Intellectual Garbage Collection (Yet Another Kevin Hassett Edition: "Dishonest and Purposefully Misleading")
John McCain Undermines Henry Paulson

DeLong Smackdown Watch (Special Self-Smackdown Edition): Greenspanism and Its Discontents

For a decade now, I have been a follower of Greenspanism[1]--the doctrine that I name after former Fed Chair Alan Greenspan that the constraint on expansionary monetary policy is inflation and inflation alone. The idea is that the first priority of the central bank is to maintain low consumer price inflation, and that the second priority is--given low current and forecast consumer price inflation--to maintain maximum employment and purchasing power--and the third priority of the central bank is that there is no other third priority.

Opposing Greenspanism is what I call Mussaism[2]. Mussaism--the doctrine I name after former IMF Chief Economist Michael Mussa--holds that there are two constraints on central bank activity. The central bank must insure:

  1. No large asset bubbles.
  2. Consumer price stability.

Only after it has successfully achieved these two higher priorities can it then even begin to worry about:

(3) Maximum employment and purchasing power.

The Greenspanist retort to the Mussaites--a retort I would have said I believed 100% a year and a half ago, 90% a year ago, and 60% last March--is that creating unemployment and idle factories because you are scared of what might happen when irrational exuberance dies away and asset prices collapse is a crime; that modern central banks are powerful; that they can successfully manage whatever crisis is provoked when it happens; and that it is easier to sweep after the elephants have gone through than to try to stop them--especially when stopping them requires the destruction of millions of jobs.

I don't see how I can maintain my belief in Greenspanism today[3].

Therefore I abjure, I recant, and I do penance. I transfer my allegiance and fealty to Michael Mussa, who is my new guru.

[1] Greenspan

Alan Greenspan: Perhaps the greatest irony of the past decade is that... success against inflation... contributed to the stock price bubble .... Fed policymakers were confronted with forces that none of us had previously encountered. Aside from the then-recent experience of Japan, only remote historical episodes gave us clues to the appropriate stance for policy under such conditions. The sharp rise in stock prices and their subsequent fall were, thus, an especial challenge to the Federal Reserve. It is far from obvious that bubbles, even if identified early, can be preempted at lower cost than a substantial economic contraction and possible financial destabilization--the very outcomes we would be seeking to avoid.... The notion that a well-timed incremental tightening could have been calibrated to prevent the late 1990s bubble while preserving economic stability is almost surely an illusion.

Instead of trying to contain a putative bubble by drastic actions with largely unpredictable consequences, we chose, as we noted in our mid-1999 congressional testimony, to focus on policies "to mitigate the fallout when it occurs and, hopefully, ease the transition to the next expansion."

During 2001, in the aftermath of the bursting of the bubble and the acts of terrorism in September 2001, the federal funds rate was lowered 4-3/4 percentage points. Subsequently, another 75 basis points were pared, bringing the rate by June 2003 to its current 1 percent, the lowest level in 45 years. We were able to be unusually aggressive in the initial stages of the recession of 2001 because both inflation and inflation expectations were low and stable. We thought we needed to be, and could be, forceful in 2002 and 2003 as well because, with demand weak, inflation risks had become two-sided for the first time in forty years.

There appears to be enough evidence, at least tentatively, to conclude that our strategy of addressing the bubble's consequences rather than the bubble itself has been successful. Despite the stock market plunge, terrorist attacks, corporate scandals, and wars in Afghanistan and Iraq, we experienced an exceptionally mild recession--even milder than that of a decade earlier. As I discuss later, much of the ability of the U.S. economy to absorb these sequences of shocks resulted from notably improved structural flexibility. But highly aggressive monetary ease was doubtless also a significant contributor to stability...

[2] Consider this passage from Mussa (2004), "Global Economic Prospects: Bright for 2004 but with Questions Thereafter" (Washington: Institute for International Economics: April 1), in which Michael Mussa writes about the then-global financial imbalances:

Michael Mussa: ... Policy interest rates are exceptionally low in most industrial countries: zero in Japan and Switzerland, 1 percent in the United States, 2 percent in the euro area, and at or near historic lows in the United Kingdom and Canada.... The very low level of policy interest rates is an imbalance (relative to normal conditions) that reflects exceptionally easy monetary policies to combat economic weakness. This policy imbalance poses an important challenge for the future conduct of monetary policy.... [T]hese situations tend to be associated with high valuations of equities, real estate, and long-term bonds, which can become fertile ground for large, unsustainable increases in asset prices.... [I]f monetary policy remains too easy for too long (perhaps because subdued general price inflation gives no clear signal of the need for monetary tightening), then large asset price anomalies may develop before corrective action is taken. The monetary authority would then confront the grim choice of trying to keep an unsustainable asset price bubble alive or trying to combat the collapse of such a bubble without a great deal of room for monetary easing...

[3] The only shred of pride in my intellect and foresight I can take in all this is my Brookings paper that warns how collapsing bubbles can produce really serious problems--how central banks need to fear asset price deflation as much as any other kind of deflation. But back then when I wrote this I was confident that they could manage it. Now I am not:

Read this document on Scribd: DeLong: Should We Fear Deflation?