The Economy

GREENSPAN TO THE RESCUE

The U.S. Federal Reserve unexpectedly slashes interest rates amid fears of recession

Andrew Phillips January 15 2001
The Economy

GREENSPAN TO THE RESCUE

The U.S. Federal Reserve unexpectedly slashes interest rates amid fears of recession

Andrew Phillips January 15 2001

GREENSPAN TO THE RESCUE

The Economy

The U.S. Federal Reserve unexpectedly slashes interest rates amid fears of recession

Andrew Phillips

The trouble with being an icon is you have nowhere to go but down. Alan Greenspan, legendary maestro of the markets, engineer of seemingly endless economic expansion, was looking like a genius—until all of a sudden he wasn’t. The U.S. economy, after racing ahead for more than nine years, was abruptly showing signs of veering into the ditch. Tech stocks plunging, consumer confidence sagging, layoffs spreading—all just in time for Christmas. From investors, analysts and politicians, the cry went up: do something!

Last week, Greenspan and his fellow governors of the U.S. Federal Reserve Board did something—and did it in spectacular fashion. In a major turnaround, they cut their key interest rate, the federal funds rate, by half a percentage point to six per cent. And they compounded the effect by adding the element of surprise, acting between their regularly scheduled meetings and earlier than anyone had expected. The move sent stock prices soaring—before falling back towards the end of the week—but also brought a chorus of I-told-you-so’s from a growing number of critics who blamed Greenspan for not cutting rates sooner after hiking them six times in 1999 and 2000 to cool off the red-hot economy. “The Fed is finally wising up,” says Kevin Hassett, a former economist at the Federal Reserve and now a scholar at the American Enterprise Institute, a conservative Washington think-tank. “They recognize that they screwed up and they’re trying to fix it.”

Screw-up or not, the Fed’s decision to act so dramatically underscored the sudden weakening in an economy that has seemed charmed for almost a decade. The last few weeks of 2000 brought a cold shower of bad news. Giants of the New Economy, like Microsoft Corp. and Intel Corp., warned they would miss their targets for quarterly earnings—and saw their stock prices clobbered. Stalwarts of the so-called Old Economy, like the Big Three automakers, saw sales plummet and announced sweeping layoffs. And economic growth slowed from 5.6 per cent in the second quarter of 2000 to just 2.2 per cent in the July-to-September

period—the economic equivalent of slamming the brakes on a speeding car.

Most worrisome to many economists, shoppers turned stingy at the worst possible time— just as the holiday selling season should have hit its stride. Consumer confidence fell sharply and Christmas sales were up a scant three per cent, compared with 6.2 per cent the year before. By year-end, the gloom was palpable. U.S. stock markets ended the year with the worst returns in two decades—the tech-heavy Nasdaq down 39.3 per cent, its biggest drop ever. With a record 49 per cent of American households owning stock, either directly or through mutual funds and retirement accounts, the result was predictable. People felt poorer—and spent less.

Even with all that, only a few forecasters predict an actual recession—two quarters of negative economic growth—in 2001. In a year-end survey of 54 prominent economists compiled by The Wall Street Journal, just two saw a recession. Most maintained that the economy will slow in the first half of the year, then recover to just below three-per-cent growth by the end— not the blazing pace of recent years, but hardly a disaster. Ken Matheny, senior economist at Macroeconomic Advisers, a leading forecasting company in St. Louis, sees growth at three per cent this year. “There’s more of a sense of fragility,” he says. “But strictly based on the fundamentals, the economy is in good shape.” Greenspan, as chairman of the Fed for the past 14 years, inevitably must make a political calculation as well as an economic one. Advisers to George W Bush, who takes over as president on Jan. 20, had been warning for weeks that the economy was slowing, that even a recession might be on the way. The Fed’s decision to cut rates validated those concerns—as did its delicately worded warning that the main risk it sees is “economic weakness in the foreseeable future.”

Bush, who by coincidence was holding an economic summit with friendly business leaders (many of them big contributors to his campaign) in Austin, Tex., when the Fed made its announcement, took it much further. He said the cut was needed “to make sure that our economy does not go into a tailspin”—-even though almost no one has predicted anything like an economic “tailspin.”

More important, Bush argued that the Fed’s move shows that his warnings « about a weakening economy were justified, and more help is needed in the form of lower taxes. He proposes using much of the projected federal surplus to reduce taxes across the board by $1.3 trillion over 10 years. With Democrats insisting on a more modest cut (closer to $500 billion) targeted at middleand lower-income workers, that is likely to spark a major fight in Washington soon after he moves into the White House. “The tax relief plan I’ve put forward,” said Bush, “is an integral part of economic recovery.”

The dilemma for Bush is that his opponents will argue just the opposite—that Greenspan has demonstrated clearly that he is on top of the situation and a big tax cut is not needed to get the economy moving. More to the point, economists agree that interest rate cuts work much quicker than tax cuts, which would likely take months to implement—by which time the economy could well be growing briskly again. And Greenspan has made it clear in the past that he prefers to see government surpluses used to pay down debt rather than to cut taxes—setting up a possible conflict between him and the incoming Bush administration.

That, of course, would just be a repeat of history. Bush’s father famously blamed Greenspan for torpedoing his chances of re-election in 1992 by refusing to cut interest rates then and prolonging the hangover from the 1990-1991 recession. “I reappointed him-—and he disappointed me,” Bush Sr. said of the Fed chairman. The younger Bush has been widely quoted as blaming Greenspan in private for keeping rates too high too long, and souring the economy just as he is about to take office. “He kicked my father on the way out, and he’s kicking me on the way in,” Bush has supposedly said— though his advisers deny any such comment.

In fact, Bush has gone out of his way publicly to embrace Greenspan, both figuratively and literally. Greenspan was the first person he met when he came to Washington for the first time last month after being declared president-elect. After the get-acquainted session, Bush pointedly threw his arm around the shoulder of the bemused Fed chairman and praised him as “a good man”—in his language the highest accolade possible. The reality is that Bush has little alternative but to get along with Greenspan, whose current term as Fed chairman runs until 2004. His slowness to act this time may have brought out the critics. But after 14 years of piloting the U.S. economy, his mystique is as great as ever. CD