On December 5, 1996, Alan Greenspan, then chairman of the Federal Reserve, gave one of his most memorable speeches, “The Challenge of Central Banking in a Democratic Society.” In that speech, given while accepting the Francis Boyer Award from the American Enterprise Institute (AEI), he coined the term “irrational exuberance.” Greenspan asked, “How do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions … ? And how do we factor that assessment into monetary policy?”

Monetary Policy and Financial Stability

That question remains to be answered as the Fed ponders tapering its large-scale asset purchases (also known as quantitative easing or QE) and raising its policy rate. The Fed has no crystal ball to tell it when there are asset bubbles or whether those bubbles need to be tamed by more restrictive monetary policy. Nevertheless, Greenspan realized that monetary policy cannot be separated from financial stability:

We should not underestimate or become complacent about the complexity of the interactions of asset markets and the economy. Thus, evaluating shifts in balance sheets generally, and in asset prices particularly, must be an integral part of the development of monetary policy.… A central mission of the Federal Reserve [is] to maintain financial stability and reduce and contain systemic risks. This mission is an extension of our monetary policy. Our country cannot enjoy the long-run “maximum employment and stable prices” objectives we are given for monetary policy if the financial system is unstable.

While recognizing the importance of financial stability, Greenspan was reluctant to outguess markets if they looked frothy. What he did do is to have the Fed seek to set a floor beneath stock prices, which become known as the “Greenspan put.” Thereafter, market participants expected the Fed to support asset prices by lowering the policy rate whenever markets tanked, but not try to prick a bubble. That policy has continued ever since.

Although “irrational exuberance” has gained the most attention from Greenspan’s speech 25 years ago, there are other parts of his speech worth reflecting upon—namely, the social function of money, the Fed’s primary mission, the limits of monetary policy, central bank independence, and rules versus discretion in the conduct of monetary policy.

Money’s Social Function

Greenspan began his speech by reminding us that “at root, money—serving as a store of value and medium of exchange—is the lubricant that enables a society to organize itself to achieve economic progress.” Sound money (i.e., money that maintains its long-run purchasing power), is the glue that holds a free-market system together. In contrast “erratic money” (i.e., wide variations in the quantity of money relative to the demand for money), distorts market price signals and the allocation of resources. Rational economic calculations, especially those affecting investment decisions, become more difficult when the future value of money is uncertain. Inflation and deflation that follow from erratic money undermine both economic and social order. As Greenspan notes,

the general price level, that is, the average exchange rate for money against all goods and services, and how it changes over time, plays a profoundly important role in any society, because it influences the nature and scope of our economic and social relationships over time.

It does so not only by influencing the allocation of resources but by impacting the distribution of income. Prices do not move uniformly following an excess supply of money or in response to monetary deflation. There will be winners and losers. Consequently, monetary policy will always have political implications depending on the interest groups affected. In the current environment of near-zero interest rates and QE, investors in stocks and real estate have gained, while those holding saving accounts with negative real interest rates have lost.

Greenspan recognized the distributional effects of erratic money and stated: “Any institution that can affect the purchasing power of the currency is perceived as potentially affecting the level and distribution of wealth among the participants of that society, hardly an inconsequential issue.”

The Fed’s Core Mission

For Greenspan, the Fed’s “most important mission … is monetary policy.” The key facet of that policy is to maintain long-run price stability. That is why he told his AEI audience that the Fed must act as the “ultimate guardian of the purchasing power of money,” and must be held accountable. Today’s calls for expanding the Fed’s mandate to include climate change and racial/​economic equity (see, e.g., “The Federal Reserve Racial and Economic Equity Act”), among other responsibilities, would take the central bank far beyond what Greenspan saw as its core mission.

The Limits of Monetary Policy

Greenspan clearly recognized that monetary policy is a blunt tool for achieving long-run economic growth, which depends on increasing real factors—such as labor, capital, and technology—as well safeguarding private property and the rule of law. Activist monetary policy may spur economic growth in the short run, but cannot do so in the long run. If it could, then all that need be done to increase the wealth of nations would be to drop money from helicopters. (See Dowd on helicopter money.)

Even though the Phillips curve has lost its shine, the rhetoric of a permanent tradeoff between inflation and unemployment is still heard, especially from so-called progressives and “modern monetary theorists.” Even the Fed acts as if it can use monetary policy to push employment to its optimum rate—that is, to attain the so-called natural rate of unemployment. Not much is said about the negative impact of high taxes, government bloat, minimum wages, unions, regulations, and certain welfare programs on labor markets and employment. Some politicians seem to think the Fed has a magic wand to create jobs and real economic growth.

Greenspan was under no such illusion. He criticized the view that excessive money growth alone could permanently expand output and employment. But he understood that there were still those who held the view that central banks have the power to create new wealth out of thin air, simply by printing more money. In his words, “With regard to monetary policy, the view—or at least the suspicion—still persists in some quarters that an activist, expansionary policy could yield dividends in terms of permanently higher output and employment.”

