The War and the Fed

["Henry C.K. Liu" <hliu@xxxxxxxxxxxxxx>]

Or how Greenspan will buy himself another term.
Or Liberating Iraq by destroying free financial markets in the US

NYTimes March 30, 2003

Another War, Same General
By EDMUND L. ANDREWS

WASHINGTON -- IT was August 1990, just a few weeks after Iraq invaded
Kuwait, and Alan Greenspan was wrestling with questions eerily similar
to those he faces today.

Mr. Greenspan, the chairman of the Federal Reserve Board, fretted that
Iraqi troops were close enough to start "kamikaze raids" on major Saudi
oil fields. Then, as now, oil prices had soared and financial markets
were panicky. Then, as now, the American economy had begun to weaken
even before the fighting started.
Advertisement


But then, as now, Mr. Greenspan was convinced that the Fed's main job
was to project stability rather than rush to action.

"Those who argue that we are already in a recession, I think, are
reasonably certain to be wrong," he then told the Federal Open Market
Committee, which sets monetary policy. "We have to recognize that there
is a rather limited chance of affecting the economy in a significant
way. I would suspect at this point that the Pentagon has more
policy-making clout than we do."

As it happened, Mr. Greenspan was wrong on an important point. The
National Bureau of Economic Research, which officially defines the peaks
and valleys of economic cycles, concluded later that a recession had
begun that very month. The Fed soon began cutting interest rates, but
the slowdown persisted and contributed mightily to the re-election
defeat of the first President Bush in 1992.

Today, Mr. Greenspan again faces the impact of war against Iraq and what
he has called a "soft patch" at home. Even more than he did in 1990, the
Fed chairman has argued that the American economy is fundamentally sound
and that growth will recover as soon as "geopolitical uncertainties" are
resolved.

But the uncertainties have been increasing. A growing number of experts
worry that business confidence may remain low for some time, even if the
war ends quickly. And when the war may end has become an increasingly
open question. Unemployment has continued to climb, industrial
production remains stagnant and the economies of Europe and Japan are
slumping even more than that of the United States.

Michael Prell, an economist consultant who was the Fed's director of
research from 1987 to 2000, said Mr. Greenspan may be overly optimistic.

"My impression is that he has put a big weight on the war and on the oil
market," Mr. Prell said last week. "But I am not persuaded that
uncertainty about the war is anywhere near the whole story behind the
sluggishness of the economy."

Mr. Greenspan, now 77 and one year away from the end of his fourth
four-year term as Fed chairman, has a complex relationship with the
White House. Alert and energetic as ever, he recently annoyed many
administration officials by casting doubt on the wisdom of the
president's tax-cutting plans.

But Mr. Greenspan is in many respects President Bush's quiet partner in
the war on Iraq.

If the war goes worse than expected, or if the economy does not bounce
back when combat ends, Fed officials have strongly suggested they will
pump money into the economy by reducing interest rates even more than
they have already.

Perhaps equally important to the Bush administration, Mr. Greenspan has
betrayed little anxiety about the costs of war or the risks of
disruption to world oil supplies. Given the extent to which political
leaders and financial markets dissect every word Mr. Greenspan utters,
his apparent comfort is a crucial source of support for Mr. Bush.

The Fed chairman meets regularly with Vice President Dick Cheney, a
longtime friend who is President Bush's most trusted adviser, as well as
with John W. Snow, the Treasury secretary. Mr. Greenspan has been at the
White House at least three times in the past 10 days, and he met with
Mr. Bush on Monday to review the economic outlook.


T the same time, tensions exist between the Bush White House and the
Greenspan Fed.

Many people who worked in the first Bush administration still blame Mr.
Greenspan for the 1992 re-election defeat. And many in the current Bush
White House would dearly like to install their own candidate when Mr.
Greenspan's term as chairman ends in June 2004. Whether Mr. Greenspan
will want to step down then is unclear.

But his credibility in financial markets is so strong and his acuity so
well regarded that Mr. Bush cannot do without him for the moment.

 Despite having long passed what many people consider retirement age,
Mr. Greenspan still appears to thrive in his job. He pores over economic
data like a sports fan immersed in baseball statistics, hunting for
anomalies that provide unexpected clues to what is really happening in
the economy.

