TCS Daily

Mr. Greenspan's Opus

By Kevin Hassett - January 21, 2002 12:00 AM

On January 11, Federal Reserve Chairman Greenspan presented his most content-laden economic speech in many years. The speech, which was presented at the Bay Area Council conference in San Francisco, reviewed the past year's economic events and placed them into the context of history.

Greenspan also connected the latest data to the debate over the new economy, and provided hints as to the near-term course of Federal Reserve policy. There is no question that this speech will be viewed as one of the more interesting speeches in Greenspan's career, and will likely be printed in its entirety in Federal Reserve histories.

The buzz after the event was, of course, Greenspan's short-term pessimism, which surprised many observers, myself included. After reviewing the many positive and negative recent data, Greenspan uttered the following offending phrase:

"But I would emphasize that we continue to face significant risks in the near term. Profits and investment remain weak and, as I noted, household spending is subject to restraint from the backup in interest rates, possible increases in unemployment, and from the effects of widespread equity asset price deflation over the past two years."

Those seemingly tame words had a chilling effect. Before he took to the lectern, futures markets had pegged the probability of a rate reduction at the next Fed meeting on January 29 at 28 percent. After the speech, the markets viewed the chance of the move to be 70 percent.

That is an enormous change in expected policy but the real-world economic impact of this change will likely be small. Most observers recognize that the recession is approaching an end, and there are two possible endgames in popular discussion for the Fed.

First, the Fed chooses not to move in late January and announces that things now look better. The second is that the Fed reduces rates a quarter of a point and then announces that it believes that its work is done. Greenspan's speech signaled that the second option has been chosen. This choice, not really all that surprising, conforms to his general strategy of increasing the transparency of Federal Reserve actions. Beyond that, the speech contains little real information concerning how far off the recovery might be.

Indeed, elsewhere in the speech, Greenspan presented ample causes for optimism, both near and long term. The biggest positive factor is the increasing evidence that new technologies have improved businesses' ability to function in a changing marketplace.

"But if the recent, more favorable developments continue and gather momentum, uncertainties will diminish, risk premiums will fall, and the pace of capital investment increase. Should those gains in investment materialize, they would, doubtless, embody the newest technologies. As we have witnessed so clearly in recent years, advances in technology have enhanced the growth of productivity, which, in turn, has been essential to lifting our standards of living."

How can we be so sure that the new technologies have been so successful? Productivity growth in the recession is, Greenspan adds, the decisive factor.

"Even as our economy slipped into recession, the growth of output per hour remained positive and, as I indicated earlier, has held up well even in the wake of September 11. Until last year, the hypothesis of an accelerated productivity trend had not been tested in the contracting phase of a business cycle. Recent developments have provided that test, and the early returns certainly look favorable to the hypothesis."

This is exactly the kind of test that Greenspan began musing about several years ago. The data now provide startling confirmation of Greenspan's earlier hypothesis. With productivity higher, the long-run potential growth rate of the economy is significantly higher, and the aggressiveness that monetary policy must exhibit toward inflation softened.

These themes have been treated often in recent years, but what makes the Greenspan speech so remarkable is that it serves as a perfect exemplar of what has made Greenspan so successful over the past 15 years. Rather than rely religiously on specific economic models, Greenspan has always maintained a healthy skepticism concerning their worth. While worried about old economic relationships when alarms were sounded, he has also eagerly sought new evidence that the old connections no longer exist. Most intriguingly, he has been willing to present the intellectual debate to the public as it developed. In past speeches, he warned that the productivity gains might be short-lived, that they might not survive a recession. Now that they have survived, the new view of the world, that, in the past, was once shrouded in linguistic qualifications, becomes a much more "favorable" hypothesis.

As Mr. Greenspan approaches the mid-point of what may be his final term as Chairman, speculation has begun to heat up concerning his possible successor. Candidates would do well to digest carefully the January 11 speech, as it perfectly characterizes the source of Greenspan's success. Bring to the job a willingness to consider the past as a guide to the future, but a simultaneous respect for the ability to surprise. Move policy in short, well-telegraphed steps so that market participants begin to trust that the Federal Reserve is not a main source of uncertainty, and so one can change policy on a dime if models turn out to be wrong. Finally, be open to the public about the difficulty of the job, and the humility that is brought to it. That way, if the world really is changing for the better, the Federal Reserve will do very little to stop it.

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