A fitting legacy for America's beloved dictator

The legislation guiding US interest rate policy is flawed. Alan Greenspan should lead a reform effort before he retires.

It is not often that we are reminded that Alan Greenspan is a man and not an institution but this winter has given us one of those reminders.

First, the implacable Federal Reserve chairman forwent a scheduled opportunity to cut interest rates notwithstanding signs of a slowing economy. Then a blizzard of bad news came down on his head and he abruptly cut rates at a time when few expected it. Mr Greenspan clearly felt he might have been tardy; now he was hurrying to act before the storm spread. In the days after he did, the market jumped around, uncertain about the results.

All of which leads one to wonder: how can it be, at a time of unprecedented faith in free markets, that we even think a government authority might have such strength? And how can it be that the world's monetary order rests on the shoulders of an individual, a much admired but still fallible economist?

The answer is America's uniquely flawed and outdated monetary law, which gives the nation's monetary chief the sort of discretion of which his peers in other developed countries can only dream. Mr Greenspan is so powerful that today he is perceived as a beloved dictator. This is only natural. For as we know from history, wherever the law is weak - in any area of politics - public credibility tends to vest itself in an individual.

Under the masterly Mr Greenspan this may not have been a terrible thing. But the end of the Greenspan era is coming into view: how many more terms can a 74-year-old serve? So now is a good time for Washington to recognise the distinction between mortal and institution and strengthen the latter.

Consider the relevant law, the 1978 Full Employment and Balanced Growth Act - also known, until this month, as "Humphrey-Hawkins", after its sponsoring lawmakers. The law's most obvious flaw is evident in its official name. Rather than focusing on inflation and price stability alone it also requires, á la Keynes, that the Federal Reserve's leadership worry about strengthening employment and the overall economy. The law codifies a specific and narrow view: that there is always a trade-off between unemployment (or slow growth) and inflation; that the Fed must navigate a way between the two evils.

There was a reason that the law set out this choice: at the time, most mainstream economists fervently believed in the trade-off. There was also a general sense that a nation's monetary authority should micro-manage growth in its gross domestic product.

These attitudes came straight out of the New Deal and the years of the second world war, when there was enormous faith in central government. Adherence to the trade-off notion was so strict that it led to nonsensical prescriptions not only in the US but also elsewhere. An example of such misguided thinking spreading abroad is recounted in Hirohito and the Making of Modern Japan by Herbert Bix (Harper Collins): "Early the next year [1949] Detroit banker Joseph M. Dodge arrived in Japan to implement a drastic deflationary fiscal policy projected to revive Japanese capitalism by generating massive unemployment."

Nowadays most economic thinkers have either jettisoned their faith in the trade-off or modified it considerably. This is in part owing to bitter experience, some of it taking place in the very period when Humphrey-Hawkins was being written. The stagflation of the 1970s painfully demonstrated that unemployment and inflation can both rise at the same time. In the 1990s, an opposite set of conditions provided a further refutation of the trade-off rule. That decade showed that strong growth and low inflation could also exist simultaneously.

The lesson that price stability must be the principal goal of central banks and that they try to manage overall growth at their peril has been recognised across the globe. It was duly incorporated in new monetary laws in Britain and the European Union.

Many would argue that it hardly matters that America is a laggard. After all, since the law is a broad one, Fed heads find themselves blessedly free in deciding how to interpret it. Both Mr Greenspan and Paul Volcker, his predecessor, have tended to focus on the inflation mandate. Mr Volcker in particular heroically imposed unpopular and punitively high interest rates on the nation in order to wring inflation out of the US economy. Mr Greenspan was hostile to expansion - fiscal or monetary - when he felt it was inflationary.

But the ambiguity embedded in the monetary law still causes damage in the form of volatility. The market can only guess how seriously the Fed takes its broader responsibilities. Unemployment is not directly related to price stability but is part of the law. On some Friday mornings - when employment numbers are published - the market gyrates, trying to divine the data's influence. There is also the endless guessing game: does the market believe in the inflation-growth trade off because there is one, or because it thinks that Mr Greenspan does?

Some economists are even attributing this season's abrupt decline to the monetary law directly. The law, says Brian Wesbury, a Chicago-based forecaster at GKST Economics and critic of Humphrey-Hawkins, makes the Fed "focus on every piece of data rather than the right piece".

This past month, President Clinton signed legislation mandating changes to the monetary law. But they are mostly cosmetic: the law has a new name, the American Homeownership and Economic Opportunity Act. The hearings will no longer be called Humphrey Hawkins.

But more profound issues went untouched. The period before the Greenspan era passes may be shorter than we think. America should use it to alter its monetary law. Of course, there may be a smooth transition to a Greenspan successor - Mr Greenspan succeeded Mr Volcker without monetary reform. Still, why seek a strong leader but forgo a strong system when it's possible to have both? And what better leader for reform than America's wisest monetary brain, Mr Greenspan himself?

© Copyright 2001 Financial Times

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