Upside Down at the Fed

Sunday, December 25, 2005

I despised Alan Greenspan long before it was fashionable. Most recently it was for his disingenuous explanation of why the Bush tax cuts for the rich were okay. We might run out of safe investments, he said, if we paid off the debt too fast. Horrors! The government would be forced to purchase equities. Imagine the temptation to corruption. Well, the retirement of the federal debt has been pushed off for another millennium, anyway. Problem solved, thanks to Greenspan and the Bush economic blunder machine.

Before that was his hiking of interest rates in the late 1990s at the same time energy prices were spiking. This caused the economy to stall as much as the bursting of the stock market bubble, and far more than 9-11.

It was back in the 1980s, though, when I first learned to distrust him. Greenspan chaired a Social Security Salvation Committee (not its true title) which pompously proposed hiking payroll taxes to protect social security from the coming demographic aging of America. Simultaneously fellow Republican Ronald Reagan was cutting income taxes. The result was a shift of the tax burden down onto working people. (And as we now see Social Security is no safer.)

But the thing that really gives me a rash every time he does it is Greenspan's use of the interest rate to fight inflation. This practice is likely to continue under the next chairman, unfortunately. It's like treating a hangnail with doses of radiation.

There are two basic kinds of inflation, cost-push inflation and demand-pull inflation. Cost-push is where producer costs go up and suppliers are forced to pass these costs along to their customers. The classic case is with energy prices. Transportation and production costs are directly tied to energy prices. These costs get embedded in everything from airline fares to the price of bread. (Only direct purchases of fuel are excluded from the so-called "core inflation" calculations.) Not surprisingly, cost-push inflation is associated with stagnation. Stagflation.

The second type, demand-pull inflation, occurs when there are too many dollars chasing too few goods. This occurred after World War II when pent-up demand rushed into a private marketplace that was not geared up for it. It occurred again during Viet Nam, when Lyndon Johnson ran his Great Society projects at the same time as the war. ("Guns and butter," it was called then.) Demand-pull is where buyers essentially bid up the price of goods. Not surprisingly, demand-pull is associated with booms in the economy.

Raising interest rates is useful only in the case of demand-pull inflation, since it increases costs and suppresses demand. Yet the Fed uses it for both. This was a great tragedy in the massive recession of the early 1980s. The Fed's hike in interest costs combined with the OPEC spike in oil prices to send the country into the deepest recession since the Great One. But increasing interest in cost-push situations only increases costs, and thus adds to, rather than subtracting from, the inflation phenomenon. [Before you start yelling, yes, I know the mechanism the Fed used was restricting the money supply, but the effect was felt in interest rates.]

At the end of that day in the 1980s, inflation did fall, but only after oil prices had fallen. Left on the battlefield were millions of unwilling inflation fighters, an army of jobless men and women whose lives would never be the same. The period of high interest and expensive dollars that began then led directly to the de-industrialization of America and the loss of millions of manufacturing jobs. In Washington, generals Reagan and Paul Volcker (Fed Chairman) congratulated themselves on their sacrifice. Of course, neither had been out of a job for a single day.

Alan Greenspan took the reins of the Fed from Volcker in the mid-1980s, and since then (insofar as he has been consistent) Greenspan has continued the tradition and raised interest rates whenever his tea leaves tell him inflation is coming. For many years this was when unemployment got too low. Yes, this was the explicit official position, that low unemployment would create demand that would drive up prices. The theoretical formula was NAIRU -- the "non-accelerating inflation rate of unemployment," a rate which if crossed would somehow loose the demons not only of inflation, but of accelerating inflation. Once upon the land these demons would create grisly outcomes, which never quite clearly identified.

The concept of NAIRU was thoroughly debunked by Nobelist Robert Eisner in the early 1990s and subsequently exposed by the experience of the late Clinton years, when unemployment tickled its historic lows and yet inflation stayed dormant. Yet this period also corresponded with the height of Greenspan's popularity, when he was touted as Maestro. Periodically he messed with the rate and when no inflation occurred he pronounced himself pleased, and the public congratulated him for the result. It was not unlike the man who wore cabbage leaves in his hat and when asked why, replied "To repel elephants." "There are no elephants around here," he was told. "Works pretty good, eh?"

In the end we were to discover, however, that Maestro Magoo relies only on the politically expedient theory and his obtuse remarks are often no more than camouflage, or more aptly, smoke. Over time, the exercise has worked well for Greenspan personally, resulting in a record term in office. Unfortunately, in combination with the Bush evisceration of common sense, it has not been such a happy result for the economy as a whole. The current system is dangerously imbalanced, domestically and globally. Like the retirement of the federal debt, the prospect of economic stability and a society that relies on earning, not borrowing, lies far, far in the future.