George Santayana, the Spanish philosopher, famously said that those who cannot remember the past are condemned to repeat it.
We have to hope that Kevin Warsh, the Federal Reserve’s new Chair, remembers both the good and bad aspects of Alan Greenspan’s long tenure as head of the Fed. Doing so will heighten Warsh’s chances of being a successful Fed Chair in meeting the Fed’s dual mandate of price stability and maximum employment. It will also help Warsh spare us from any repeat of a 2008-09 style economic and financial market crisis that left a dark stain on Greenspan’s otherwise successful period as Fed Chair.
Start with the good aspects of Greenspan’s long period at the Fed’s helm. Warsh already seems to have internalized Greenspan’s healthy belief that the Fed should avoid declaring premature victory in defeating inflation, especially after a recent inflationary episode. That helped Greenspan consolidate Paul Volcker’s success in getting the early 1980s inflation genie back in the bottle, and in producing the 1990s Great Economic Moderation of rapid economic growth and low inflation. In his first Federal Open Market Committee (FOMC) meeting, Warsh struck an appropriately hawkish tone about the future course of monetary policy. That allayed market fears that he would do President Trump’s bidding and be unduly soft on inflation.
Warsh also seems to have learned from Greenspan’s success as a communicator and as one who used his words sparingly. Not only did Warsh limit the Fed’s recent interest rate policy statement to a mere 130 words, he also indicated that the Fed would no longer continue the practice of giving markets forward guidance and that it would undertake a study of its communication policies with a view to avoiding unnecessarily overloading the public with the Fed’s views.
One of Greenspan’s greatest successes was that he took the then out-of-consensus view in the early 1990s that the internet revolution would substantially increase productivity and reduce wage and price inflation. Armed with that view, he correctly resisted calls for higher interest rates. In turn, that paved the way for rapid economic growth and low inflation through much of the 1990s.
On the eve of the Artificial Intelligence (AI) revolution, Greenspan’s successful handling of monetary policy during the internet revolution has particular salience for Warsh’s term. Fortunately, it seems that Warsh has grasped how the AI revolution can help the Fed achieve its inflation objective without hampering economic growth. In numerous public statements, Warsh has taken the view that AI might be increasing the speed limit at which the economy can grow without compromising the Fed’s inflation target. That view is likely to prevent Warsh from following an unduly tight monetary policy that would otherwise limit the economic benefits that we might derive from the AI revolution.
Where Greenspan failed miserably in his tenure was that he forgot that the Fed is supposed to take away the punch bowl when the financial market party is getting out of hand. By keeping interest rates too low for too long in the first years of the 2000s, he provided fuel for the mother of all housing and credit market bubbles. When that bubble eventually burst in 2008, the US and the world economies experienced their worst postwar economic recession as underlined by an unemployment rate that reached 10 percent.
Warsh now starts his tenure as Fed Chair at the very time when we appear to be in the midst of another financial market bubble. Equity valuations, buoyed by investor exuberance about AI, are now at lofty levels all too reminiscent of those that prevailed on the eve of the bursting of the 2000 dot-com bubble. At the same time, JPMorgan’s Jamie Dimon keeps reminding us that the $3 trillion private credit market has been characterized by irresponsible lending practices that threaten a wave of loan defaults.
If there is one lesson that Warsh should draw from Greenspan’s unfortunate bubble experience, it is that he needs to be prepared to take the punch bowl away from the financial markets before they get further out of hand. In particular, he should turn a deaf ear to siren calls for interest rate cuts anytime soon. Failing to do so is likely to further inflate the financial market bubble and set us up for a hard economic and financial market landing on his watch when that bubble bursts.
Warsh has made a promising start as the Fed’s new Chair. If he is to continue to succeed, he needs not only to keep hewing an independent monetary policy course. He also needs to learn from Greenspan’s major policy mistake that would seem all too relevant today at a time when financial markets once again are characterized by irrational exuberance.