Greenspan's legacy vs Volcker's demarche
By Hossein Askari and Noureddine Krichene
In the face of rising inflation, a free-falling dollar, explosive prices for
food, oil and other commodities, and an impending economic recession, numerous
pundits have contrasted the opposing approaches of two former US Federal
Reserve chairmen.
In recent days, Alan Greenspan (1987-2006) has been preoccupied with defending
his legacy while Paul Volcker (1979-87) has offered a diagnosis of our current
predicament and some warnings about the dangers of a Fed that responds too
easily to political pressure and fails to protect the value of the dollar. What
can we learn from the very different approaches of these two former Fed chiefs?
Undoubtedly, the present economic crisis is the delayed outcome of an overly
discretionary approach to monetary policy initiated by Greenspan and embraced
by his successor Ben Bernanke, forcing interest rates to their lowest levels in
decades, expanding credit at abnormally high rates, irrespective of risks and
returns, and fueling speculation in housing and in a number of other markets.
On the one hand, Greenspan's policy showed how far discretion could get out of
control, as feared by the late Milton Friedman. Greenspan relied on what is
called the interest rate rule, which amounts to a direct setting of interest
rates by the central bank and deliberately neglecting the control of monetary
aggregates as Alan Blinder, a former vice chairman of the Fed and proponent of
this rule, clearly stated: "We did not abandon the monetary aggregates, they
abandoned us".
Such a prevailing view at the Fed led to the neglect of monetary aggregates,
supervision and safety rules. It would have been a miracle if the present
crisis had not occurred. On the other hand, by repudiating the interest rate
rule, and controlling monetary aggregates, Volcker was able to halt a
double-digit inflation (14%) and reduce unemployment (12%).
The ongoing inflation has gained strong momentum over seven years of cheap
money and negative real interest rates, in turn spawning uncertain prospects
and in all likelihood fueling strong inflationary expectations. The Fed has
created considerable instability, crippled economic growth, caused a flare-up
of food, energy and other basic necessities prices, and sent the dollar to
record lows.
The Fed's cheap money policy will only accelerate inflation further. While it
is costless to reduce interest rates and print billions of dollars, these
actions will not lift world oil production above 80 millions barrels a day
(approximately 30 million from the Organization of Petroleum Exporting
Countries and 50 million from non-OPEC) any time soon. In the near future, oil
output will constrain economic growth, and further monetary expansion will only
inflame oil prices through higher demand for oil and a falling dollar.
The same physical constraint applies to basic food commodities. Fragility of
oil and food markets may increase and may lead to some form of rationing in the
event of some disruptive output shocks. Actions to accelerate inflation may
lead to regressive supply for basic commodities, rising unemployment, unfair
redistribution of wealth, impoverishment and malnutrition.
It would be foolish to believe that, in the context of rampant inflation, cheap
money policy will lead to economic recovery and restore full employment. High
interest rates and tight money did not get us into this predicament and easy
money will not pull us out of it.
Expansionary monetary policy can never bring recovery once inflationary
dynamics have gained traction. It only brings more social and economic
instability. The best-known demand expansion model was put forward by John
Maynard Keynes, a model built on a premise typical of the Great Depression,
assuming involuntary unemployment and total absence of wage and price
inflation. Such is not the case under today's high inflationary conditions.
How long do economic and financial uncertainties have to prevail before the Fed
repudiates Greenspan's legacy and adopts Volcker's demarche? Do oil prices have
to accelerate to $200 per barrel, the dollar to collapse to $2 per euro, food
prices to run up to starvation levels for hundreds of millions around the
globe, and unemployment to jump to the digit level before the Fed starts
addressing inflation?
Historically, in no country and during no inflationary episode was inflation
brought under control except by strict control of money supply. At this
juncture, policymakers have to pay careful attention to Volcker's expert advice
that comes from experience as a successful Fed chairman. The main
responsibility of a central bank is to safeguard the value of currency and
soundness of the financial system.
The Fed cannot restore monetary stability without strict control of money
supply and credit. The sooner the Fed implements Volcker's demarche, the sooner
confidence, stability and growth will be restored to the financial and real
sectors in the US and around the globe.
Hossein Askari is professor of international business and international
affairs at George Washington University. Noureddine Krichene is an
economist at the International Monetary Fund and a former advisor, Islamic
Development Bank, Jeddah.
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