Alan Greenspan’s greatest legacy may be the Fed’s independence

Former Federal Reserve Chair Alan Greenspan’s tenure is often remembered in a few different lights. On one hand, he was known for an almost mystical approach to steering the Fed and was lauded as a “maestro” conducting the central bank like an orchestra. On the other, he’s remembered for presiding over the Fed in the lead-up to the 2008 financial crisis.

Yet there’s a lot more to Greenspan’s legacy. He led the Fed for over 18 years and served in President Gerald Ford’s administration before that. And in light of the Fed’s recent attempts to curb inflation while avoiding a recession (otherwise known as a “soft landing”), Greenspan’s Fed was the last to achieve this in 1994.

“There was a 40-year period from the mid-’60s to the mid-2000s when he was kind of in the public sphere,” said Sebastian Mallaby, senior fellow at the Council on Foreign Relations. “Which maps onto the making of modern finance the United States.”

Mallaby spent half a decade researching Greenspan for a biography he published in 2016, “The Man Who Knew: The Life and Times of Alan Greenspan,” and he spoke with Marketplace then about his findings. Marketplace” host Kai Ryssdal recently followed up with Mallaby on how Greenspan’s legacy has changed. The following is an edited transcript of their conversation.

Kai Ryssdal: It occurred to me as I was getting ready for this interview and reviewing your book that the book came out in 2016. But more to the point, Alan Greenspan left the Fed in 2006, which means there’s a whole generation of economic actors in this country and on the planet who don’t really know who he is or what he did. And I guess my first question is: Why does Alan Greenspan still matter?

Sebastian Mallaby: Well, he was the longest-tenured Fed chair in quite a while. He served for 18 and a half years — more than twice as long as Ben Bernanke, more than twice as long as Janet Yellen. And on top of that, Alan Greenspan had also been chairman of the Council of Economic Advisers in the Ford administration back in the 1970s. And I’d say there was a 40-year period from the mid-’60s to the mid-2000s when he was kind of in the public sphere, which maps onto the making of modern finance the United States.

Ryssdal: Yeah, so dig down into the whole “creation of modern finance in the United States.” What was Greenspan’s role there? And how does that manifest today?

Mallaby: Well, first of all, what do we mean by the making of modern finance in the late 1960s? Interest rates were regulated, capital flows across borders were regulated, derivatives hardly existed. Currencies couldn’t fluctuate because they were pegged together. And so really the freewheeling modern system did not exist. And from the end of the ’60s, the emergence of inflation — all of that started to crack. Technology drove the creation of derivatives. And it all leads up to the 2008 financial crisis, when that freewheeling system came unstuck. And Greenspan’s role during this period was partly to be in the debate, to be observing. But when he became chairman of the Fed in 1987, he went from an influential thinker and debater to a sort of a central actor. And that’s where I think there’s a really rich discussion to be had about where he was at fault and where he might have been right.

What Greenspan did right: Fed independence

Ryssdal: Well seeing as how it’s only a half an hour program, we’re gonna have to not have a rich discussion, but I do want to have a sort of a truncated version of it. I guess the first thing I want to give him credit for is what he did right in getting the American economy to where it is today.

Mallaby: Yeah, I think his central contribution was to get inflation really properly anchored. Of course, Paul Volcker, who was chairman of the Fed for eight years before Greenspan, is correctly credited with breaking the back of the 1970s inflation and bringing it down from, you know, around 10% to around 4%. But then, when Greenspan took over, the job had not been finished. It was still 4% — higher than what is now, the modern target of 2%. And Greenspan surprised people by being very tough about completing the job, denying the Republican politicians who had appointed him as Fed chairman, denying them what they wanted. So George H. W. Bush, the first President Bush, was expecting Greenspan to be compliant, to cut interest rates to help his political prospects. Greenspan refused, and in so doing, he brought inflation down. And at the same time, he demonstrated that the Fed could be independent from politicians, which kind of further anchored market expectations of what inflation was going to be.

What Greenspan got wrong: the importance of asset bubbles

Ryssdal: More to come in a second on Fed independence and market expectations in regards to the Fed, but all of that credit where credit’s due that you just mentioned, where did he blow it? Where did he go wrong?

Mallaby: Where he blew it, I think, is in thinking that 2% inflation was the be-all and end-all, because it turns out, of course, that economies can be disrupted by things other than the price of eggs going up too fast. The price of nest eggs matters too. In other words, asset markets, stock markets, bond markets, real estate markets — when these things go up too fast and then they crash, that is what actually caused the recession in the U.S. in 2001. That was sort of the prelude to that recession when the tech bubble burst. Then you get the real estate bubble bursting in 2008 and leading to the sharp recession that was experienced after that, was yet another demonstration of how disruptive asset price gyrations can be. And Greenspan did not pay attention to that adequately.

Ryssdal: Come with me now to today and Jay Powell, who is, let’s see, one, two, I guess three removed from Chairman Greenspan. Powell talks all the time about Paul Volcker and has as much as said he tried to emulate his decision-making process and the way he thinks about the central bank and its role. You don’t hear Greenspan coming out of his mouth practically at all.

