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Positive Economic Commentary
Alan Greenspan Is The Luckiest Fed Chairman In The Post-WWII Period
Back on April 11th, I wrote a commentary entitled, "Bill Clinton Was The Luckiest
President In The Post-WWII Period." This week’s commentary is sort of a reprise to
the April 11th piece - same melody, but different lyrics. The table below shows what
happened to consumer inflation on the watches of post-WWII Fed chairmen. In
terms of the growth in the CPI over the entire terms of the five chairmen, William
McChesney Martin posted the low score at 2.05%. But Alan Greenspan, while still
on the course, is not too many "strokes" off the low net at 3.05%. Another way to
look at the inflation records of the chairmen is to compare what inflation was
running at when they vacated the chair versus what it was when they assumed the
chair. In terms of "most improved," Paul Volcker wins hands down, having shaved
7.54 points off his score. Again, Greenspan still is on the course. But if he were to
step down now, he would leave the chairmanship with the lowest consumer inflation
rate, 2.11%, of all of his predecessors. What I will argue is that the low inflation
that has occurred during Greenspan's chairmanship has had a lot do with his luck of
the draw. In other words, a Fed chairman would have had to have been really inept
to have had a bad record on inflation during the time Greenspan has been
chairman. I might add that, in my opinion, Greenspan's successor will not be so
August 22, 2003
The factors that have made Greenspan's job in controlling inflation easier than his
predecessors are: the breaking of the back of inflation by Volcker, the decade long
stagnation of the Japanese economy, the slowdown in growth of government
spending, the end of the Cold War and the economic opening up of China, and the
formation of the European Monetary Union (EMU).
I have already touched on Fed Chairman Volcker's contribution. When he took the
helm of the Federal Reserve in August 1979, CPI inflation was running 11.82%.
When he handed the helm to Greenspan in August 1987, inflation had slowed to
4.28%. So, Paul Volcker had done most of the heavy lifting in terms of breaking the
back of inflation and inflation expectations by the time Greenspan took over.
The Japanese economy is the second largest economy in the world - third largest if
you treat the EMU bloc as a single economy. Having the second (or third) largest
economy in a stagnant mode for more than a decade takes pressure off global
resource markets. In other words, Japan was not a source of global inflationary
impulses that the Fed would have had to counter. Chart 1 shows the sharp
slowdown in the growth of nominal Japanese domestic demand starting in the
1990s along with the deceleration in U.S. CPI inflation. Correlation does not
necessarily mean causation, but causation in this case is not farfetched.
Government spending is inflationary for two reasons. Firstly, the more resources used or under the direction of the government sector, the fewer resources there are available for use by the private sector. The private sector inherently uses resources more economically efficient than the government sector because it faces day-to-day competition. Thus, the more the government spends, the worse the trade-off will be between real output growth and inflation. The Fed is under political pressure to promote higher employment. The economic stagnation brought about by high government spending induces the Fed to follow a more expansionary policy. This results in stagflation. The other way government spending leads to higher inflation is through incipient upward pressure on interest rates, especially if the spending is financed through debt issuance. In part because of political constraints, in part because of inadequate knowledge, the Fed is typically slow to allow the fed funds rate to rise to a level sufficiently high to prevent faster money supply growth. (See Seven Indicators That Move Markets by Kasriel and Schap for a discussion of the money creation process.) So, the faster money growth prevents the increased government spending from crowding out private aggregate demand, with higher inflation being the result. Chart 2 shows that total government (federal plus state/local) expenditures on goods and services as a percent of GDP throughout most of Greenspan's chairmanship have been the lowest since early 1950s. So, Greenspan has not had aggressive government spending policies to deal with, unlike his predecessors.
An important reason why federal government spending had fallen so dramatically
relative to GDP in the 1990s was the defeat of the "Evil Empire." With the breakup
of the Warsaw Pact, the U.S. could cut back on its military budget.
But another economic benefit of this was the inclusion of former Warsaw Pact economies in the
global trading community. Even more important was the inclusion of China. In
effect, the global economic pie is now significantly bigger with these economies now
participating in global trade. This has put downward pressure on U.S. import prices
as shown in Chart 3.
Lastly, the formation of the EMU forced a number of European countries to get their
inflation rates down and get their fiscal houses in order. For example, Italy had for
years been the bad boy of Western Europe in terms of inflation. And, as shown in
Chart 4, Italian consumer inflation had typically been above U.S. consumer inflation
until the late 1990s. Why the convergence in the late 1990s? Italy had to rein in its
inflation in order to qualify for EMU membership. Italy, along with other European
inflation "offenders" became ex-offenders in preparation for EMU membership in the
late 1990s. Similar to the situation with Japan, Italy no longer was a source of
global inflationary pressures. This eased the inflationary pressures in the U.S. that
Greenspan would have had to combat.
Just as President Clinton enjoyed the "sweet spot" of geopolitical history in the
post-WWII era, I believe that Fed Chairman Greenspan has enjoyed the sweet spot
of inflation history. Volcker left Greenspan a great inflation hand to play. Greenspan
is more likely to leave his successor a hand similar to that which Miller inherited
from Burns. Government spending is on the rise for as far as the eye can see. The
U.S. indebtedness to the rest of the world is high and will be rising as far as the eye
can see. U.S. policymakers will attempt to lessen the impact of this indebtedness
on the standard of living of Americans by running Fed Governor Bernanke's
greenback printing press overtime. At first, this will induce foreign central banks to
speed up their printing presses as no country right now wants a strong currency.
This will lead to global reflation. Later, however, foreign central banks will get that
anti-inflation religion again. This will lead to a run on the dollar and a sharp
acceleration in U.S. inflation.
Director of Economic Research
The information herein is based on sources which The Northern Trust Company believes to be reliable, but we cannot warrant its accuracy or completeness. Such information is subject to change and is not intended to influence your investment decisions.
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