Is central bank independence all it’s cracked up to be?
By Joseph Stiglitz
Alan Greenspan attained an almost iconic status as Governor of the Federal Reserve Board. So, as his term draws to a close and his mantle of infallibility is passed on to his successor, it is worth examining whether his legacy will measure up and what we can expect from the new Fed chief, Ben Bernanke.
Few central bank governors have the kind of hagiography lavished upon them, especially in their lifetime, that Greenspan has had. But what makes for a great central bank governor in our modern societies, great institutions or great individuals?
In economics, we seldom have a clearly defined counterfactual: Would the economy have performed even better or a little differently if someone else had been at the helm? We can’t know, but there is little doubt that those “managing” the economy receive more credit than they deserve, if sometimes less blame.
Many forces behind the boom of the 1990’s, including advances in technology, were set in motion before Bill Clinton took office (just as the legacy of President George W. Bush’s deficits will be felt long after he leaves). So Greenspan cannot be given credit for the boom. But, while no central bank governor can ensure economic prosperity, mismanagement can cause enormous harm. Many of America’s post-World War II recessions were caused by the Fed hiking interest rates too fast and too far.
There is little doubt that Greenspan had great moments, when one could at least imagine a less deft governor doing the “wrong” thing with disastrous consequences. One such moment was the stock market crash of 1987. Perhaps another occurred in 1998, when the Fed lowered interest rates in the face of what appeared to be an impending global financial crisis.
These successes, combined with the 1990’s boom and the seeming durability of price stability, reinforced Greenspan’s exalted status. But they also led many to forget less successful moments. The Fed failed to avert the economic downturn of 1990, and a reading of Greenspan’s testimony to Congress during that period makes clear that the basic nature of the economy’s problems was not well understood.
But the real problem for Greenspan’s legacy concerns what happened to the American economy in the last five years, for which he bears heavy responsibility. Greenspan supported the tax cuts of 2001 with the most specious of arguments – that unless something was done about America’s soaring fiscal surpluses, the national debt would be totally paid off within, say, ten to fifteen years. According to Greenspan, immediate action needed to be taken to avert this looming disaster, which would impede the Fed’s ability to conduct monetary policy!
It says a great deal about the gullibility of financial markets that they took this argument seriously. More accurately, tax cuts were what Wall Street wanted, and financial professionals were willing to accept any argument that served that purpose. Of course, if, say, by 2008 the disappearing national debt really did appear to pose an imminent danger, Congress would have happily obliged in cutting taxes or increasing expenditures.
Greenspan’s irresponsible support of that tax cut was critical to its passage. The fault was not only in the magnitude of the tax cut, but also in its design; by directing the cuts at upper-income Americans, it provided little economic stimulus.
But soaring deficits did not return the economy to full employment, so the Fed did what it had to do – cut interest rates. Lower interest rates worked, but not so much because they boosted investment, but because they led households to refinance their mortgages, and fueled a bubble in housing prices.
In short, as Greenspan departs, he leaves behind an American economy burdened with high household and government debt and fragile balance sheets – a legacy that is already contributing to global financial instability.
It is still not clear what led Greenspan to support the tax cut. Was it a massive economic misjudgment, or was he currying favor with the Bush administration? The most likely explanation is a combination of the two, for he and Bush were pursuing the same “starve the beast” political strategy, which calls for tax cuts to be used to reduce revenues, thereby forcing the public sector to be downsized.
The traditional argument for an independent central bank is that politicians can’t be trusted to conduct monetary and macroeconomic policy. Neither, evidently, can central bank governors, at least when they opine in areas outside their immediate responsibility. Greenspan was as enthusiastic for a policy that led to soaring deficits as any politician; but the fig leaf of being “above politics” gave credence to that policy, engendering support from some who otherwise would have questioned its economic wisdom.
This, then, is Greenspan’s second legacy: growing doubt about central bank independence. Macroeconomic policy can never be devoid of politics: it involves fundamental trade-offs and affects different groups differently. Unemployment harms workers, while the lower interest rates needed to generate more jobs may lead to higher inflation, which especially harms those with nominal assets whose value is eroded. Such fundamental issues cannot be relegated to technocrats, particularly when those technocrats place the interests of one segment of society above others.
Indeed, Greenspan’s political stances were so thinly disguised as professional wisdom that his tenure exposed the dubiousness of the very notion of an independent central bank and a non-partisan central banker. Unfortunately, many countries have committed themselves to precisely this illusion, and it may be a long time before they take heed of Greenspan’s most important lesson. Stressing the new Fed chief’s “professionalism” may only delay the moment when this lesson is learned again. dt-ps
Joseph E. Stiglitz, a Nobel laureate in economics, is Professor of Economics at Columbia University and was Chairman of the Council of Economic Advisers to President Clinton and Chief Economist and Senior Vice President at the World Bank. His most recent book is The Roaring Nineties: A New History of the World’s Most Prosperous Decade.