Opinion pieces and speeches by EPI staff and associates. 

THIS PIECE ORIGINALLY APPEARED IN SPRING 2001 ISSUE OF DISSENT MAGAZINE.

The Politically Talented Mr. Greenspan

by Jeff Faux

A few short days after Bill Clinton vacated the White House this January, Federal Reserve Board head Alan Greenspan publicly endorsed the new tenant’s $1.6 trillion tax cut. Democrats who had been convinced by both Clinton and Greenspan to give paying off the debt priority over education, health, and other social investments were “shocked” and “stunned” to hear the chairman brush aside concerns that the government would have to borrow money in order to finance George W’s largesse, 40% of which would go to the richest 1% of Americans. The New York Times announced that we had entered the “Greenspan-Bush” era, following the “Greenspan-Clinton” era, in which the president of the United States came to be the junior partner in the management of the U.S. economy.

The story of the Greenspan-Clinton relationship has been embellished into a charming tale of an “odd-couple” policy-wonk romance in which the brilliant, shy economist teaches the economic facts of life to the brilliant, party-going president. The typecasting doesn’t quite fit reality. Not only is Greenspan a well-known Georgetown partygoer, his reputation as a scholarly economist is not as heavy among his peers as the business press would have us believe. In his recent generally worshipful biography of Greenspan, Bob Woodward reports that “the Chairman’s language was highly idiosyncratic, often not fully grounded in the data.”* At the meetings of the Federal Open Market Committee, the Ph.D.s in the room “would be nearly rolling their eyes as the chairman voiced his view about how the economy might be changing.”

A closer look at the Greenspan-Clinton era suggests that the chair’s genius stems more from his political talents than his economic insights. Thus, on the basis of dubious economics and weak history, he convinced Bill Clinton to give top priority to the elimination of the deficit, as opposed to the public investments in education, health, and infrastructure that Clinton had promised the Democratic faithful in his campaign. In effect, Clinton spent much of his presidency shortchanging the Democratic Party’s constituency so he could pay down the debts run up by his two Republican predecessors. As a result, George Bush II is the lucky recipient of a massive fiscal surplus, which he fully intends to use for military spending and tax cuts to promote the interests of the Republicans’ higher-income clientele.

As Woodward reports, Greenspan argued that federal deficits would ignite inflation, frightening Democrats with the memory of the late 1970s, when double-digit increases in consumer prices enabled Ronald Reagan to drive Jimmy Carter out of the White House. What Woodward doesn’t tell us is that Greenspan’s dire warnings were not supported by economic evidence. Other than in wartime, there is no clear relationship between federal deficit spending and inflation. Moreover, the economic scenario of an overheated peacetime economy triggering a politically unacceptable wage-price spiral has never happened in modern times. Every major episode of inflation that cut short growth over the last century has been triggered either by war or increases in global oil prices. The last price flare-up was generated by a short-lived panic in oil markets when the 1990 Gulf War was launched. It was also the shock of suddenly rising global oil prices-not runaway economic growth-that sparked the inflation of the 1970s. The previous price run-up was kicked off by Lyndon Johnson’s refusal to raise taxes to pay for the Vietnam War. The inflation spell before that was ignited by the Korean War, the one before that by the lifting of price controls after World War II, and the one before that, by the impact of World War I.

Greenspan is unlikely to be ignorant of this history. Therefore, an explanation for Greenspan’s behavior that better fits the facts is that his underlying motive was to restrain federal domestic spending, rather than contain impending inflation. Greenspan is, after all, an ideological conservative, an early acolyte of the social Darwinist novelist Ayn Rand and Ronald Reagan’s choice for Fed chair. Greenspan was also from Wall Street and has been trained to view the stock market as the fundamental measure of the country’s economic health.

Conventional wisdom holds that Clinton had no choice but to accept Greenspan’s view of the world. Had he not, the Fed would have raised rates in mid-1996 when the unemployment rate dipped below the 5.5 percent to 6 percent area that Greenspan had previously claimed to be the inflationary trigger. Higher rates would have killed the Clinton expansion just before the reelection campaign, repeating the mistake Greenspan made when his monetary policy forced a recession on George Bush I just before the campaign of 1992. You don’t make that mistake twice in a row if you want to be reappointed as chair of the Fed, which Greenspan was in 1996.

So Greenspan was bluffing. Clinton understood what all this budget cutting was doing to the Democratic agenda and complained to his staff that they had become “Eisenhower Republicans.” But each time he wavered, his treasury secretary, Bob Rubin, former chair of Goldman Sachs, reminded him of the risks of a Wall Street reaction if Greenspan was right. In the end, Greenspan won all the political chips. The Clinton years saw a decline in social investment as a share of the nation’s income, and by the end of the 1990s, his administration became a champion of eliminating the entire national debt–a position that would have been hooted out of the Democratic Caucus a few short years before. During his presidential campaign, Al Gore told the Wall Street Journal that if a recession came, instead of pumping up government spending he would cut it, “Just as a corporation has to cut expenses when revenues fall off, and that sometimes turns out for the long-term benefit of the company.” This put the Democratic standard-bearer somewhat to the right of Herbert Hoover.

