Alan Greenspan

English

Research Papers in Economics

In the spirit of this conference, I asked myself what developments
in the past 18 years—both in the economy and in the economics
profession—were most important in changing the way we at the
Federal Reserve have approached and implemented monetary policy.
The Federal Reserve System was created in 1913 to counter the
recurrent credit stringencies that frequently had been experienced in
earlier decades. As lender of last resort, we had a mandate that, at least
viewed from today’s perspective, was limited. We did not engage in
Systemwide open market operations until the 1920s. And as recently
as the 1950s, the framework within which those open market opera-
tions were formulated was still being developed. Credit was eased
when the economy weakened and tightened when inflation threat-
ened, but largely in an ad hoc manner. As a consequence, the Federal
Reserve was perceived by some as often accentuating, rather than
damping, cycles in prices and activity. Importantly, however, the
surge in prices that followed the removal of wage and price controls
after World War II and again after the Korean War kept monetary
policy makers wary of the threat of inflation.
But concern that the monetary restraint of the 1950s had led to
unnecessarily high unemployment persuaded the Federal Open
Alan Greenspan
Opening Remarks
1Market Committee (FOMC) to adopt a more stimulative policy
stance in the mid-1960s. Those actions appear to have been predi-
cated, in part, on an acceptance of the then-prevalent view that a
long-term tradeoff existed between inflation and unemployment.1
Subsequently, however, the experience of stagflation in the 1970s and
intellectual advances in understanding the importance of expecta-
tions—which built on the earlier work of Friedman and
Phelps—undermined the notion of a long-run tradeoff.2 Inflation
again became widely viewed as being detrimental to financial stability
and macroeconomic performance. And as the decade progressed, a
keener appreciation for the monetary roots of inflation emerged both
in the profession at large and at central banks. Indeed, the insights from
the work of Friedman and Schwartz a decade earlier gained greater
prominence in the realm of practical policy.3
These events, both economic and intellectual, significantly influ-
enced the tool kits employed by macroeconomists inside and outside
policymaking institutions. The large-scale macromodels that had
been the focus of so much work in the 1960s came under attack on
two fronts.
Most prominently, greater recognition of the importance of expec-
tations suggested those models, which for the most part incorporated
autoregressive expectations, were excessively reduced form and back-
ward looking in nature and, thus, insensitive to changes in economic
structure and the policy process. In addition, some researchers
observed that simple time-series models often produced better fore-
casts than the large macromodels of that period.4
One prescription was to focus on uncovering, at a more fundamen-
tal level, the structural parameters of the economy. Needless to say,
this task has proven to be a very tall order that has yet to be filled.
Partly in response to these difficulties, a substantial body of research
focused on improvements in empirical modeling, such as vector
autoregressions for forecasting and, in some cases, for policy analysis.
2 Alan Greenspan
 Each of these approaches has proven to be useful, and their descen-
dants currently are employed in various forms in central banks
throughout the world. But as of yet, none of these approaches is
capable of addressing the full range of policymakers’ needs.
At various points in time, some analysts have held out hope that a
single indicator variable—such as commodity prices, the yield curve,
nominal income, and of course, the monetary aggregates—could be
used to guide the conduct of monetary policy reliably. If it were the
case that an indicator variable or a relatively simple equation could
extract the essence of key economic relationships from an exceedingly
complex and dynamic real world, then broader issues of economic
causality could be set aside, and the tools of policy could be directed
at fostering a path for this variable consistent with the attainment of
the ultimate policy objective.
M1 was the focus of policy for a brief period in the late 1970s and
early 1980s. That episode proved key to breaking the inflation spiral
that had developed over the 1970s, but policymakers soon came to
question the viability over the longer haul of targeting the monetary
aggregates. The relationships of the monetary aggregates to income
and prices were eroded significantly over the course of the 1980s and
into the early 1990s by financial deregulation, innovation, and glob-
alization. For example, the previously stable relationship of M2 to
nominal gross domestic product and the opportunity cost of holding
M2 deposits underwent a major structural shift in the early 1990s
because of the increasing prevalence of competing forms of interme-
diation and financial instruments.
In the absence of a single variable, or at most a few, that can serve
as a reliable guide, policymakers have been forced to fall back on an
approach that entails the interpretation of the full range of economic
and financial data. Policy is implemented through nominal and,
implicitly, real short-term interest rates. However, reflecting the
progress in economic understanding, our actions are based on better
information about the pitfalls associated with relying on nominal
Opening Remarks 3
 interest rates to set policy and the important role played by inflation
expectations in gauging the stance of monetary policy.
Our appreciation of the importance of expectations also has shaped
our increasing transparency about policy actions and their rationale.
We have moved toward greater transparency at a “measured pace” in
part because we were concerned about potential feedback on the
policy process and about being misinterpreted—as indeed we were
from time to time. I do not intend this brief and necessarily incom-
plete review of events to illustrate how far we have come or to despair
of how far we have to go. Rather, I believe it demonstrates the