In private meetings, administration officials say, Mr. Greenspan has
been unruffled by possible disruptions in Middle East oil supplies. Oil
production is more "elastic" than many people believe, he has told
listeners. And though higher oil prices would constitute a "tax" on the
economy, he has said, they would not necessarily lead to broader
inflation or a recession. He told finance ministers from the Group of
Seven industrialized countries on Feb. 25 that their countries were only
half as vulnerable to oil shocks from the Middle East as they were
during the price shocks of the early 1970's.
Advertisement



The Persian Gulf now accounts for a smaller share of world production
than in 1990, he has said, and the major industrial economies have grown
faster than their consumption of oil.

Mr. Greenspan has also proved himself adept in financial crises. When
the stock market crashed on Oct. 19, 1987, two months after he became
chairman, the Fed lent tens of billions of dollars to financial
institutions and pushed down overnight lending rates. The moves flooded
financial markets with money, which helped them restore confidence.

When terrorists destroyed the World Trade Center on Sept. 11, 2001,
obliterating large parts of Wall Street's financial infrastructure, the
Fed pumped $100 billion into the monetary system in four days. On Sept.
12 alone, the Fed lent banks $46 billion. The Federal Reserve Bank of
New York, which runs the Fed's trading operations, flooded the banking
system with additional billions by buying up Treasury securities at
record volumes throughout the week.


O Fed chairman has had as much influence as Mr. Greenspan, but the key
to that influence is his credibility in financial markets and with
political leaders. Though his reputation has been tarnished since the
stock market bubble burst in 2000, most economists still credit him with
being early to recognize major turns in the economy and bold in his
responses.

In 1994, he began gently raising interest rates in an effort to prevent
the economy from overheating and to engineer a "soft landing" without a
recession. By 1997, he was far ahead of the Fed's own economists in
recognizing that American productivity growth had accelerated sharply,
allowing the economy to grow at a considerably faster rate without
causing inflation. His navigation of rate policy, many economists agree,
helped to foster the longest economic expansion in American history.

"It was the most brilliant forecasting call I can think of in my entire
career as a professional economist," said Laurence H. Meyer, a Fed
governor at the time of that debate who acknowledged he was a "grudging"
convert to Mr. Greenspan's views.

A large number of economists say Mr. Greenspan was too slow in
recognizing the excesses of the "new economy" in the stock market
bubble. But many say Mr. Greenspan was alert in recognizing the economic
slowdown that began in early 2001.

Since then, the Fed has lowered interest rates 12 times and reduced its
benchmark federal funds rate to the lowest level in 41 years.

So far, Mr. Greenspan's policies have dovetailed fairly well with
President Bush's goals. When talk of war escalated last year, raising
anxiety levels in business and among investors, the Fed reduced the
federal funds rate in November by an additional one-half percentage
point, to 1.25 percent from 1.75.

But that decision only focused more attention on how the Fed will
respond to events in coming months.

Fed officials are far less worried about the impact of high oil prices
now than they were during the Persian Gulf war. Back then, fears about
inflation were still widespread and the Fed felt much greater pressure
to respond to higher oil prices with an increase in interest rates.

 Today, inflation expectations are extremely low; in fact, there is
more fear of possible deflation. Even if oil prices move up, Mr.
Greenspan has made it clear that the Fed could easily reduce interest
rates further, without causing inflation.

On March 18, one day before President Bush ordered the bombing of Iraq
to begin, the Fed declared that uncertainties about Iraq had made it too
difficult to assess the "balance of risks" to the economy.
Advertisement


Mr. Greenspan has repeatedly expressed optimism that business and
investor confidence will rebound as soon as shooting subsides in Iraq.
But minutes from the January meeting of the Federal Open Market
Committee suggest that many other Fed officials, expecting a war, were
both baffled and anxious.

"Indeed, a number of members commented that it was possible that some
easing of geopolitical tensions would not lead to a major near-term
upturn in business confidence," the committee reported, adding that
economic growth could turn out to be either much higher or much lower
than expected.

The Fed could face uncomfortable choices regardless of whether the
United States achieves a quick victory.

