to monetary policy based on formal inflation targets. Greenspan was not so keen on this idea. He preferred the greater flexibility that comes with the present, much vaguer, standard of accountability.
But what does this difference really amount to? Not much, in practice. Central banks in many other countries, including the Bank of England and the European Central Bank, have been given formal inflation targets. Their task, explicitly laid down, is usually to maintain the inflation rate within a band—in Britain's case, between 1 and 3 percent. If they fail, they have to explain why. One advantage of this for countries which, unlike the United States, lack a tradition of central-bank independence, is that it tells the public what to expect (and what not to expect) of monetary policy. This eases the political burden that the central bank has to carry, and makes it easier for the bank to explain its actions. On the other hand, it makes the questions asked of the central bank more intelligent, and it forces the bank to communicate more informatively. If you prefer to operate in the dark, that is inconvenient.
For Bernanke, that seems to be the key point. He favors the greatest degree of openness in framing and explaining policy, because he thinks that will help to anchor the public's expectations—and the more confidently people expect inflation to remain low, the easier it will be for the Fed to deliver low inflation. Greenspan, mind you, at least in comparison with Volcker and earlier Fed chairmen, also liked openness: He began publishing minutes of the Fed's policy-making committee earlier than before, for instance. But sometimes this devotee of tortured prose seemed to use vagueness as an instrument of policy. A formal inflation-target regime would frown on that. But keep this in perspective: Judging by the way the Fed set interest rates, and by outcomes, Greenspan was an inflation-targeter in all but name.
In two other, more telling, respects, Bernanke and Greenspan again seem very alike. The first concerns productivity. As the Fed watches fluctuations in the economy, it has to judge how far output (growing over time) lies below the economy's overall capacity (also growing over time). The smaller that gap, the greater the inflationary pressure. At the moment, the long-term growth rate of capacity is difficult to judge. The late 1990s saw a dramatic increase in productivity growth—that is, in the rate at which capacity was growing. Some economists saw this as the dawn of a new era; others were more skeptical.
Looking ahead, a productivity optimist will be slower to get alarmed about inflationary pressures than a productivity pessimist. Greenspan was very much an optimist. The surge in productivity growth and its implications for the economy were the theme of many recent speeches. And Bernanke seems to agree. In a speech at the start of this year, while emphasizing the range of uncertainty around specific estimates, he said, "The productivity optimists have a good case." He believes that the recent improvement in productivity growth is not going to fizzle out soon, and that "continued growth in productivity in the range of, say, 2 to 2.5 percent a year probably represents a good baseline assumption." That view, for as long as the facts appear to support it, will help to keep interest rates down.
The other issue on which Bernanke seems to agree with Greenspan is asset-price inflation—as opposed to inflation in the prices of the ordinary goods and services that make up the consumer price index. Some economists argue that central banks should regard asset-price inflation (soaring house prices or stock markets, for instance) as a sign of excess demand and a precursor of broader CPI inflation, and should raise interest rates to choke it off. Greenspan never bought that theory. Bernanke seems reluctant to buy it, too.
In a recent speech, he explained that, in his view, external developments—and especially a glut of foreign savings (relative to diminished investment opportunities) in many developing countries—had driven up American asset prices. The resulting inflow of capital boosted investment and raised stock prices in the United States in the late 1990s; more recently, it has pushed down long-term interest rates and thus boosted house prices.
These are natural forces: No cause for alarm, seems to be Bernanke's view. Over the next few years, capital flows and asset prices will have to move back to more normal levels, he believes, but fundamentally, he sees "no reason why the whole process should not proceed smoothly." Again, nothing here leads one to expect that Bernanke will be an interest-rate hawk before he has to be.
Views like these served Greenspan pretty well. Most central-bank chairmen would be thrilled to settle for his track record. But it will be several years yet before the history of the Greenspan years can be closed. You could say, his luck lasted. If it deserts the economy—if the "whole process" does not, after all, proceed smoothly—then Bernanke may well be tested the way Volcker was.