Greenspan's philosophy assailed Hands-off approach blamed for bubbles

By Craig Torres and John Fraher
Bloomberg News Posted August 28 2005

Federal Reserve Chairman Alan Greenspan's hands-off policy toward soaring stock and housing prices may be one part of his legacy that doesn't last long beyond the end of his term in January.

Greenspan, whose 18-year record as Fed chairman was the focus of an annual central banker symposium that ended Saturday in Jackson Hole , Wyo. , holds that central banks should work to ease the aftermath of burst asset bubbles instead of trying to prevent them by raising interest rates.

While the Federal Open Market Committee so far has supported Greenspan's view, that may change. Fed Bank of San Francisco Senior Vice President Glenn Rudebusch said this month there's no "open and shut case" against the idea of using rates to deflate threatening bubbles. Fed Gov. Donald Kohn has directly cited housing as one of the so-called imbalances in the economy.

"I consider it an open issue for the Federal Reserve," former Fed Gov. Laurence Meyer said in an interview. "It will be more of an issue when Greenspan is gone because he was so definitive on the indirect approach to asset bubbles."

Greenspan drew the line in a January 2004 speech, saying suggestions that the Fed could have prevented the 1990s run-up in technology stocks without damaging the economy are "almost surely an illusion."

A collapse of dot-com stocks ultimately contributed to an eight-month recession in 2001, and to low job creation and investment spending in the following recovery. The Fed put the Greenspan doctrine to work, cutting the overnight lending rate 13 times from January 2001 to June 2003, eventually reaching a 45-year low of 1 percent.

Now, with the Fed's low interest rates pushing home prices to records, some Wall Street economists say Greenspan's position puts the United States at risk of another bursting bubble and slowdown.

"Five years ago, it was the equity bubble," said Morgan Stanley chief economist Stephen Roach in New York . "Today, it's the property bubble. One bubble has spawned the next. And we have the Federal Reserve to thank for this grand continuum and the cumulative toll it is taking on the U.S. economy."

Central bankers in Europe and New Zealand also disagree with the hands-off approach to asset prices; the Bank of England, raising rates in 2003, even explicitly cited housing markets that threatened to blow its inflation goal off course.

A record expansion

European Central Bank President Jean-Claude Trichet, Bank of England Gov. Mervyn King and Bank of Japan Deputy Gov. Kazumasa Iwata were among the dozens of central bankers, policy makers and economists who gathered in Jackson Hole for the Kansas City Federal Reserve Bank's annual symposium, which took place Friday and Saturday.

Between plates of roast buffalo washed down with Fat Tire Amber Ale, and amid a social agenda that included rafting trips and hikes around the Grand Tetons, the officials discussed the 79-year-old Greenspan's contributions to monetary policy and global stability over almost two decades.

Greenspan presided over the longest economic expansion in U.S. history, from March 1991 to March 2001. Annual inflation excluding food and energy fell below 2 percent for the first time in 31 years in 1996, and the unemployment rate dropped below 4 percent for five months in 2000 as the chairman tested the limits of the economy to grow without price increases.

Greenspan's legacy, business cycles and communication policy were among topics on the Jackson Hole agenda. While asset prices aren't a separate topic, economists said they are sure to be discussed.

To prick a bubble

"The biggest challenge for central bankers for the next decade is going to be dealing with asset valuations," said Stephen Cecchetti, former research director at the New York Fed and now professor of economics and finance at Brandeis University in Waltham , Mass. "It would be irresponsible to walk away and say, 'We only care about inflation.'"

Greenspan's contrary conclusions stem in part from a view that governments shouldn't be in the business of picking correct valuations for free markets, and that trying to stop bubbles may do greater overall damage. That position has support beyond the Federal Reserve.

"Who are we to say a person's decision to buy a house is right or wrong?" said Hung Tran, deputy director at the International Monetary Fund in Washington . Central banks should make sure financial institutions are strong and lending prudently. "That is more relevant."

Even banks that act against bubbles acknowledge risks. Charles Bean, the Bank of England chief economist who also came to Jackson Hole , said in January 2004 that a rate increase large enough to dent an asset price boom may have a "significant adverse impact" on growth. He turned out to be right.

The Bank of England raised rates five times between November 2003 and August 2004, partially to offset house prices that more than tripled in the decade through the first half of 2004. The central bank on Aug. 10 cut its 2005 growth forecast for the second time this year, to about 2 percent, the slowest in two years. It also ended its rate-increasing cycle this month, cutting borrowing costs to 4.5 percent.

'Mitigate the fallout'

The Bank of England's experience may lend weight to Greenspan's view that interest rates are too blunt to use against specific asset markets.

The best strategy is "to mitigate the fallout when it occurs and, hopefully, ease the transition to the next expansion," Greenspan said in his January 2004 speech to the American Economics Association in San Diego .

For support, he cited the economic recovery that started in November 2001, a year in which the Fed cut interest rates 11 times. He said the Fed's bubble-bailout strategy "has been successful."

That conclusion is now being reassessed, even within the Fed. While tax cuts combined with the Fed's interest rate cuts did limit the 2001 recession to just eight months, the recovery was stymied by lingering business caution.

Hiring was slower after the 2001 recession than in any other expansion in postwar history. Spending on equipment and software fell below 8 percent of gross domestic product from the first quarter of 2002 until this year, the lowest since 1994.

"The dot-com bubble spurred overinvestment in fiber optic cable and decimated the provision of venture capital for new technology start-ups for years," Rudebusch, the senior vice president at the San Francisco Fed, wrote in an Aug. 5 research note. "It is possible to conceive of a situation in which reducing the bubble in advance is a preferred policy strategy."

Rudebusch said in an interview: "It's not an open and shut case."

 

 

 

 

 

 

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