Many believe he is invincible, but when it comes to market forces Alan Greenspan is a mere mortal.
The ancient Greeks believed their world was ruled by gods and goddesses living on the summit of Mount Olympus.
There was a god of the sea, Poseidon; a goddess of love, Aphrodite. From this lofty pinnacle, the Olympians decided the fate of mortals, rewarding the good and punishing the wicked. They were very like human beings, apart from being endowed with superhuman powers. But in a world vulnerable to war, pestilence and disaster, the rulings of the Olympians provided an explanation for when life got tough.
The modern world has its own Olympians. Wim Duisenberg, president of the European Central Bank, is a new Olympian, as is Horst Köhler, the managing director of the International Monetary Fund. Mike Moore, director general of the World Trade Organisation, is another, along with Bill Gates, Rupert Murdoch and a host of lesser deities.
While there seems to be no candidate for the new Aphrodite, there is no doubt who is the Zeus in this pantheon: Alan Greenspan, chair of the United States Federal Reserve. When he acted last week to cut half a point off US interest rates it was the equivalent of a thunderbolt hurled down from on high. Such was the faith in this god of gods that the markets instantly stopped selling shares and began buying truckloads instead.
Greenspan had spoken. All would now be well. The reaction of the financial markets is fascinating, for two reasons. First, it is in flat contradiction to the orthodoxy of the past quarter-century, namely that policymakers have little control over economic activity, and that when they do try to meddle they do more harm than good.
Yet here we had the situation where the mood in the markets changed simply because a central banker had loosened monetary policy by half a point. This belief in the omnipotence and omniscience of technocrats was supposed to have died out in the mid-1970s, but is apparently alive and well in the dealing rooms of Wall Street.
As John Llewellyn of Lehman Brothers put it recently: “Investors and traders typically pore over policymakers’ utterances with an almost unimaginable intensity, revealing a belief in the effectiveness of policymaking that the policymakers, or at least their advisers, rigorously deny.” This does not mean policymakers are powerless. Take the following example.
A government comes into power committed to a policy of “education, education, education”. Three and a half years later, the number of applications for post-graduate teaching courses is down 16,1% on the year and some schools are going on four-day weeks. Clearly, there is a shortage of people willing to sell their labour to the government for the going rate. The solution is to raise salaries.
There is a mismatch between demand and supply—the culmination of decades in which increased workload and the decline in teachers’ pay have made the job less attractive. In a perfect market either the salaries of teachers would rise to attract and retain more or consumers of education would take their custom elsewhere. Given that the government is a monopoly employer and, for most, a monopoly provider, it can buck the market.
But the problem can only be resolved by making them work harder, importing teachers from overseas, cutting the length of the school week, or a combination thereof. Even then, it is only a short-term solution. Teachers of economics, assuming that there are any left, might like to get their A-level students to sketch out some demand and supply curves for teachers to see why this is the case.
Resolving a market failure in education is one thing; assuming Greenspan can play god is quite another. Increasing the supply of teachers is a two-dimensional problem; steering the global economy away from recession involves making sense of the decisions of millions of individual economic agents. This would be impossible even if they behaved rationally, but they do not.
After the bail-out of Long Term Capital Management in 1998, we were assured that the markets had learned their lesson. But last weekend rumours were swirling about exactly which US institution managed to lose so much money that Greenspan was forced to take emergency action.
Greenspan is a clever man, but his attempts to manipulate macroeconomic policy amount to little more than a shot in the dark. Even in the days when policymakers were shielded from global events by tariff barriers and capital controls, it was absurd to believe that by pulling a few levers the economy could be kept in a state of perfection.
Today, with most of the barriers to trade and money torn down, it is impossible for central bankers and finance ministers to know what the effects of any policy move will be. A cut in interest rates should stimulate demand, but if individuals and firms believe the move is a portent of hard times, it may encourage them to save, rather than spend.
Even if it does boost demand, some of the additional spending may leak out in the form of higher imports. Greenspan knows this. The Federal Reserve is privately putting it about that the rate cut was not prompted by signs of distress but by the need to reassert its psychological hold over the markets. This has the ring of truth about it. Greenspan’s one real weapon is his ability to generate confidence, particularly among those who are the true believers in the myth of his invincibility—the practitioners in the financial markets.
But as with the ancient Greeks, the time comes when faith starts to wear thin. It is becoming clearer that the US faces two structural problems—over-investment by companies and an orgy of debt-financed spending by consumers. Over-investment explains the spate of recent profit warnings, an intensification of a trend that has been under way for two years: the fact that too much of the capital spending during the heady days of the boom was not profitable.
This explains why inventories are piling up and why the real long-term threat to the US is not inflation but deflation. Up to a point, the extra supply has been soaked up by consumers’ live-now, pay-later approach, but this only works when lenders and borrowers are willing. When banks are reluctant to extend credit and consumers are trying to rebuild their savings, cutting interest rates is—to coin a phrase—pushing on a piece of string.
The Federal Reserve was right to cut rates, and there will be further cuts before the year is much older. But to believe anybody is really in control of the global economy is as fanciful as believing that winter begins when Persephone descends into the underworld. That may be a scary thought, but it is the way that it is.