inevitable and ongoing uncertainty faced by policymakers.
Despite extensive efforts to capture and quantify what we perceive
as the key macroeconomic relationships, our knowledge about many
critical linkages is far from complete and, in all likelihood, will
remain so. Every model, no matter how detailed or how well-
conceived, designed, and implemented, is a vastly simplified
representation of the world, with all of the intricacies we experience
on a day-to-day basis. 
Formal models are a necessary, but not sufficient, system of analy-
sis. To be sure, models discipline forecasts by requiring, among many
restraints, that identities are indeed equal, inventories are non-nega-
tive, and marginal propensities to consume are positive. But we all
temper the outputs of our models. We test their results against the
ongoing evaluations of a whole array of observations that we do not
capture in either the data input or the structure of the models. We are
particularly sensitive to observations that appear inconsistent with the
causal relationships of our formal models. Tentative revisions of that
structure are reflected in our add factors.
Given our inevitably incomplete knowledge about key structural
aspects of an ever-changing economy and the sometimes asymmetric
costs or benefits of particular outcomes, the paradigm on which we
have settled has come to involve, at its core, crucial elements of risk
4 Alan Greenspan
 management. In this approach, a central bank needs to consider not
only the most likely future path for the economy, but also the distri-
bution of possible outcomes about that path. The decisionmakers then
need to reach a judgment about the probabilities, costs, and benefits
of various possible outcomes under alternative choices for policy.
The risk-management approach has gained greater traction as a
consequence of the step-up in globalization and the technological
changes of the 1990s, which found us adjusting to events without the
comfort of relevant history to guide us. Forecasts of change in the
global economic structure—for that is what we are now required to
construct—can usefully be described only in probabalistic terms. In
other words, point forecasts need to be supplemented by a clear under-
standing of the nature and magnitude of the risks that surround them.
In effect, we strive to construct a spectrum of forecasts from which,
at least conceptually, specific policy action is determined through the
tradeoffs implied by a loss-function. In the summer of 2003, for
example, the FOMC viewed as very small the probability that the
then-gradual decline in inflation would accelerate into a more conse-
quential deflation. But because the implications for the economy
were so dire should that scenario play out, we chose to counter it with
unusually low interest rates.
The product of a low-probability event and a potentially severe
outcome was judged a more serious threat to economic performance
than the higher inflation that might ensue in the more probable
scenario. Moreover, the risk of a sizable jump in inflation seemed
limited at the time, largely because increased productivity growth was
resulting in only modest advances in unit labor costs, and heightened
competition, driven by globalization, was limiting employers’ ability
to pass through those cost increases into prices. Given the potentially
severe consequences of deflation, the expected benefits of the unusual
policy action were judged to outweigh its expected costs.
Opening Remarks 5
 The structure of our economy will doubtless change in the years
ahead. In particular, our analysis of economic developments almost
surely will need to deal in greater detail with balance sheet considera-
tions than was the case in the earlier decades of the postwar period.
The determination of global economic activity in recent years has
been influenced importantly by capital gains on various types of assets
and the liabilities that finance them. Our forecasts and, hence, policy
are becoming increasingly driven by asset price changes.
The steep rise in the ratio of household net worth to disposable
income in the mid-1990s, after a half-century of stability, is a case in
point. Although the ratio fell with the collapse of equity prices in
2000, it has rebounded noticeably over the past couple of years,
reflecting the rise in the prices of equities and houses.
Whether the currently elevated level of the wealth-to-income ratio
will be sustained in the longer run remains to be seen. But, arguably,
the growing stability of the world economy over the past decade may
have encouraged investors to accept increasingly lower levels of
compensation for risk. They are exhibiting a seeming willingness to
project stability and commit over an ever more extended time horizon.
The lowered risk premiums—the apparent consequence of a long
period of economic stability—coupled with greater productivity
growth have propelled asset prices higher.5The rising prices of stocks,
bonds, and, more recently, homes have engendered a large increase in
the market value of claims, which, when converted to cash, are a
source of purchasing power. Financial intermediaries, of course,
routinely convert capital gains in stocks, bonds, and homes into cash
for businesses and households to facilitate purchase transactions.6
The conversions markedly have been facilitated by the financial inno-
vation that greatly has reduced the cost of such transactions.
Thus, this vast increase in the market value of asset claims is in part
the indirect result of investors accepting lower compensation for risk.
Such an increase in market value is too often viewed by market partici-
6 Alan Greenspan
 pants as structural and permanent. To some extent, those higher values
may be reflecting the increased flexibility and resilience of our economy.
But what they perceive as newly abundant liquidity readily can disap-
pear. Any onset of increased investor caution elevates risk premiums
and, as a consequence, lowers asset values and promotes the liquida-
tion of the debt that supported higher asset prices. This is the reason
that history has not dealt kindly with the aftermath of protracted
periods of low risk premiums.
Broad economic forces are continuously at work, shaping the envi-
ronment in which the Federal Reserve makes monetary policy. In
