Alan Greenspan's Legacy On Inflation And Trade

Former Federal Reserve Chairman Alan Greenspan died Monday at age 100. He served more than 18 years (from August 1987 to January 2006) as Fed Reserve chair. He was renominated again and again by one president after another, partly because he was doing such a good job of keeping both inflation and unemployment low.

Brilliance on Inflation and Unemployment

In his memoirs, Greenspan partly attributed his success and that of his predecessor Paul Volcker to having implemented the advice of Milton Friedman, founder of the "Monetarist" school of economics. He wrote:

The money supply, then measured by a statistic called M1, consists mostly of currency in circulation and demand deposits, such as checking accounts. When money expands faster than the totality of goods and services produced – in other words, when too many dollars chase too few goods – everybody's money tends to be worth less, that is, prices rise. The Fed could indirectly control the money supply by controlling the monetary base, mainly currency and bank reserves. Monetarists like the legendary Milton Friedman had long argued that until you contained the money supply, you hadn't tamed inflation. [p. 85]

During Volcker's term, slowing the growth in money supply led to high interest-rate shock-therapy which brought unemployment up to 10.8% in 1982 while bringing inflation down from its peak at 14.8% in March 1980 to 4.3% when Volker left office in August 1987.

It was not easy for Greenspan to follow Friedman's prescription that M1 should increase just slightly faster than the economy, because new inventions, including credit cards and money market accounts, kept making M1 an ever-less accurate measure of the amount that consumers and businesses could spend. But Greenspan was up to the task. Over his 18 years at the Fed, the inflation rate never rose above 5.4% (May 1989) and the annual unemployment rate never rose above 7.4% (1992). Each year, Greenspan's Fed would take in more interest from its government bond holdings than it needed for its expenses, and then would rebate its resulting budget surplus to the U.S. Treasury.

Instead of managing interest rates by manipulating money supply, Greenspan's most recent successor, Jerome Powell, managed interest rates through an expensive price floor. It all started when Greenspan's immediate successor at the Fed, Ben Bernanke, responded correctly to the Great Recession of 2008 by buying the bad mortgage loans from U.S. banks so that those banks could again become solvent and start lending.

Bernanke did not invent Quantitative Easing. It had been invented by the Bank of England (Britain's central bank) in 1914 when the balance sheets of Britain's banks were filled with bad loans to European countries with which Britain was at war. So, the Bank of England bought up all of those bad loans from British banks at "face value," and then those banks had the ability to finance the investment that was needed for the British war effort.

So, Bernanke's first Quantitative Easing was justified. It quickly got the American economy going again and prevented the Great Recession of 2007–2008 from turning into a second Great Depression. If Bernanke had stopped buying long-term bonds and building up the money supply, he would have gone down in history as one of our greatest Fed chairs ever. Unfortunately, he treated "Quantitative Easing" as a new toy and used it to increase money supply again and again, as did his incompetent successors Janet Yellen and Jerome Powell.

As a result of the huge money supply that the Federal Reserve has built up since Bernanke's chairmanship, inflation peaked at 9.1% in June 2022. In order to contain that inflation, Jerome Powell's Federal Reserve used an expensive-to-maintain price floor to bring-up interest rates. Instead of rebating interest earned on government bonds to the Treasury, the Federal Reserve under Powell ran huge budget deficits.

If Kevin Warsh, the new Chairman of the Federal Reserve is wise, he will gradually sell off the Federal Reserve's huge bond inventory and return to the inexpensive and successful method that Alan Greenspan used to keep both inflation and unemployment low.

Blindspot on Foreign Trade

In 1997 Greenspan made his biggest mistake at the Federal Reserve. He let the currencies of the Asian Tigers, the booming countries around the Pacific Rim, collapse without offering their central banks currency swaps that they could have used to stabilize them. When the Federal Reserve failed to help them in 1997, their central banks sought to build up huge dollar reserves to prevent currency collapses in the future. Bernanke's successor at the Fed explained their strategy in a March 2006 lecture:

In practice, these countries increased reserves through the expedient of issuing debt to their citizens, thereby mobilizing domestic saving, and then using the proceeds to buy U.S. Treasury securities and other assets. Effectively, governments have acted as financial intermediaries, channeling domestic saving away from local uses and into international capital markets.

As money poured into U.S. securities, competitors discovered what Japan had already discovered, that building up dollar reserves allowed them to steal American industries. The financial flows boosted the value of the dollar, making U.S. manufacturing uncompetitive. The U.S. manufacturing workforce declined from 17.6 million to 14.2 million between January 1998 and January 2006 when Greenspan left the Fed.

In October 2008, Bernanke showed that he had learned from Greenspan's 1997 mistake. When the dollar spiked upward in foreign exchange markets due to a sudden international liquidity crunch following the Lehman Brothers collapse, he offered currency swaps to friendly central banks so that they could borrow dollars and use them to strengthen their own currencies or help their own businesses pay dollar-denominated loans. It was Bernanke's finest hour.

But Bernanke and his successors never figured out that they needed to prevent one-sided capital flows engineered by foreign central banks. Offering currency swaps is not enough. If foreign central banks insist upon buying dollar reserves, then the Fed can simply buy the same value of their currency reserves that they buy of dollar reserves.

It is worth emphasizing that two-sided flows provide a solution to the "Triffin paradox." Some economists, following Robert Triffin (1960), assume that trade deficits are inevitable in the country whose currency serves as the world's reserve currency. But there is nothing inevitable about them. Foreign dollar reserves can be created through currency swaps without giving the United States trade deficits. Bernanke's currency swaps demonstrated this technique. Two-sided currency flows provide international liquidity without requiring trade imbalances.

As far as inflation and unemployment are concerned, Greenspan gets an "A". As far as international trade is concerned, he gets an "F". The new Federal Reserve Chairman Kevin Warsh should learn from the mistakes of Greenspan and his successors. He could let his counterparts at foreign central banks know that the era of one-sided currency flows is over.

The Richmans co-authored the 2014 book Balanced Trade, published by Lexington Books, and the 2008 book Trading Away Our Future, published by Ideal Taxes Association.

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