Hamish McRae: The history books will record the true cost of Greenspan's cheap money policy

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The Independent Online

Longevity is a desirable characteristic for central bankers, partly to ensure that there is an embedded memory of bear markets and bull markets, busts and booms. Until you have been through a couple of full economic cycles, a central banker hasn't much hope of judging the dangers and opportunities ahead. And by the same token, we punters cannot judge a central banker until we have seen them perform in bad times as well as good.

There are several reasons to welcome the re-appointment of Alan Greenspan as chairman of the Federal Reserve Board. These include, depending on your view of the world, the need for continuity in troubled times, or conversely the desire to see him dig his way out of the inflationary bubble that his policy of very low interest rates has created. But appointing a 78-year-old, albeit a sprightly one, to the top monetary job in the world does test the case for longevity. The appointment is for another four years. Will he really go on until 2008 and what would be the consequences of that?

First, and don't take this too seriously, he will go on at least until the middle of 2006 and then may well step down. Why? Well, that would make him the longest-serving Fed chairman of all time. William McChesney Martin was appointed in April 1951 by President Eisenhower and served under Kennedy and Johnson, and indeed for a month under Nixon, retiring in February 1970. I make that nearly 19 years. Mr Greenspan was appointed by President Reagan in August 1987. If he is to exceed the term of service of Mr McChesney Martin, he has to stay until the summer of 2006.

But why, you might ask, should he feel the need to become the longest-ever chairman? Tony Blair surely is not trying to outlast Margaret Thatcher to be the longest-serving PM in modern times? Well, perhaps that is a bad example. No, there is a practical reason for his wanting to hang on: he would have a good chance of getting a building named after him.

The Fed's main office is called the Eccles Building, a 1930s white marble-halled temple to the power of finance, complete with pillars and fountains, named after the former Fed chairman Marriner S Eccles. That's the one in the graphic. Then there is the McChesney Martin building nearby, a 1974 modernist office block, named after the longest-serving chairman. And then a few blocks away, there is the New York Avenue building, a 1972 commercial office block that the Fed acquired in 2001. It does not have a name, just the street number, 1709. Clearly it ought to have a name and, to follow form, it ought to take the name of a former chairman. But there are many contenders: there is Paul Volcker, or maybe Alan Burns. If, however, the present incumbent becomes the longest-ever chairman, it would be kind of difficult not to call it the Alan Greenspan Building.

As I said, don't take this too seriously. But let's make the working assumption that Mr Greenspan will serve another two years, what then? I suggest that it means cheap, or at least cheapish money for another two years. You want to leave the job on a high note. Sure, cheap money may be stacking up trouble in the future and rates will have to rise a bit. But Mr Greenspan's present reputation has been built on bringing the US through the early 1990s recession in good shape, setting in train the longest-ever boom, and making the 2001 recession the least serious of recent times. The costs? Well, the next chairman can cope with those, can't he?

You can catch a feeling for both the achievement and the dangers from the charts. If you say the prime task of a central banker is to deliver monetary stability, in conditions that make it possible for economies also to deliver steady growth, then it is a pretty fine achievement. The top left chart shows how US prices (excluding food and energy) peaked in 1990 but then have pretty consistently fallen so that underlying inflation by the end of last year was down to a little more than 1 per cent.

Not bad, eh? Well yes, but have a look at the graph alongside, which goes back a little further and shows what has happened to the price of durable consumer goods. Since 1995 inflation has plunged and has been strongly negative for the past couple of years. So the overall price level has been depressed by one particular group of products. And the reason for that is largely that cheap imports from China have been exerting a huge downward pressure on prices. Half the fridges imported into the US come from China. If you greatly increase your imports from low-cost producers you hold down your prices but at the cost of a deteriorating trade balance - as the bottom left-hand graph shows.

It would not be fair to lay all the blame for the deteriorating current account balance on the Fed. Fiscal policy has played a part in boosting demand, particularly since the present administration's tax cuts. But if you look at that graph, you can see the main deterioration started in 1998, under the Clinton administration and just at the time when arguably the Fed should have started tightening policy if it was to prick the share-market bubble early. Indeed, too-cheap money in 1999 helped underwrite a surge in US retail sales (bottom right-hand graph).

It is far too early to be judging Mr Greenspan's term of office and not just because he has at least another two more years in post. He could, if he wanted to, presumably run right through his new four-year term. But I do think when the economic history books are written they will focus as much on the failure to tighten policy in 1999 as on the use of very low interest rates to pull the country through the 2001 recession.

But it is not too early to be asking some questions about the costs of cheap money - actually free money, since the US has negative real interest rates - and whether these costs will become more evident in the next couple of years.

There are several questions about inflation. You should not blame the Fed for the rise in the price of oil, the markets' current concern, but you can blame it for home-generated inflation in the US. That seems now to be becoming more evident. You can blame it for inflated property prices. There are hot-spots where prices have been almost as frothy as in the hot-spots in the UK. There is the concern, noted above, that the US has been able to hold down inflation by a surge in imports of cheap goods and that surge is unsustainable.

There are several questions about the other distortions of cheap money. There is the way it has forced cash into unwise investments in the search for yield. There is the extent to which it has worsened the current account. There is the damage to household savings.

And then there are questions about the dollar. The US has got away with only modest weakening of the dollar because Japan and China have been prepared to finance the US current account deficit by buying dollar securities. At some stage they will have to pare back their purchases, maybe soon.

So cheap money is a policy where in the US case at least the benefits are obvious and immediate and the costs less obvious and longer term. If I'm right and there will be another two years of cheap money then some of those costs will become more evident - even if Mr Greenspan does get his name on a building after all.

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