June 6, 2004
The Maestro Slips Out of Tune
he time has come, in my judgment, to consider a budgetary strategy that is consistent with a pre-emptive smoothing of the glide path to zero federal debt or, more realistically, to the level of federal debt that is an effective irreducible minimum.'' Translation: Go ahead and cut taxes.
With those words, delivered in Senate testimony on Jan. 25, 2001, Alan Greenspan -- revered during the 1990's as the nonpartisan architect of America's prosperity -- inserted himself decisively into politics, on the side of George W. Bush. The chairman of the Federal Reserve didn't specifically endorse Bush's plans, but his words were exactly what Bush needed. Before Greenspan's testimony, many political observers questioned whether the victor in a disputed election could get an enormous, controversial tax cut through Congress. After Greenspan spoke, much of the resistance collapsed.
Yet in retrospect we know that Greenspan's ''judgment'' -- that tax cuts were needed to prevent excessive budget surpluses -- was a misjudgment of Rumsfeldian proportions. In fact, the United States is headed for a budget deficit of more than $400 billion this year, more than half of it a result of tax cuts passed since Greenspan gave Bush his support.
Greenspan is still a figure of enormous prestige and power; he is to economic policy what J. Edgar Hoover once was to law enforcement. After 17 years as Fed chairman, Greenspan has become an icon, and it's hard to imagine America without him; indeed, last month the president nominated him for a fifth term. Yet his reputation is not what it once was. At the height of the boom, he was the monetary maestro whose advice was sought on many aspects of economic policy. Now his record as a monetary leader has been called into question, and his judgment on fiscal policy has been proved disastrously wrong. Worse, he seems to have abandoned the long tradition that places the Fed above the political fray.
He had the good fortune to follow an illustrious predecessor. Paul Volcker assumed office at a time of double-digit inflation. During Volcker's eight years as Fed chairman, he tamed inflation and steered the world through a major financial crisis, then oversaw a powerful economic recovery. On becoming chairman in August 1987, Greenspan inherited both a healthy economy and an office whose prestige had never been higher.
He enhanced that prestige with his deft handling of the stock market crash of October 1987. Still, in the early 1990's few would have considered Greenspan a great Fed chairman. When the economy stalled in 1990, Greenspan's Fed was caught by surprise and was too slow to react by cutting interest rates. What resulted was a nasty if brief recession that, among other things, ensured the first George Bush's electoral defeat. (Some Wall Street analysts suggest that the second George Bush delayed Greenspan's latest reappointment to pressure him to keep interest rates low until after the election.)
But then came the great boom.
Greenspan jump-started that boom by cutting interest rates once he realized that the economy was weakening, but any Fed chairman would have done the same thing. After the recovery began, he again followed standard operating procedure. William McChesney Martin, who was Fed chairman from 1951 to 1970, famously said that the Fed's job is to take away the punch bowl just when the party really gets going -- that is, to raise interest rates and slow down a booming economy before the boom turns into an inflationary spiral. Greenspan dutifully raised interest rates through 1994.
But as the boom continued and the unemployment rate dropped to new lows, he did something unexpected: nothing.
Around 1994, some businessmen began talking about a ''new economy,'' in which old rules no longer applied. In the 70's and 80's, an unemployment rate below 6 percent signaled an overheating economy, on the verge of inflation. The new-economy advocates claimed, however, that this was no longer true -- that thanks to accelerating productivity growth and increased competition, it was possible to run much closer to full employment without a takeoff in inflation.
Unlike most economists at the time, Greenspan took those claims seriously. And sure enough, the optimists were right. Over the next six years unemployment fell to 4 percent, a level not seen in 30 years, yet inflation remained quiescent. Greenspan didn't create the economic miracle of the 90's, but -- to his great credit -- he didn't stand in its way. And his name therefore became associated with the boom.
Greenspan's ''irrational exuberance'' speech was clearly intended to caution the markets. Soon afterward, he raised interest rates slightly, again with the clear intention of sending a warning signal to investors. But then he backed off. There were no more rate increases, and Greenspan began lauding the economy's achievements. Bad call: his first instinct was right. It was a bubble, after all.
Critics say that by letting the bubble develop unchecked, Greenspan set the stage not just for future market losses but also for trouble in the economy as a whole. Greenspan counters that the Fed can't target stock prices the way it targets inflation, because you can't know whether a bull market is a bubble until it bursts. The Fed, he says, should not consider asset prices part of its brief. Is he right?
When the bubble burst, the United States' economy went into recession, just as critics of Greenspan's inaction feared. Still, if he had been able to lead our economy into a quick, decisive recovery, his position would have been clearly vindicated. But though recovery was quick -- the recession of 2001 officially lasted only eight months -- it wasn't decisive. On the other hand, if the economy had fallen into a Japan-type deflationary trap, Greenspan would have been proved clearly wrong. That didn't happen, either. Over the last few months, the recovery has finally started to look like the real thing. We seem to have avoided a Japan syndrome, at least this time.
On balance, I think the critics are right and Greenspan is wrong. We avoided becoming Japan after the bubble burst, but it was a near miss: with interest rates down to 1 percent, the Fed had almost run out of ammunition before the economy turned around. And even if the economy is finally on the mend, over the last three years millions of American workers lost their savings or suffered the indignity and financial hardship of prolonged unemployment -- pain that could have been avoided if Greenspan had burst the bubble before it grew so big.
But this argument will probably go on forever. Fifty years from now, economic historians will still be arguing over whether Greenspan's performance as monetary manager deserves an A or a B-. What they won't argue about is Greenspan's culpability for America's plunge into deficit.
