AS THE ECONOMY TURNS

GHOSTS OF MEETINGS PAST

Dr. William Shingleton

February 7, 2006

Being the new Chair of the FEDERAL RESERVE BOARD is quite a job. Not only do you have to bear the responsibilities that are associated with guiding the world’s most important economy, at $183,500 you are not even particularly well-paid [SOURCE: <http://www.federalreserve.gov/generalinfo/faq/faqbog.htm#3>]. Even worse, when you are new, as BEN BERNANKE is, you have to battle ghosts. The ghost of ALAN GREENSPAN’S term is going to hang over every decision for a while, so it is going to be a little like going out on what you thought was going to be a hot date with a new character and hearing him/her talk all night about how great the old girlfriend/boyfriend was. There is other, more important ghosts as well, those of A.W. PHILLIPS and the paper he wrote in 1958. At least Mr. Phillips really is dead.

Let’s look at everything through the two most popular lenses for viewing the health of our economy, the RATE OF INFLATION and RATE OF UNEMPLOYMENT. Both of these measures are assembled by the BUREAU OF LABOR STATISTICS in monthly reports to the world. The rate of inflation attempts to measure how fast retail prices are rising, so anytime it is a positive number, that means that prices are going up. [NOTE: The BLS inflation rate does not include the cost of any taxes. We will be using the historical data from : <http://data.bls.gov/PDQ/servlet/SurveyOutputServlet>. When we give the inflation reading for a month, such as August, what we have done is to calculate the percentage change in the price index over the most recent 12-month period.]

The rate of unemployment attempts to measure the percentage of people who are in the labor force and who are looking but are unable to find a job. Again, we will be using the historical BLS data from : <http://data.bls.gov/PDQ/servlet/SurveyOutputServlet>. The BLS provides the seasonally adjusted data for each month so there are no necessary calculations on our part.

Compared to Mr. Bernanke, Mr. Greenspan actually had bigger shoes to fill when he took over from PAUL VOLCKER in 1987. Mr. Volcker had accomplished quite a bit during his tenure, including getting along with both Jimmy Carter and Ronald Reagan, and re-establishing the credibility of the FEDERAL RESERVE after taking over from the incompetent G. WILLIAM MILLER in 1979. [NOTE: Mr. Miller, in turn, may have been the least qualified chairman of all time, so Mr. Volcker did not have to worry about filling his slippers. Miller had been appointed because he was Finance Chairman in the Jimmy Carter election campaign, which just goes to show that George W. did not invent cronyism. It has to be just a coincidence that both have G.W. as their first two initials. A listing of all of the chairmen of the Federal Reserve Board is provided by the Federal Reserve at: < http://www.federalreserve.gov/bios/boardmembership.htm#chairmen>].

When Mr. Volcker took over, the inflation rate was 11.8 percent and there was some discussion about whether or not it would ever go back down below ten percent again. However, by the time he resigned in 1987, the rate of inflation was down to 4.0 percent, so his term, if judged on this basis, was a spectacular success. It is hard to imagine now, but because Mr. Volcker was so successful in taming inflation, there was considerable debate about whether or not Mr. Greenspan could handle the job. Again sticking to the two most widely recognized measurements of the economic health of the nation, we find that Mr. Greenspan took the 4.0 percent inflation rate he had been left with in 1987 and brought it all the way down into negative territory in April 2002 [NOTE: As noted earlier, we are using 12-month data here. There have been a number of individual months with negative data but they are mostly aberrations.]. When DEFLATION, meaning prices actually going down, was recognized as a potential problem in our financial markets, policy was adjusted to bring inflation back up to a safe, low level. At last report, even with the effect of the higher energy prices, inflation is right back to the 1987 level of 4.0 percent. Unlike Mr. Volcker, Mr. Greenspan did not have an inflation dragon to slay, but he kept his sword sharp and his horse saddled. Most of us hope that Mr. Bernanke will have a similar experience.

The tenures of the last two chairs also vary widely on their experiences with unemployment. Mr. Volcker never really got blamed for the wild ride the country experienced with the unemployment rate during his time at the Federal Reserve, from the 5.9 percent when he took over, to a peak of 11.4 percent in January 1983 and back down to 5.8 percent when he left. To some extent, that was thought to be the ghost of Mr. Phillips presiding. In contrast, Mr. Greenspan’s effect on the unemployment rate has been even more remarkable. He took the 5.8 percent that he started with and, while it bumped up to 7.8 percent in June 1992, it has spent a few months under 4.0 percent and now, even with the slowing of the economy at the end of 2005, it is only 4.7 percent. [NOTE: New data come out Friday morning.] Nobody knows for sure what the ideal rate of unemployment in the United States might be, but it does seem that Mr. Bernanke is coming in while we are in the neighborhood.

Mr. Bernanke’s first responsibility is going to be to convince the markets that he can handle the job. When the first crisis comes, as it will, there will inevitably be comparisons to how Mr. Greenspan would have handled it. Greenspan was more of a tealeaves kind of guy, looking into every corner of his data cup. Mr. Bernanke, by most accounts, seems to lean toward a set of simple and fixed policy rules. There is nothing wrong with that until the underlying parameters change. Mr. Greenspan, by avoiding fixed rules, and by talking in an unknown dialect, could steer policy up or down any time he thought it necessary. Mr. Bernanke, who speaks an understandable form of English, may scare the markets the first time he needs to change his mind, because that may mark him as indecisive. Only after Mr. Bernanke weathers his first crisis will the ghost of Greenspan be banished from the discussions.

But the other ghosts are A.W. Phillips and the paper he wrote in 1958 [See the journal, ECONOMICA, November 1958]. In modern economics we are well beyond the idea of a simple trade-off between inflation and unemployment. However, as Keynes said “…in the field of economic and political philosophy there are not many who are influenced by new theories after they are twenty-five or thirty years of age.” [SOURCE: THE GENERAL THEORY 1936]. In spite of the facts, many of the policy-makers in the governments around the world, including here in the united States, still have the concept in the back of their minds, so many of the reactions to the decisions at the Federal Reserve will be forged in that crucible.

The idea is that increases in aggregate demand will cause increases in both output and prices. The output increases will require more resources to be used, increasing the demand for inputs like labor, raising employment, and reducing the unemployment rate. The reason we do not just push demand to the limit is that, as aggregate demand increases, we begin to strain our capacity limits in our resource markets, increasing wages, and firms pass more and more of the cost increases on to their buyers in terms of higher prices and inflation. If this is your perspective, then there is a concern about how fast we can push the aggregate demand to provide jobs and income for the economy.

Mr. Greenspan, among others, believes that, through improvements in technology, we are in the process of expanding our capacity a good deal faster than many people anticipated. The more rapid expansion of capacity by integrating improvements in productivity, have allowed the Federal Reserve to push the economy toward faster growth rates than most models were predicting while not causing substantive increases in prices. From what we have seen, Mr. Bernanke comes to much the same conclusions, although from a slightly different angle, allowing a greater role for MARGINAL TAX RATES, the percentage of your money that the government steals as your income rises. If Mr. Bernanke is as well-spoken as his reputation, he may be able to continue the case for more rapid growth in the economy. However, if the economy stumbles, particularly with respect to inflation, the ghost of Mr. Phillips will be among the critics.

Final notes: If you would like to be removed from the distribution list just send a reply on email. Back issues are available on my website <http://www.oocities.org/wsirius30/2cents.html>. The opinions expressed in these newsletters are those of the author. Comments, including suggestions for future newsletters, are always welcome.