In thinking about the limits of monetary policy, Greenspan was frank about the knowledge problem facing central bankers:

[There is no] bound volume of immutable instructions on my desk on how effectively to implement policy to achieve our goals of maximum employment, sustainable economic growth, and price stability. Instead, we have to deal with a dynamic, continuously evolving economy.… There is, regrettably, no simple model of the American economy that can effectively explain the levels of output, employment, and inflation. In principle, there may be some unbelievably complex set of equations that does that. But we have not been able to find them.

The complexity of the economic system precludes finding all the equations that would give perfect forecasts to guide Fed policymaking. The best we can do, argues Greenspan is to use “ad hoc partial models and intensive informative analysis to aid in evaluating economic developments and implementing policy.” But even here, the Fed’s forecasts of inflation and the real economy have been off the mark.

That is why Stanford economist John Taylor has long advocated a rules-based monetary regime. Likewise, Charles Plosser, former president of the Federal Reserve Bank of Philadelphia, has argued for placing limits on the central bank. In particular, he would narrow the Fed’s mandate to price stability, or at least make that the primary target; limit the Fed’s asset-acquisition activity to U.S. Treasuries; limit the Fed’s discretionary power “by requiring a systematic, rule-like approach” to policymaking; and limit the Fed’s authority to engage in credit allocation. Doing so, Plosser argues, would help maintain the Fed’s independence, improve policymaking, and promote accountability.

Central Bank Independence

Greenspan understood that the Fed is a creature of Congress and is ultimately responsible to it for maintaining whatever independence it has been delegated in implementing its mandates. However, he also recognized

that if the Federal Reserve’s monetary policy decisions were subject to Congressional or Presidential override, short-term political forces would soon dominate. The clear political preference for lower interest rates would unleash inflationary forces, inflicting severe damage on our economy.

Consequently, he emphasized that, “Our monetary policy independence is conditional on pursuing policies that are broadly acceptable to the American people and their representatives in the Congress.”

Foreseeing some of the issues written about by Paul Tucker in his book, Unelected Power: The Quest for Legitimacy in Central Banking and the Regulatory State, Greenspan warned: “It cannot be acceptable in a democratic society that a group of unelected individuals are vested with important responsibilities, without being open to full public scrutiny and accountability.”

Rules versus Discretion

Greenspan valued the classical gold standard, which was a rules-based regime that brought about long-run price stability and constrained the fiscal hand of government. But, in a fiat money world, he leaned more toward a discretionary central bank than one subject to rigid rules. He thought that once the velocity of money became less stable, changes in the money supply became less reliable in forecasting nominal income. Therefore, a simple monetary rule was no longer of interest to the Fed: “Unfortunately, money supply trends veered off path several years ago as a useful summary of the overall economy.”

Nevertheless, Greenspan did not totally disregard the quantity of money in thinking about the conduct of monetary policy. He went on to say, “Still, if money growth is better behaved, it would be helpful in the conduct of policy and in our communications with the Congress and the public.” Of course, if the Fed had actually implemented a Friedman-style money growth rule and stuck to it, the velocity of money may have been more stable, and the link between money and prices more predictable.

After Paul Volcker tamed the double-digit inflation of the late 1970s and early 1980s, by restricting excess growth of money and credit, monetarism lost its luster among Fed economists—due to financial innovations that weakened the link between money and prices. Yet, Greenspan did temporarily (and implicitly) follow a monetary rule in the form of targeting total demand, measured by “final sales to domestic purchasers” (i.e., nominal GDP adjusted for the change in private inventories less exports plus imports). As William Niskanen explains, “a demand rule is potentially superior to a money-supply rule because it accommodates unexpected changes in the demand for money.” He shows that from 1992 to 1998, the Greenspan Fed kept nominal income (i.e., total demand) on a level growth path of 5.5 percent per year. Sticking to such a rules-based monetary regime—by constraining the growth of nominal income (total spending)—would help reduce uncertainty about the course of monetary policy and the price level, bringing about greater economic and social harmony. (It is also said that Greenspan, for a time, followed the Taylor rule.)

Conclusion

Much can be learned by reflecting on Greenspan’s 1996 speech, especially given the global financial crisis of 2007–2009 and the current pandemic—both of which have increased the Fed’s power and weakened its independence. There is still no monetary rule to guide monetary policy, even as inflation has reared its head once more. What jumps out from Greenspan’s speech is how he posed a problem that the Fed never solved, and then made things worse.

The New Year will test the Fed’s resolve to taper QE, “normalize” interest rates, and slow inflation. With unprecedented fiscal deficits and debt, at least in peacetime, there is a strong need to redelineate the distinction between fiscal and monetary policy—and to recognize the limits of monetary policy. Asking the Fed to do “too much” risks further politicizing the central bank, with the consequent loss of credibility.

Although Greenspan never formally adopted a monetary rule, he certainly understood the knowledge problem facing central bankers. Perhaps he might be more open to a rules-based monetary policy today, if he were to reflect on Karl Brunner’s insights regarding rules versus discretion:

Our life moves in a grey zone of partial knowledge and partial ignorance. More particularly, the products emerging from our professional work reveal a wide range of diffuse uncertainty about the detailed response structure of the economy.… A nonactivist [rules-based] regime emerges under the circumstances … as the safest strategy. It does not assure us that economic fluctuations will be avoided. But it will assure us that monetary policymaking does not impose additional uncertainties … on the market place.