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When Dr. Alan Greenspan, who passed away at 100, took the Fed chairmanship in July 1987, the Fed already held massive power under Paul Volcker. That was memorialized in the “Secrets of the Temple” released in 1987.
Greenspan would add many layers to the Fed’s power during his five four-year terms, even though he was intellectually opposed to big government. He tightened the grip of the Chairman, participated actively in the Swiss-based Bank for International Settlements, and approved the international banking standards in the Basel accords. He almost doubled the Washington DC staff to over 3000.
Importantly, Greenspan changed the Fed’s approach to monetary policy. He moved the Fed from Volcker’s monetarism and control of the M2 money supply — a system that some blame for the depth of the 1982 recession — to data dependence and Fed funds targeting.
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Greenspan was renowned as a data geek. He used such measures as rail car loadings and tons of production to form his judgment on the appropriate Fed funds rate. At times he referred to commodity price indices, a nod to his economic origins as a sound money advocate. Years later, the rate-setting system would evolve into formal inflation-targeting in 2014, but in the 1990s and first years of the 21st century, financial markets came to accept the notion that Alan Greenspan’s judgment and mastery of data would suffice.
In 1996, Greenspan cautioned Wall Street with the phrase “irrational exuberance”. It came in the middle of a decade-long boom that included the peace dividend and Newt Gingrich’s push for lower tax rates. Investors listened intently but remained exuberant all the way into the devastating 2000 dot-com crash. Greenspan’s thinking on asset bubbles evolved away from anticipating them to the point in 1999 that he told Congress: “Human nature has exhibited a tendency to excess through the generations with the inevitable economic hangover… It is the job of economic policymakers to mitigate the fallout when it occurs, and, hopefully, ease the transition to the next expansion.”
Under Greenspan’s guidance, the Fed became a fast, dependable provider of emergency liquidity, dubbed the “Greenspan put”. His first emergency came soon after his 1987 Senate confirmation when the Dow fell a single-day record 23% on October 19, 1987, Black Monday. The Fed acted immediately to expand bank reserves, which at that time were a limiting factor in the banking system’s ability to make loans and support broker-dealers. With the added liquidity, the Fed funds rate fell on October 20 and for several days after. By the 1998 and 2000 market crashes, multiple interest rate cuts were used proactively to support financial markets during distress. The era was captured in the 2000 book Maestro: Greenspan’s Fed and the American Boom.
The Fed has added more layers of power and responsibility since Greenspan’s Fed retirement in 2006. He had advocated for the Fed paying interest to banks for bank reserves. That became law much sooner than expected during the 2008 financial crash. The Fed’s powers now extend to bond buying, the standing repo facility (which loans to primary dealers and approved banks at the discount rate), and the commitment to maintaining ample bank reserves that grow with the economy. The Fed’s regulatory power has also expanded massively — from the pre-Greenspan leverage ratio through the risk-based capital Basel framework to the sweeping liquidity requirements and regulatory mandates in the current system.
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The Fed is much more deeply enmeshed in fiscal policy than in the Greenspan era — through its duration mismatch (borrowing short-term, lending long-term), its multi-hundred billion dollar bond market losses, and its control of repo markets which use Treasuries as collateral.
Greenspan added greatly to the Fed’s power and reputation, but he didn’t resolve the economic foundation. It falls to the current Fed and its able Chairman Kevin Warsh to continue this evolution. One of the most important questions, one that Greenspan explored a great deal in his two decades as Chairman: can price stability be better achieved through data-based judgments on the neutral interest rate, inflation data, or forward looking price rule indicators?
David Malpass is a former Treasury undersecretary.
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