Mallaby: Yeah, I think because Volcker is remembered, you know, unambiguously as the tough guy who came in when inflation was way too high. You know, Greenspan’s reputation suffered, of course, when 2008 happened. He had left the Fed in 2006, but clearly he had presided over the conditions that led to this real estate collapse, to the financial crisis in 2008. And so, whereas he had been celebrated as “the maestro,” to quote the title of a book about him that came out back around 2000, by the time he had retired, he went, I would say, from hero to zero faster than anybody else I can think of an American public life.

The state of the Fed’s credibility

Ryssdal: You mentioned the Fed’s independence, and by extension, its credibility. Where do you think today the Fed’s credibility sits with the last two-ish years of inflation they’ve had to deal with, and, you know, the Fed’s role in in the 2008 financial crisis as well?

Mallaby: I think in terms of the recent inflation, history will relate, and maybe public opinion will come to accept, that this was really an extraordinary episode of trying to steer the economy through something like COVID-19. And I think one should credit the Fed with at least having got the inflation back down again. So I think the Fed’s credibility is pretty good on that score. I think in terms of the 2008 saga, people criticize the Fed for a failure to regulate derivatives, a failure to regulate irresponsible mortgage lending by financial institutions. And people say, “Well, that’s what led to the financial crisis.” I think there’s a more complex story, which is that sometimes on some of those issues, the Fed did try and politics made it impossible. For example, clamping down on crazy mortgages and generally getting mortgage finance under control is something that would have involved getting Fannie Mae and Freddie Mac capped in their size. And that, you know, those institutions are so well connected politically that although Greenspan tried that, he was thwarted. So I think they tried more than is understood. But you’re right that in the public perception, both ’08 and the 2021 inflation is going to be a black mark.

Ryssdal: Just on the politics of monetary policy in this economy, as a guy who studies this, do you worry about the Fed’s independence? I mean, every now and then there are spasms of “Oh, we’ve got to crack down on the Fed” from Congress. And one does imagine that one day it might stick.

Mallaby: Sure. I mean, if President Trump were to be reelected, his regard for American institutions is limited, it seems, and the Fed would be on his list. And I was worried in the first Trump administration that this would cause a severe compromising of Fed independence. I was pleasantly surprised that actually the Fed navigated through pretty well and escaped. But whether that would happen in a second Trump term, I think nobody can guess,

Rethinking the relationship between the Fed and the markets

Ryssdal: As you sit here, and we’re now, like, nine years out from you haven written this book, what’s the postscript you would write today?

Mallaby: Well, I think part of the postscript is to observe that the mistake that Greenspan made in not raising interest rates to fight the asset bubble in real estate was sort of repeated in COVID-19. There was a moment when the Fed could have — should have — tightened interest rates faster, and one signal that would have encouraged that was the fact that the stock market was going nuts. It was just roaring upwards. Another thing is that it’s a problem when the Fed becomes too obsessed with signaling what it’s going to do, then starting to do it slowly, and then finally getting around to it, which is kind of what happened with raising interest rates coming out of COVID-19. There was a reluctance on the part of the Fed to surprise the markets by suddenly saying, “Right, inflation is properly stuck in. We’ve got to raise rates, and we’re going to do it now, and we’re going to [do it] in size.” That is what Greenspan would have done. That’s what he did do in 1994. But it’s became sort of the wisdom in the second part of Greenspan’s tenure, and then very much cemented by chairmans Bernanke and Yellen, that you should always signal in advance, not take markets by surprise. And I think that was a lesson that was overlearned.

Ryssdal: Well, so let’s talk about that for a second, because you did a piece in Foreign Affairs in which you discussed this signaling. “Forward guidance” is the is the term of art. What I hear you saying is that the Fed ought to just do stuff and not worry so much about the market’s feelings.

Mallaby: Exactly. That’s what I think. I mean, I think the markets need to be reassured when you’re in a position where you’ve already cut interest rates to zero. And so an additional way of stimulating the economy is to promise the markets that you won’t surprise them with an interest rate hike. That then gets long-term interest rates to fall a little bit extra. And that’s useful when you’re trying to stimulate the economy. But on the other hand, that, you know, ceased to be the right prescription once inflation started to pick up in ’21. And I think we just need to learn that surprising the market is OK in this environment.

Ryssdal: That’s an interesting thought, and I would love to see that play out in real life just once, to see what would happen if the markets actually got surprised. And maybe we’d all learn the lesson. But look, how do you reconcile that “just do stuff” paradigm with the political awareness that we know Jay Powell has, and that we know Alan Greenspan had, right? They are both very political animals. And it’s just not in their nature to just do things, you know?

Mallaby: I think that’s the modern reality, but it was not true in 1994. For example. I mean, in 1994, what happened was that —

Ryssdal: When we had the last soft landing, we have to set that for everybody, right? The last time the Fed actually negotiated a soft landing.

Mallaby: Correct. And on the way to that soft landing, it’s useful to remember that Greenspan raised rates and surprised the markets. Raised them aggressively, repeatedly. Caused hedge funds to blow up. Almost caused a big bank failure. It caused a lot of financial pain, but as you just pointed out correctly, the real economy had a soft landing. And I think that’s where we draw the lesson, is that sometimes shocking the financial system, causing pain in the financial system is a salutary lesson for risk-takers on Wall Street and can be coupled with a soft landing for Main Street.