If the war goes badly, depressing business confidence further and
tilting the country toward a new recession, the Fed has only so much
room for cutting interest rates, since it cannot reduce the federal
funds rate for overnight loans to below zero.

But Mr. Greenspan and other Fed officials insist that even if the
overnight Fed funds rate is zero, they still have tools to stimulate the
economy. They would do so by buying up longer-term Treasury securities,
such as two-year or five-year or even 10-year securities. By paying cash
for such securities, the Fed would essentially be pumping money into the
economy and pushing long-term interest rates even lower than they
already are.

Lyle Gramley, a former Fed governor who is now a senior economic adviser
with Schwab Capital Markets, said that the Fed could push 30-year
mortgage rates as low as 2.5 percent.

"They would have to be ready to stand by and buy every 10-year Treasury
security that anybody wants to sell them at that rate, and they would
have to persist until they have long-term success," Mr. Gramley said.
"We're talking about massive increases of liquidity into the system."

But the Fed has almost no experience with that kind of effort, and
officials acknowledged that the precise impact might prove unpredictable.

There are scores of other issues. The Fed's easy-money policies have
already stoked a storm of home buying and refinancing, prompting
consumers to convert the equity in their homes to cash to buy furniture,
appliances and cars. But this easy money has done nothing to rejuvenate
business spending, and a growing number of economists suspect that war
jitters are not the only reason.

"The Fed is powerful, but it's powerful over the long term," said Allan
Meltzer, an economics professor at Carnegie Mellon University and author
of a voluminous new history of the Federal Reserve. "The mistake comes
in thinking that they can turn things around quickly."

But the White House may face problems from the Fed if the war in Iraq
turns out exactly as administration officials hope. Assuming that a
quick victory helps to revive business confidence and the stock markets,
Fed officials have already made it clear that they would soon need to
start raising interest rates to thwart inflation.

Diane Swonk, chief economist at the Bank One Corporation, predicted that
the Fed could start raising rates just as the presidential election
campaign heats up.

"It's going to take a lot of skill, and it's going to take some conflict
between the administration and the Fed," added Mr. Meltzer, noting that
Fed monetary policy has been relaxed for a long time and that rapidly
rising federal budget deficits create added pressures on the Fed to
tighten up.

Mr. Greenspan has provided no hint of whether he wants to continue after
his term as Fed chairman expires. Because of the peculiarities of rules
governing terms on the Fed board, Mr. Greenspan's term as a governor
does not actually expire until 2006. That raises the perplexing
possibility of Mr. Greenspan staying on as a governor even if the White
House wants a new chairman.

People who know Mr. Greenspan — and who emphasize that they have no
direct information — say they believe he wants to remain chairman at
least until 2006. Most of the speculation about possible successors
centers on Martin Feldstein, a Harvard professor who was chairman of the
Council of Economic Advisors under President Ronald Reagan.

Others mentioned as possible successors are John B. Taylor, a respected
monetary economist who is now deputy secretary of the Treasury; and R.
Glenn Hubbard, who stepped down recently as chairman of Mr. Bush's
Council of Economic Advisers and returned to Columbia University.

Still, none of the names have generated much excitement among Fed
watchers and most analysts believe the Bush administration will not
focus on the issue until the war with Iraq is over.


WHAT is most striking is the White House's refusal to criticize Mr.
Greenspan publicly, even when he upsets it with disparaging remarks
about the administration's contention that the country needs big tax
cuts. Shortly after Mr. Greenspan expressed skepticism during a Senate
hearing last month, Robert Novak, the conservative columnist, quoted
unidentified White House officials as saying that Mr. Greenspan might
not be nominated for another term as chairman.

But administration officials quickly put out the word that they were not
at all unhappy with Mr. Greenspan, and that they held him in the highest
regard.

Whether or not that is true, the behavior is in sharp contrast to that
of top officials in the Reagan administration and the first Bush
administration, who routinely and publicly criticized Fed decisions that
displeased them.

David M. Jones, an economist and author of many books on the Fed, said
Mr. Greenspan's importance in world markets and his close ties to people
like Mr. Cheney meant that Mr. Greenspan still had control over his future.

"I think the most important person in deciding the successor of Alan
Greenspan," Mr. Jones said, "will be Alan Greenspan."