recent years, the U.S. economy has prospered notably from the
increase in productivity growth that began in the mid-1990s and the
enhanced competition engendered by globalization. Innovation,
spurred by competition, has nurtured the continual scrapping of old
technologies to make way for the new. Standards of living have risen
because depreciation and other cash flows generated by industries
employing older, increasingly obsolescent technologies have been
reinvested to finance newly produced capital assets that embody
cutting-edge technologies.
But there is also no doubt that this transition to the new high-tech
economy, of which expanding global trade is a part, is proving diffi-
cult for a segment of our workforce that interfaces day by day with
our rapidly changing capital stock. This difficulty is most evident in
the increased fear of job-skill obsolescence that has induced signifi-
cant numbers of our population to resist the competitive pressures
inherent in globalization from workers in the major newly emerging
market economies. It is important that these understandable fears be
addressed through education and training and not by restraining the
competitive forces that are so essential to overall rising standards of
living for the great majority of our population. A fear of the changes
necessary for economic progress is all too evident in the current
stymieing of international trade negotiations. Fear of change is also
reflected in a hesitancy to face up to the difficult choices that will be
required to resolve our looming fiscal problems.
Opening Remarks 7
 The developing protectionism regarding trade and our reluctance
to place fiscal policy on a more sustainable path are threatening what
may well be our most valued policy asset: the increased flexibility of
our economy, which has fostered our extraordinary resilience to
shocks. If we can maintain an adequate degree of flexibility, some of
America’s economic imbalances, most notably the large current
account deficit and the housing boom, can be rectified by adjust-
ments in prices, interest rates, and exchange rates rather than through
more-wrenching changes in output, incomes, and employment.
The more flexible an economy, the greater its ability to self-correct
in response to inevitable, often unanticipated, disturbances. That
process of correction limits the size and the consequences of cyclical
imbalances. Enhanced flexibility provides the advantage of allowing
the economy to adjust automatically, reducing the reliance on the
actions of monetary and other policymakers, which often have come
too late or been misguided.
In fact, the performance of the U.S. economy in recent years—
despite shocks that in the past would surely have produced marked
economic contraction—offers the clearest evidence that we have
benefited from an enhanced resilience and flexibility.
We weathered a decline on Oct. 19, 1987, of one-fifth of the
market value of U.S. equities with little evidence of subsequent
macroeconomic stress—an episode that provided an early hint that
adjustment dynamics might be changing. The credit crunch of the
early 1990s and the bursting of the stock market bubble in 2000 were
absorbed with the shallowest recessions in the post-World War II
period. And the economic fallout from the tragic events of Sept. 11,
2001, was limited by market forces, with severe economic weakness
evident for only a few weeks. Most recently, the flexibility of our
market-driven economy has allowed us, thus far, to weather reason-
ably well the steep rise in spot and futures prices for crude oil and
natural gas that we have experienced over the past two years.
8 Alan Greenspan
 This morning, I have tried to outline my perceptions of the key
developments that have influenced the conduct of monetary policy
over the past 18 years. I acknowledge that monetary policy itself has
been an important contributor to the decline in inflation and infla-
tion expectations over the past quarter-century. Indeed, the Federal
Reserve under Paul Volcker’s leadership starting in 1979 did the
heavy lifting against inflation. The major contribution of the Federal
Reserve to fashioning the events of the past decade or so, I believe,
was to recognize that the United States and global economies were
evolving in profound ways and to calibrate inflation-containing poli-
cies to gain most effectively from those changes.
For reasons that may not be too obscure, I will pay close attention
to, and hope to learn from, the deliberations of the next couple of
days. I have been asked to make a few closing remarks tomorrow
about some of the unresolved challenges facing policymakers in the
years ahead and about my experiences living inside the Federal
Reserve for nearly two decades, after so many years of observing our
institution from afar.
Opening Remarks 9
 Endnotes
1See Romer, Christina D., and David H. Romer, The Evolution of Economic
Understanding and Postwar Stabilization Policy, NBER working paper 9274,
October 2002, p. 39. 
2Friedman, Milton. "The Role of Monetary Policy," American Economic Review,
vol. 58, no. 1 (March 1968) pp. 1-17. Phelps, Edmund S. "The New Microeco-
nomics in Inflation and Unemployment Theory," American Economic Review (May
1969) pp. 147-160. 
3Milton Friedman, and Anna Jacobsen Schwartz. A Monetary History of the
United States, 1867-1960. (Princeton University Press, Princeton, NJ, 1963). 
4Sims, Christopher A. "Macroeconomics and Reality." Econometrics, vol. 48, no.
1 (January 1980), pp. 1-48. 
5Despite the two-year bear market following the stock market collapse of 2000,
equity prices have risen at an annual rate of 10 percent since 1995.
6Capital gains do not add to GDP. The higher prices of plants and equipment
and homes are reflected in an economy's cost structure, which directly or indirectly
increases prices of goods and services, leaving real output largely unaffected. Capital
gains, of course, cannot supply any of the saving required to finance gross domes-
tic investment.
10 Alan Greenspan
 

Opening remarks : the Greenspan era : lessons for the future

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Opening remarks : the Greenspan era : lessons for the future

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