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How Greenspan Diminished the Fed

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It must be miserable to be a central banker these days. Not only are they confronted with the worst mess in at least a generation, but too many interested parties, from the financial services industry to politicians and some members of the media, expect them to deliver the impossible, namely status quo ante.

The reassessment of Greenspan’s tenure is in full swing, and the focus has been on the wisdom of his policy moves. Many observers now argue it wasn’t such a good idea to have him drop rates every time things got a wee bit rocky, no matter how good it felt at the time.

We think Greenspan did damage in another way: he weakened the authority of the office.

Once upon a time, central bankers, to the extent they spoke at all, were voices of probity and reason, possessing the virtues of old-fashioned bankers but endowed with considerably more grey matter. But their stock has slumped as badly as the ABX (subprime) index, and the conditions were put in place by 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.

And his legacy lives on. Yesterday, in a Financial Times opinion, its top economics editor Martin Wolf lambasted Bernanke for succumbing to political influence and signalling his willingness to shore up financial markets. Wolf’s message was that the health of the system is not the sum of the health of the individual players. Firms that had bad business practices should suffer the consequences. Players that tout the virtues of capitalism and reap outsized rewards in bull markets shouldn’t have their mistakes socialized when the tide turns.

But Bernanke (and perhaps his ECB counterparts; unfortunately, even in the Financial Times, their remarks get little coverage) seem to be trying to both soothe rattled players yet maintain the pretense that they can and will be disciplinarians. But Greenspan has so compromised their ability to be candid that any truth will be interpreted through the Greenspan filter and read as worse than it is. And while the authorities don’t want to coddle market participants, they don’t want to feed their panic either.

Moreover their actions already belie that they can maintain both postures, that of being both supporter and disciplinarian. Like Greenspan, they seem to be coming down on the side of accommodation. Some examples:

While Fed officials had been trying to distance themselves from Senator Dodd’s “use all tools at his disposal” promise, even commentators that view Bernanke favorably and think he is being fairly tough, like Bloomberg’s Caroline Baum, still expect a Fed funds rate cut.

The Fed has implemented a de facto, if small, Fed funds rate cut already by letting it fall below the official level.

The ECB has also been more accommodate than most news reports suggest (hat tip The Prudent Investor).

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