That Greenspan was more interested in cutting federal spending than he was worried about inflation explains what seems to many a mystery in his shifting attitude toward the stock market boom of the late 1990s. After publicly suggesting in 1996 that “irrational exuberance” had made the market dangerously overvalued, Greenspan then shut up and proceeded to accommodate a speculative frenzy that drove up share prices of companies with no profits and little prospects to outrageous heights. Between June 1996 and June 2000, the Dow rose 93% and the NASDAQ 125%, and the overall ratio of stock prices to corporate earnings reached record highs. Greenspan stood by as stock market hucksters in the guise of objective analysts hyped worthless paper in fly-by-night boiler rooms, on national television, and in thousands of newsletters to gullible customers, who were able to leverage their gambling with easy credit supplied by the Federal Reserve.

Greenspan’s story is that his mind was changed about the market’s overvaluation when he became convinced that the new economy was generating higher rates of productivity, which he said explained the absence of inflation. Increased productivity would not only keep prices from rising, it would in time power future profits high enough to justify the booming share prices. But the higher rates of productivity only began to appear in 1996, which was much too early in the process for anyone, much less the chair of the Federal Reserve, to believe that the economy had arrived at a new plateau of permanently higher efficiency.

Moreover, in 1999, Greensp
an initiated a series of interest rate hikes, when inflation was even slower than it was in 1996 and productivity was growing even faster. In addition to his rote reference to the specter of inflation, Greenspan indicated that he had finally decided to do something about the overpriced stock market. But why was it necessary to slow down the entire economy because speculators had driven up the price of corporate shares? A much better and safer way would have been to use his authority to restrict credit to the stock market by requiring higher “margins,” that is, down payments on the purchase of stock. By 1999, margin debt in the stock market had reached the heights it held just prior to the market meltdown in 1987.

A number of market observers, including financier George Soros and Stanley Fischer, deputy director at the International Monetary Fund, advocated that the Fed let the air out of this credit boom by raising margin requirements. But Greenspan refused this more sensible strategy. At his confirmation hearing before the U.S. Senate Banking Committee in 1996, he said that he did not want to discriminate against individuals who were not wealthy and therefore needed to borrow in order to play the stock market. Given that people who use margin leverage to buy stock are typically wealthy by any reasonable standard, this is a weak rationale for favoring higher interest rate policies that would cause unemployment and personal bankruptcies among lower- and middle-income working people.

His refusal to raise margin requirements suggests that Greenspan’s goal was not to lower share prices. Rather, it was to raise profits to levels that would justify the high stock prices. Obviously, a stock’s price-earnings ratio can be lowered by changing either side of the ratio by reducing prices or raising earnings. Given that the economy was already at high levels of productivity and close to full capacity, there was little room to raise profits through more economic growth. But a dose of unemployment might help squeeze labor costs. Thus, Greenspan’s raising of the interest rates can be seen not so much as a “pre-emptive” strike against a phantom inflation, but a rather desperate effort to avoid a market decline by raising the earnings of investors through lowering the earnings of workers.

It is widely known that the government’s labor cost index, rather than its consumer price index, is the Greenspan Fed’s favored indicator of inflation potential. Moreover, Greenspan himself observed publicly on a number of occasions that the anxiety of American workers over losing their jobs was a critical factor in keeping wages down during most of the 1990s. By 1999, tight labor markets (plus an increase in the minimum wage) were beginning to raise wages. Slowing down the economy was a way of weakening workers’ resolve to demand more pay.

Today, it looks like Greenspan’s gamble failed. The stock market began to tumble in the first half of 2000, not because labor costs were rising, but because limits of investor credulity were finally reached. The business press, which a year before was proclaiming the 30-year-old dot-com executives as pioneers of the new economy, was now ridiculing the public for having believed that the stock of companies that would never make a profit could go up forever. The new economy, as one Wall Street Journal writer put it, now looks like an old-fashioned credit bubble.” In the second half of that year, consumers whose debt-to-in-come ratios were at record highs, began to pull in. Christmas sales flopped, and by early January Greenspan reversed himself and lowered interest rates.

About that same time, just after the Supreme Court appointed him president, George W. Bush began forecasting a “Clinton” recession. But the blame for a downturn will be hard to pin on the absent Clinton. So George W. better watch out. Having cost Bush’s father the presidency and Bill Clinton his political soul, Alan Greenspan is at the top of his game. If the next year gives birth to a growing economy, it will be named after him. If it’s a recession, it will be named for his junior partner in the White House.
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*Maestro: Greenspan’s Fed and the American Dream (Simon and Schuster, 2000)

Jeff Faux is president of the Economic Policy Institute.

[ POSTED TO VIEWPOINTS ON JUNE 1, 2001 ]