A hard act to follow
Oct 13th 2005
From The Economist print edition
Who could fill Alan Greenspan's shoes?
ON THE ground floor of the Federal Reserve building in Washington, DC, there is an electronic game which tests a visitor's skill at setting interest rates. You have to decide how to respond to events such as rising inflation or a stockmarket crash. If you get all the answers right, the machine declares you the next Fed chairman. In real life, because of huge uncertainties about data and how the economy works, there is no obviously right answer to the question of when to change interest rates. Nor is there any easy test of who will make the best Fed chairman. So who would The Economist select for the job?
Alan Greenspan will retire as Fed chairman on January 31st, after a mere 18 ½ years in the job. So George Bush needs to nominate a successor soon. Mr Bush has a penchant for picking his pals to fill top jobs: last week he nominated his personal lawyer Harriet Miers to the Supreme Court. But his personal bank manager really would not cut the mustard as Fed chairman. This is the most important economic-policy job in America—indeed in the whole world. The Fed chairman sets interest rates with the aim of controlling inflation, which in turn helps determine the value of the dollar, the world's main reserve currency. It is hardly surprising that financial markets worldwide can rise or fall on his every word.
Financial markets are typically more volatile during the first year after the handover to a new chairman than during the rest of his tenure. In October 1987, barely two months after Mr Greenspan took office, the stockmarket crashed. Current conditions for a handover are hardly ideal. America's economy has never looked so unbalanced, with a negative household savings rate, a housing bubble, a hefty budget deficit, a record current-account deficit and rising inflation. Figures due on October 14th are expected to show that the 12-month rate of inflation has risen above 4%—its highest since 1991.
Because Mr Greenspan is widely rated by investors as the greatest central banker ever, their confidence in his mystical powers has helped to hold down bond yields and prop up the dollar. But combine America's domestic and external financial deficits with a looming “Greenspan deficit” next year and markets could well push down the dollar and push up bond yields, thereby bursting the housing bubble. With inflationary pressures rising, the new Fed chairman will need to push short-term interest rates higher; there will be much less room to cut rates later, as Mr Greenspan did after the stockmarket bubble burst in 2001. Would any sane person want this job?
It is worth recalling that in 1987 many doubted whether Mr Greenspan could fill Paul Volcker's shoes. The skills required of a Fed chairman are indeed demanding. He or she needs to be an expert in monetary policy, have a good instinct for economic data and an insight into the big policy debates. A chairman must be respected by financial markets, able to keep a cool head in crises, and be politically independent, while well attuned to political opinion. Mere mortals need not apply.
All the main candidates commonly touted are highly respected economists who could be trusted to pursue a sound monetary policy, and yet each also has serious drawbacks. President Bush said last week that he is looking for a successor to Mr Greenspan who would be seen as politically independent and who would thus inspire global confidence. Yet the leading candidates have all advised or worked for Mr Bush. Mr Greenspan, of course, also has close Republican ties, but financial markets will be less forgiving of his replacement. Any suspicion that Mr Bush has selected someone simply because he is a loyal Republican would undermine confidence in the next chairman, even before he takes office.
Expert and independent
If Mr Bush means what he says about the next chairman being politically independent, then we believe the best choice would be Don Kohn, a governor on the Federal Reserve Board, who is not affiliated to any party. Mr Kohn has another big advantage. As a staff member before being promoted to governor in 2002 on Mr Greenspan's recommendation, Mr Kohn has been attending the Fed's policy-making meetings for almost 24 years, even longer than Mr Greenspan. His vast experience of monetary-policy decisions and financial crises would be invaluable in troubled times. He is highly regarded by economists in the Fed and on Wall Street, and having worked with Mr Greenspan for so long, his thinking on interest-rate policy and financial markets is also close to the chairman's. He would offer continuity and a safe pair of hands.
Yet how can The Economist endorse Mr Greenspan's right-hand man, when we have long criticised the chairman for failing to curb the stockmarket bubble in the late 1990s, and later for propping up the economy by inflating a housing bubble? The answer is that the maestro seems to be changing his tune. In several recent speeches Mr Greenspan has expressed concern about the housing market and, in an apparent effort to talk it down, gave warning that prices could fall. There is a stronger case for restraining housing bubbles than stockmarket bubbles, because they tend to cause greater economic harm when they burst. His public view on the link between monetary policy and asset prices has also shifted. He now concedes that the Fed's success in delivering low inflation and interest rates may have made bubbles more likely, ironically, because investors are demanding less compensation for risk.
Whether central banks should respond to asset-price bubbles is one of the hottest debates in monetary policy. The Fed's failure to curb bubbles, while aggressively easing policy when they burst, is partly to blame for America's imbalances, which could give the next Fed chairman a lot of grief. Mr Kohn's experience within the Fed makes him the best man to cope with this. Mr Greenspan could help him immeasurably and enhance his own legacy by going much further, and explicitly supporting the view of many other central banks that sometimes policymakers should act to restrain asset-price booms. When you are the world's greatest central banker, after all, you should be able to admit the odd mistake.