As an institution, the Federal Reserve is set up more like the Supreme Court than like an ordinary government agency. Members of the Federal Reserve Board serve for long terms; chairmen typically serve across several administrations from both parties. There's a reason for this: economists often argue that the Fed, like the Supreme Court, must be insulated from the political process so that it can make necessary but unpopular decisions. The quid pro quo for this insulation, however, is that the Fed must stand above the political fray. Like Supreme Court justices, the members of the Fed board undermine the rationale for their independence if they use their power for partisan purposes.
So was that 2001 testimony partisan? Yes. Greenspan argued on the basis of budget projections -- which he must have known are notoriously unreliable -- that the federal government would pay off all its debt in a few years. If this happened, the government would be forced to invest future surpluses in the financial markets -- which, he argued, would be a bad thing. To avoid this outcome, he claimed, surpluses had to be reduced with tax cuts.
It was a peculiar, tortured argument, full of holes. For example, partial privatization of Social Security -- which Greenspan supports -- would impose ''transition costs'' in the trillions of dollars, easily taking care of the supposed problem of excessive budget surpluses. As many warned at the time, Greenspan was also completely wrong about the budget prospect -- projections of huge surpluses quickly gave way to projections of huge deficits.
Above all, Greenspan's fear-of-surpluses argument was at complete odds with what he had said in the past. All through the Clinton years, Greenspan preached the virtues of fiscal restraint, and he did not change his views when the budget deficits of the 80's and early 90's vanished. Just six months before his 2001 testimony, Greenspan saw no problem with large projected budget surpluses. ''The Congress and the administration,'' he said in July 2000, ''have wisely avoided steps that would materially reduce these budget surpluses. Continued fiscal discipline will contribute to maintaining robust expansion of the American economy in the future.'' But then a Republican entered the White House, brandishing a tax-cut proposal -- and Greenspan suddenly developed an elaborate theory of why it was necessary to reduce those surpluses, after all.
Any doubts that Greenspan holds George Bush to different standards than he held Bill Clinton were dispelled in the years that followed. He didn't call for a reconsideration of the 2001 tax cut when the budget surplus evaporated. He didn't even offer strong objections to a second major round of tax cuts in 2003, when the budget was already deep in deficit.
Since then, Greenspan has gone back to warning against the evils of budget deficits. But he still hasn't called for a reconsideration of recent tax cuts; on the contrary, he has endorsed Bush's plan to make the tax cuts permanent. Instead he calls for spending cuts, emphasizing the need to trim Social Security benefits. I went back to testimony Greenspan gave in February 2001; sure enough, he assured nervous senators that tax cuts would not threaten future Social Security benefits.
But it's even worse than that. Before Greenspan became Fed chairman, he headed a commission that recommended changes in Social Security to secure its future. The most important recommendation, adopted by Congress, was for an increase in the payroll tax -- a regressive tax that falls much more heavily on lower- and middle-income families than it does on the well-off. The ostensible purpose was to generate a surplus within the Social Security system, building up a trust fund to pay benefits once the baby boomers retire.
That was the bait; now Greenspan has pulled the switch. The sequence looks like this: he pushed through an increase in taxes on working Americans, generating a Social Security surplus. Then he used the overall surplus, mainly coming from Social Security, to argue for tax cuts that deliver very little relief to most people but are worth a lot to those making more than $300,000 a year. And now that those tax cuts have contributed to a soaring deficit, he wants to maintain the tax cuts while cutting Social Security benefits. He never said, ''Let's raise taxes and cut benefits for working families so that we can give big tax cuts to the rich!'' But that's the end result of his advice.
Why did he do it? There are two possible interpretations. The more generous one is that he never gave up the ideals of his younger days. Into his 40's, Greenspan was an acolyte of Ayn Rand, the libertarian novelist and philosopher, and Greenspan has never repudiated his Randian association. Nonetheless, during the Clinton years he came to be viewed as a moderate. Maybe that was a mask, and all those years he was just waiting for an opportunity to use the prestige of his office to undermine the hated institutions of the welfare state.
The less generous interpretation is that Greenspan simply abused his position to help his friends. Kenneth Thomas, a finance professor at the Wharton School, has calculated that Greenspan visits the White House about once a week, as The Christian Science Monitor reported last month, and that is almost four times as often as he did when Clinton was president.
Part of the genius of George Bush's political operatives is their ability to persuade people (Colin Powell, Tony Blair) to betray their principles, to say and do things they will later regret, in support of a presumed shared cause. Paul O'Neill, Bush's first treasury secretary, falls into the same category: he was a moderate Republican who for a time played good soldier, defending the Bush tax cuts despite private qualms, to help the new president -- a man he thought shared his values -- by giving him an early political victory. And guess what: O'Neill was a close friend of Greenspan's.
According to Ron Suskind's book ''The Price of Loyalty,'' written with O'Neill's cooperation, Greenspan told O'Neill that a tax cut without triggers -- that is, conditions that would cancel the cut if projected surpluses didn't materialize -- was ''irresponsible fiscal policy.'' Yet Greenspan never made a forceful public case against a trigger-free tax cut, perhaps because he did not want to make trouble for his friend O'Neill. And by the time he realized just how irresponsible the tax cut really was, he was trapped -- too deeply associated with the administration's policies to change course without losing face.
Either way, Greenspan did something remarkable. After becoming a symbol of America's economic turnaround in the 90's, and anointing himself the nation's high priest of fiscal probity, he lent crucial aid and comfort to the most fiscally irresponsible administration in history. In the end, that will be his most important legacy.
Paul Krugman is a Times columnist and a professor at Princeton. His latest book is ''The Great Unraveling: Losing Our Way in the New Century.''